The Gold Trade: Prepare for the Plunge

I don’t think I’ve ever seen one trade or investment get as much attention as gold is getting right now. Well obviously gold is talked about when we discuss inflation, fear, currency devaluation, and the other pressing issues of the day. It was only a couple days ago when an investor I manage money for contacted me and asked my opinion of putting about 20% of his portfolio into the hard metal, that I was forced to really think through the position and why or why not it would make sense in today’s environment. Gold has had a stellar three-year run, doubling from around the 800 level and rising, in both the inflationary market we saw from 2008-2011 when oil rose over 100 a barrel, as well as in the current fear-filled market. European debt fears have seemingly more than replaced inflationary concerns, as hard and soft commodities have in many cases dropped nearly 40-50%.

Now most people look at the price of gold and see it at the 1800 level, which is double where the commodity was just about 2 years ago, and see the metal as an asset that has outperformed most asset classes including, the stock market, in a volatile tape - and seemingly continues to go up in every possible scenario. Besides the fact that gold is offered on TV, in vending machines, and is called by many, including CNBC’s Cramer, the world's “new currency”, it is also talked about as something than can win in almost scenario - kind of like the teflon metal. If inflation occurs gold wins because it's an effective hedge on the diminishing purchasing power of hard currencies. If deflation occurs fear will escalate and people will anticipate further stimulus and the risk of devaluation of countries’ currencies, so gold wins again. Now to be sure, I think we all understood why gold was going up when oil tripled from 30 to 90 on its way to 115 on the WTI contract, and other hard and soft commodities soared as everyone including the Fed and White House seemed to be fine with what clearly was a weak dollar policy designed to enhance our exports and inflate asset prices. Currencies were being devalued and inflationary costs were rising, perhaps even soaring. Gold traditionally does very well in an inflationary environment, although not as well as many of the commodities like oil that more than tripled during that time, or oil stocks, which also tripled and paid hefty dividends during that time. But now that the inflation story has died we are to believe that gold is the place to be, not because it's a hedge on currency devaluation but rather as the "fear trade": it’s the new currency and thus a place to hide from the latest crisis: The European Debt crisis.

I don’t accept that gold can continue to outperform in a clearly deflationary environment or that it's really a new currency and here’s why. First, historically, gold and oil have been very highly correlated since oil is often seen as an effective measure of inflation and gold is used as a way to hedge such fear of rising prices and diminishing purchasing power of the world's most held currencies. Second, if people really thought that gold was the new currency and had such little confidence in the dollar, why is the 10-year treasury getting more capital than ever and trading at levels not seen since the 1930s? Third, why has gold not soared at the rate the equity markets have dropped or the vix has risen during this latest crisis? No, something is amiss here. Sure, in the short-term the heavily elevated levels of fear reflected in the yields in the 10 and 30 year treasury and the vix may cause traders to spike gold prices, but longer-term it simply is not rational to believe that gold prices can continue to rise in a deflationary environment when major currencies are not seeing diminished purchasing power. The reality is that when gold is not moving on mere speculation but is moving up as an inflationary hedge (as it has historically for the decades we have data on the metal's movement), the decision to buy gold is really a decision to short the currency you are buying gold in. If the world's reserve currency, which is the most held currency by most governments and companies around the world, is no longer depreciating and is in fact rising against most major currencies, it seems odd to think that it has been replaced by a metal that is an inflationary hedge in an environment where commodity prices are plummeting.

In essence, to me you aren’t just buying gold, you are selling your currency and locking in its current purchasing power. If inflation occurs gold historically rises proportionally to the rate of inflation but little to no more. If deflation occurs and the currency you are effectively selling to buy gold appreciates against commodities and other currencies, you generally do not come out ahead. Once the speculative hype and extreme levels of short-term fear subside, just keeping that currency rather than buying gold could produce greater gains as you can keep your dollar in safe assets earning real returns while gold cannot be put in bond and money markets. I think this is also why most who have gold for decades have gotten around 5% a year, less than half the average 30 year return of stocks, and about on par with the average 10 year return of stocks over the last decade. Also, you have to presumably sell gold and accept a currency when you sell it - presumably the same currency you bought gold in. Therefore, while it may appear that gold is increasing rapidly, theoretically, gold should just be appreciating under normal circumstances at the rate at which inflation or the purchasing power of the dollar (the currency all major commodities are priced in worldwide) is diminishing once, again, the speculative element comes out of the trade.

The evidence is strong and I suspect will soon be repeated that gold, over the long-term (once speculation and fear are at normal levels), offers historical returns of 4-6% a year, fairly subpar compared to most asset classes, especially stocks. Even in the 1980s when gold hit its all-time highs adjusted for inflation, stocks generally outperformed gold over almost any 10 year span. I don't expect that to change simply because we have extreme levels of fear best shown by the vix rising nearly 40% this week to levels not seen since last summer, when it promptly dropped nearly 50% over the next several months. The dollar today is clearly no longer diminishing in purchasing power and has even gone to parity with the commodity or often inflation-leading currencies of both Canada and Australia. While talk of further stimulus is rampant and the recent debt ceiling bill clearly showed fiscal stimulus is dead, Bernanke has been similarly unwilling to expand upon the bond purchases and reinvestment of assets from selling those purchases in QE2.

The U.S., like most first world and emerging market economies, has shifted from promoting fiscal and monetary stimulus to a period of less spending and more limited forms of quantitative easing. Now if gold were truly the world's “new currency”, rather than the dollar, it certainly seems to be moving pretty modestly given the level of fear reflected in the vix, treasury yields, and the recent movement in equity markets. The fact that Bank of New York Mellon (BK) recently announced a special surcharge for new 50 million plus deposits by individuals to avoid massive FDIC charges to insure such large amounts suggests that much of the capital fleeing risk on assets or risky currencies is also finding its home in the good old greenback rather than the world's new currency. The 10 year bond is trading at the lowest yield since 1937 and the 30 year yield is trading at levels not seen since the Lehman levels days - both moves suggesting strong and robust demand for dollar denominated assets continues. All this tells me one thing, the dollar is still the reserve currency of the world and gold, while interesting in times of extreme fear, is still just another way to diversify your portfolio during times of fear and when inflationary risks are rising. The Bank of New York Mellon is taking dollar depositors, not gold ones, and the 10 and 30 year treasuries are futures contracts that give people the right to be paid in dollars, not gold. Now fear may continue to stay at elevated levels for some time and may even rise in the short term from today's levels, but remember, at some point the vix will stop going up 40% in a day and Europe won’t constantly seem on the verge of implosion. When current fear levels in the market diminish and governments reestablish at least basic levels of confidence, growth will likely still be slow to anemic, and inflationary fears will likely remain similarly tepid as well. What will people do with a commodity like gold at all-time highs when they look at oil likely in the 70s and a market down nearly 30% from its highs? A good note here is that the last time the vix was at these levels it dropped by nearly 50% over the next couple months, albeit in part because of QE2.

Now, to be sure, no one knows when the top will be, but I’d think sooner rather than later people will look to sell gold and move into traditionally higher returning assets like stocks and other industrial commodities that are largely near their lows while gold is at near all-time highs. While that move may not come in a couple weeks, I would strongly bet that it will result in a far bigger move downward than many of the moves up we've seen in this metal over the last year. As many people are already beginning to believe, as I do, that stocks and other commodities are moderately to significantly undervalued while gold is significantly to extremely overvalued, the move could be swift and severe.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in GLD over the next 72 hours.