Gold Long-Term: Nowhere To Go But Down

by: Nasser Khraishi

In my article relating to QE, I enumerated that at least $10 trillion were injected into respective economies through central bank actions in the US, England, Europe and Japan. If you are a gold bull and did the same math, you may be thinking $2000/ounce. Yet, I strongly argued in that article that prospects of hyper-inflation are little to none. The reason being that this money injection process is a highly-engineered operation, with multi central bank collusion, and with the money injected destined to return where it came from: Central Bank oblivion. As such, it is my belief that precious metals in general, and gold in particular, have nowhere to go but down. In this article I will try to expand on that point by looking into more aspects of gold pricing and not only QE related.

My arguments here relate to gold even though I believe the logic equally applies to other precious metals, and silver (NYSEARCA:SLV) in particular. Further, as far as I am personally concerned, trading gold has become synonym to the SPDR Gold Trust ETF (NYSEARCA:GLD). Hence, I will use that ETF symbol interchangeably with gold.

Gold has traditionally served two main purposes: as a currency -- directly or indirectly -- and for consumption. The direct use of gold as a currency has long ceased while the indirect use as a "currency guarantor" is usually mentioned in historic perspective. After all, few central banks, if any, pay much attention to gold reserves anymore. In the US, the gold-standard was abandoned in 1971 by Richard Nixon. Having said that, I would argue that, even though the perceived use as a currency is no longer with us, it did not totally die. Such use evolved into gold's global role as a hedge against inflation and political unrest. That is, gold became a global currency that you resort to when you do not trust sovereign ones.

The direct consumption of gold is either as an input into manufacturing or as jewelry. Use in manufacturing has largely ceased for gold, and in particular due to cost more so than utility. After all, precious metals do have superior thermal and electrical conductivity and act as excellent catalysts in many chemical reactions. The use as jewelry and the like, mainly in developing countries and in particular through the region from south to east Asia, remains as a major source of demand, and has actually improved with the rise of such economies. Albeit, such demand is clearly tied to the economic health of the respective economies, and hence currencies, especially as it relates to the US Dollar -- the currency in which gold is usually quoted on the exchanges.

The following chart describes GLD's rise prior to and after the Financial Crisis. It is clear that no one factor fully explains the pricing of gold during this era. The global economic expansion started in 2003, and was accelerating along with the global strife that ensued -- in Iraq, Afghanistan and other areas. As such, the initial rise in gold prices can be explained with gold's traditional role as a hedge against political strife and inflation. This appreciation in price accelerated a bit during the subprime crisis, as the US Dollar took a beating against other currencies, and as developing countries' economies experienced an enormous leap (see the GDP per capita for India and China). Then, during the Financial Crisis, gold took its own, though short-lived, beating, especially as the USD strengthened significantly in the initial aftermath of the crisis. Afterwards, as you can see from the chart, gold sparkled like no other time. After all, it became the only "currency" that a central bank cannot print trillions of, with a stroke of a pen or click of a mouse. This article attempts to explain the slide you see at the end of the chart and proposes a thesis for what is to follow.

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Let me start my argument by adding other circumstances that I believe contributed to gold's historic sparkle in the wake of the Financial Crisis. Traditionally, as inflation fears were stirred for a given currency or geography, people moved from one currency to another. Given the global scope of the Financial Crisis, and the "money printing" collusion -- call it QE -- between central banks, currency-hopping was not an option this time around. Further, equities traditionally serve as an anti-inflationary investment vehicle. Unfortunately, with the deep global recession that ensued, this option was also taken away from investors. As such, with the central banks' easing coinciding with the flight from equities, money found precious metals, and particularly gold, as its logical home. After all, this solved the problem of many money managers: why should I hold a near-zero yielding bond, from a money-printing country, when I can sleep better with my money in gold?

To explain why I believe gold prices are still heading south, let me start by repeating my belief that the inflationary fears due to the central banks money printing are unfounded. After all, Japan, the original manufacturer of quantitative easing, is still suffering from deflationary pressures more so than inflationary. Further, as I mentioned in the introduction, the trillions of "newly printed dollars" will not make it, at least not in the amounts printed, into the conventional economic cycle. This was strongly argued in my earlier article. Hence, I strongly believe that, over 2-3 years -- notwithstanding unexpected circumstances such as a new global recession -- interest and inflation rates will revert to historical means. In particular, for the USA, the declared target for inflation is 2%. Historically, 10-year treasuries yielded 1-3% above inflation. Given that target inflation can over/undershoot by 1%, you will get a range of 2-6% for the 10-year treasuries. I believe 3-5% is more realistic, and 4% is the expected mean. Actually, at today's inflation rate of 1%, one should reasonably expect 10-year treasuries to yield above 3%.

Further, as the record run in the equities market puts more pressure on owners of lower returning assets, then, unless a serious recession evolves, some of the side money, part of which is currently in gold, will eventually move into equities. Additionally, as fears of corporate default are significantly subsiding and as money managers are judged on relative returns, risk taking is finding its way into the investment community's psyche.

As such, the questions that will pose itself strongly for holders of large positions in gold relate to "opportunity cost" and "risk-return tradeoff."

For instance, for managers who would have held fixed income securities if they were not in gold, the question will be: how can I justify holding gold if a risk-free instrument, such as a 10-year treasury, is yielding 3-5%? Once it becomes clear that there is no reasonable chance of unusual levels of inflation, the follow up question would be: how much insurance am I willing to pay for inflation protection? I believe that there will be a comfort level violation for such money managers at around 3-4% yield on the 10-year treasuries.

For managers who would normally have held equities, the question will be: why am I fully on the sidelines when the stock market is yielding above 20% annually? That is, noting that the DJIA ETF (NYSEARCA:DIA) is yielding 2.24%, such managers will be under increasing pressure to explain this chart to their clients. Mind you, even the 5-year chart still shows equities as winning. Such managers can argue as much as they want that they have outperformed equities over a ten-year period, but they will still have to explain why they are still holding significant quantities of a negative-yielding asset, when the tide has clearly turned, years ago.

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Additionally, as the money printing eases and economic stability is gained, developed countries' currencies will grow stronger. The higher interest rate and stronger currency combination - in particular USD - has traditionally hurt developing countries' currencies, as we have seen recently when interest rates in the USA spiked due to taper talk. As much as that may contribute to trade imbalance in favor of these countries, in reality, gold will become more expensive in local currency. Hence, demand for jewelry by ordinary citizens should suffer. Thus, the other traditional pillar for supporting gold prices may become shaky. Do look at some of the economic patterns for some of these Asian countries (I use this site for that), and try to correlate with the USA.

For completion, more so than conviction, if I were to argue the bull's view, I would not subscribe to the inflationary scenario at the end of the global QEs. Instead, I would indicate that there is a chance of some recession. The current expansion has been going on since late Q2 2009, with the bust-boom cycle starting in early 2008. That is, unless the central banks play the cards very well, we may be due for another recession. Even though recessions are deflationary in nature, in the case of gold and in this new era of central-bank collusion and QEs, treasuries dropping below 3% will actually restore some of the sparkle of gold. Conversely, if the 10-year treasury yields do climb into the 5-6%, some inflationary fears may be reignited and gold can restore some of its diminishing shine.

I view these last two scenarios as academic, more so than highly probable. Hence, I do stick with my evaluation that over the next 2-3 years, gold prices will be significantly lower, percentage wise, than their current levels. As such, if I were a gold investor, I would use the up-cycles on this long zigzagging journey down to offload some of my holdings.

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.

Additional disclosure: I have not traded gold since January 2012 and have no intention to do so in the near future.