As usual, precious metals markets have received plenty of attention recently. While many market prognosticators are calling for an end to the gold “bubble,” we believe that we are still in the early stages of the bull market in gold due to overwhelmingly bullish fundamentals.
The following chart shows the price of gold in yellow against the size of the Fed’s balance sheet in red since the year 2000. The chart has been normalized for percentage.
(Click charts to expand)
The reason the Fed’s balance sheet is an important metric to track against the price of gold is that as the Fed’s balance sheet grows, the likelihood of the US government monetizing its debt (aka printing dollars to pay back debt) increases. Throughout the history of time, any government that has been as indebted as the US currently is has had to finance the debt by printing money, at least in part. Obviously, creating money out of thin air to pay back debts is a highly inflationary and currency debasing activity. The gold market is reacting to the increased likelihood of such an event before its actual occurrence.
As can be seen, the price of gold has risen 375% since 2000, while the Fed’s balance sheet has increased 354%. When viewing the price of gold in this context, it is very difficult to claim that gold is in any sort of bubble. As investors lose confidence in the government’s ability to make interest and principal payments on our debt, they increasingly turn to gold as a store of value. While gold has no industrial or commercial use outside of jewelry, it has been a store of wealth for thousands of years, and today’s environment is no different. While it may be “irrational” to own gold under the premise that it does not pay any yield and it does not have industrial demand to support its price, gold’s status as an alternative to paper currency is so unquestioned that central banks hold massive amounts of it,and emerging market central banks are buying more.
To further illustrate gold’s relationship to government debt levels, the following chart shows gold in yellow and total US public debt outstanding in white.
As can be seen, while gold may appear to be rising parabolically, so is US public debt. This incredible increase in public debt means that inflation is becoming more and more likely.
An argument I have also been hearing frequently of late is that gold is “overvalued.” My question is, compared to what? While stocks have some very loose boundaries as to valuation (i.e. there are usually far fewer willing buyers of a stock at a 100 P/E than a 10 P/E), gold has no such ceiling. Furthermore, when a commodity such as crude oil rises too much, consumers use less; this phenomenon is known as demand destruction. However, since all of the demand for gold is investment demand, demand for gold will not decrease solely because it has gone up in price. In fact, it may actually increase at some point as momentum gains behind the price of gold and investors late to the party pile in.
In this manner, precious metals (and commodities as an asset class on some level) are a momentum trade. As long as governments remain fiscally irresponsible and over-indebted, precious metals will continue to rise in price. As there is no way to know exactly how inflationary these steps will be, and when inflation will peak, putting a price target on gold and silver is an exercise in futility. The only aspect of precious metals prices an analyst can place a reasonable probability on is direction, not price.
Viewing the same argument from the reverse angle, if an investor expected a recession or deflation in the near future, the sale of gold would be a highly favorable strategy. However, with the renowned willingness of central bankers around the world (most notably Ben Bernanke) to print money at the slightest hint of deflation, our view remains that the risk is to the side of inflation and not deflation.
Additional Disclosure: All information included herein is the opinion of the firm and should not be considered investment advice. Past performance is not necessarily indicative of future results.