Why Gold And Silver Prices Are Not Headed For The Stratosphere

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 |  Includes: GLD, SLV
by: Mark Bern, CFA

By Mark Bern, CPA CFA

A little background

Most analysts and investors are in one of three camps:

1. Rising inflation is expected at some point in the not-too-distant future.

2. The Federal Reserve (Fed) has everything under control; economic growth will continue.

3. The biggest risk on the immediate horizon is deflation.

I was in the first group from the beginning of the financial crisis (Great Recession) until mid-2010. At that point, I questioned whether the Fed could create inflation, because it seemed to be trying hard to do so and not getting anywhere. The US dollar was weakening, but inflation wasn't showing up to the extent expected because demand growth was tepid due to slower-than-usual job and wage growth during a recovery. Without growth in household income, inflation has remained tame. Thus, I moved to the second group.

But late in 2012, something happened that changed my view once again. I found that I could make a strong argument for an expectation for either inflation or deflation. That is when I suspended my writing and began to do some more basic research to identify the most likely outcome for the intermediate future. After all, the answer was extremely important to my investing thesis and what I could recommend in my articles. I just couldn't feel comfortable taking a position and recommending it unless I could do so with greater conviction.

My assumption was that nothing spectacular was likely to happen, one way or the other, unless there was a major trigger event, because equities were not behaving rationally, but were being guided primarily by Fed policy, which appeared unlikely to change until the second half of 2013 at the earliest. That date was then moved forward to 2014 through communications by the Fed Chairman and supported by notes from subsequent meetings of the Federal Open Market Committee [FOMC].

I have been looking for the "best" answer for nearly a year now, and I have finally come to the conclusion that the most likely scenario lies in expectations held by the third group. How I arrived at that conclusion and much of my argument is an interesting story that can be found in a series of a few short postings on my blog for those who are interested in the argument that supports a coming deflationary period. That is not to say that I don't expect inflation at all; rather, that I am convinced that no severe inflation will occur until after a deflationary period.

Gold and Silver

Now, let's move on to the argument about Gold and Silver prices. Precious metals generally make good investments in two types of economic environments: highly inflationary or major crisis (creating pervasive uncertainty throughout the financial and investment sectors of the economy). Let's look at those arguments and the likelihood of either coming to fruition.

Crisis?

I will begin with the major crisis scenario first. I can't deny that a major crisis could happen, but the one that most people fear the most is a meltdown of the global financial system, similar to what almost happened in 2008. The Fed, Central Banks and Governments around the world have already proven their willingness to do "whatever it takes" to keep the large, money center banks from failing in order to prevent a massive financial crisis. I do realize that it would be more difficult this time around, but banks have taken significant steps toward shoring up their balance sheets and are in much better condition than before. There is still much risk in European banks, since far too much of their capital is invested in sovereign debt, but the Fed will work in tandem with the European Central Bank [ECB] to minimize the damage. Liquidity will be made available; of that I am certain.

There is a significant risk of another sell-off in equities, but I don't expect a flash crash scenario, because the Central Banks and their accomplices, the large, money-center banks, will intervene to prevent such an occurrence, since the big banks have too much exposure to equities through their trading operations. It is far more likely that we will experience a slow, grinding bear market, and that all the financial pundits will continually tell us that the "correction" is healthy and will be over soon for months and months. Precious metals prices will likely respond by rising at first, but then, when it becomes obvious that deflation is setting in instead of inflation, those prices are far more likely to reverse and begin to fall along with equities. I will provide reference as to why that will happen below in my discussion of the inflation scenario near the end of this article.

Inflation?

The Fed has aggressively attempted to devalue the US dollar through inflation. (I used this argument in an earlier article dated November 15, 2010, in which I predicted a top in silver of $50 and which accumulated a great thread of comments and discussion.) The problem is that the Fed has had little success even while adding $85 billion to its balance sheet each month (nearly $1 Trillion per year of the digital equivalent of printing money) since it initiated its fourth quantitative easing [QE] program, often referred to as QE-Infinity.

Add to that the staggering deficits piled up by the U.S. Federal Government since 2008, averaging more than $1 trillion per year, and the efforts to create inflation have been monumental. I won't go into the details about all the different efforts by the Administration, Congress and the Fed to kick start our economy, since there already exists a myriad of articles that do so right here on Seeking Alpha. The problem is that the economy is still stuck in first gear, and inflation remains very low. My point here is simple: the Fed can't create inflation as easily as expected. The velocity of money is falling, and the Fed seems far more impotent than investors assumed. If inflation were coming in a big way, it would be here already, in my opinion.

The effectiveness of Fed policy is waning, and it is now considering tapering its QE program. The first such announcement of a potential policy change sent shock waves throughout the financial sector. Even the hint that such a change is actually going to become reality has shaken some of the irrationality out of the equities market. A good example of this is stress visited upon equities as measured by the Hindenburg Omen [HO] indicator. In the last eight trading sessions, the HO has issued a signal no less than six times! This may be the largest cluster in such a short time span ever issued. The only other two signals that contained a large cluster in such a short period happened in early 2000 and late 2007. The HO is not perfect, but it has gotten my attention. A great blog series tracking the HO, written by Seeking Alpha contributor Albertarocks, can be found here.

What seems to be going on within the market is that stocks are beginning to move more independently as they should in a rational market. For the last few years since the bottom was hit in March 2009, the majority of stocks have been moving more in unison than could be considered normal. Assuming that rationality is returning to equities, then earnings growth will become far more important than a mere beat of expectations.

Of those expecting inflation, many expect interest rates to rise to levels not seen since the early 1980s. I don't expect that to happen anytime soon either. Interest rates correlate highly with moves in inflation, with inflation usually leading the way. Inflation is remaining tame; thus, unless this situation changes, I do not foresee an imminent rise in interest rates either. Both short and long-term rates have been held artificially low by the Fed. The Fed controls short-term rates more directly than it does long-term rates through the discount rate. However, the Fed has been manipulating long-term rates lower through the purchase of mortgage-backed securities [MBS] and Treasury debt, thus creating an artificial demand and keeping rate bids lower than otherwise would be the case.

Normally, 10-year Treasuries will trade in a free market with about a two percent spread over expected long-term average inflation. That has not been the case with the Fed intervening with QE. The spread has narrowed significantly to less than one percent. If rates were allowed to trade freely, the rate would gravitate to between 3.5 and 4.5 percent. Rates did jump quickly upon the Fed's initial testing of the water statement about tapering, but have settled down a bit since and remain artificially low. Should the Fed allow rates to find the free market level, there could initially be a spike above the expected range, but bond arbitrage investors would get involved and bring the market back into equilibrium.

The Fed has everything under control?

As for scenario two, it is simply a continuation of kicking the can down the road and hoping that it becomes someone else's problem in the future. The problem with such tactics is that the problem keeps getting bigger and bigger until it can no longer be kicked. We are approaching that point more quickly than most could imagine. The Fed cannot continue to print new money without endangering its credibility as well as that of the U.S. Government in global markets. Bond buyers will only allow so much debt relative to GDP before they begin to demand a higher return to bear the ever-rising risk; notice what happened in Europe. Therefore, QE and excessive deficit spending can only be employed on a temporary basis before interest rates must be allowed to find "normal" levels again. When that happens, the federal deficit becomes a much larger problem as the cost of servicing the debt rises significantly. This cannot go on much longer before the wheels start to come off and the Fed understands this much. The more borrowing by the U.S. Treasury, the less capital there will be available to private borrowers to help expand the economy.

Deflation?

In order to conclude that deflation was the most probable scenario that we face, I went back to that place that has always served me so well; I began to look for answers in the baby boomer generation. Consumption patterns of the baby boomer generation have driven the U.S. economy for decades. In a nutshell, the boomers are entering a period of reduced consumption for two primary reasons:

1. Boomers' children are going to college and those tuition/housing bills are enormous.

2. Boomers are realizing that retirement is either upon them or close at hand.

The second reason listed above results in paying down debt, saving more and spending less. The first reason simply reduces the amount of disposable income available to spend. We have recently passed the crest of the spending curve in many categories for the majority of boomers. As the boomer generation reduces spending in a significant way, demand will shrink. This is what happened in Japan beginning in the early 1990s. It is a trend, not an event. We probably will not notice until we are well into the trend.

Finally, there is an argument floating around that says that a deflationary economic environment will result in price appreciation for precious metals. That thesis is debunked by this article. Written in 2009 by Gary North, the article also provides a very lucid argument supporting inflation. Obviously, I disagree with what Mr. North wrote in 2009, but it is a good read and should be considered as a strong voice from the other side of the debate. Mr. North did get one thing very right: precious metals prices will fall in a deflationary economic environment.

If you want a more detailed explanation of my reasoning supporting the coming deflationary period, please refer to my short blog series.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.