Why Gold Investments Will Shine

 |  Includes: GDX, GFI, GLD, GOLD, PHYS, RGLD
by: Tony Abbate, CFA

With world economies on the cusp of a downturn, I think gold related investments will do well as one of two scenarios unfolds. Scenario one involves continued money printing by the Federal Reserve as a measure to intervene and minimize the effect of deleveraging. The Federal Reserve has more than illustrated time and again they will intervene at all costs. From 1987 to 2007, whenever there was a crisis, they intervened by cutting interest rates. During the financial crisis in 2008 they tried cutting interest rates to almost zero and the economy and markets did not respond. Hence, they had to resort to about a dozen quantitative easing strategies which were facilitated by massive money printing.

I believe it is likely the Fed will continue to pursue irresponsible policies of printing endless amounts of dollars. I base this on the following three facts/statements:

In 2002, prior to becoming Fed Chairman, Ben Bernanke said the following which outlines his viewpoints on printing money:

The U.S. government has a technology, called a printing press (or today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at no cost.

On June 9th, 2010 at a House Budget Testimony session, Bernanke was quoted as saying:

“I don’t fully understand the movements in the price of gold.”

The startling fact, cited by David Rosenberg in his July 5th edition of Breakfast With Dave, is another reason why I think money printing will continue:

Since Ben Bernanke took over as Fed Chairman on February 1, 2006, over half the country’s money supply, since our country’s founding 234 years ago, has been created.

It is no wonder through the end of the 2nd quarter, the price of gold has increased by 119% since Bernanke took over as Fed Chairman on February 1, 2006. I think it is highly likely the Fed will continue to print more and more money to fight off deflationary pressures (i.e. try to create inflation) and minimize the economic problems associated with troubled sovereign and municipal governments and a weak economy.

A second potential scenario I see unfolding involves a political shift associated with the November elections. The U.S. government is running the largest budget deficits since World War II. The current budget deficit is 88 percent of Gross Domestic Product. As we saw last week at the G20 summit, the U.S. was the only nation pounding the table on a large deficit spending policy. All the other countries were pushing austerity measures. Based on primary election results, there seems to be a movement towards politicians who are running on a platform of reducing the budget deficits and implementing austerity measures. If this happens, this could be very damaging to the economy and push it into a ‘double dip’.

The odds are high that austerity measures would create significant economic weakness. Two Harvard Professors, Alberto Alesina and Silvia Ardagna studied 107 situations where austerity measures were implemented in OECD countries between 1970 and 2007. In 27 cases, or 25 percent of the time, economic growth was able to coexist with austerity measures. In the other 75 percent of the time, austerity measures created economic weakness. Regardless of which scenario unfolds, historically gold has done well in an inflationary, money printing environment (1970s and early 1980s) and in a deleveraging, deflationary environment (i.e. 1930s).

The easiest way to participate in the probable appreciation of gold is via the Gold Miners ETF (NYSEARCA:GDX), the SPDR Gold Trust ETF (NYSEARCA:GLD) or the Sprott Physical Gold Trust (NYSEARCA:PHYS). I have opted for the mining companies because they have underperformed the metal over the past 10 years. I expect the miners to outperform the bullion given the fact that the cost of production of gold is about $500 per ounce and every dollar increase should benefit the miners due to favorable operating leverage. I own Randgold Resources (NASDAQ:GOLD), Royal Gold (NASDAQ:RGLD) and Gold Fields (NYSE:GFI) for myself and our clients.

On June 30, gold closed the quarter at $1,245.90 per ounce. On an inflation adjusted basis, this is just over half its inflation adjusted high of $2,310 per ounce achieved in 1980. I think as one of the above scenarios unfold, gold will appreciate towards its inflation adjusted all-time high over the next 5 to 10 years and gold related investments should perform well.

Disclosure: The author and Granite Value Capital's clients are long RGLD, GFI and GOLD.