The End Of The Gold Boom And Resurgence Of Deflation Fears

 |  Includes: GLD, QQQ, SPY
by: Ivan Mutaftchiev

In an article July 12, I forecasted the beginning of a bear market. The market averages have dropped over 10% since. The one safe-haven for investors has been gold - whether in its physical form (bullion) or as a security via the many ETFs tracking it, or even the shares of gold miners - gold has seen a meteoric rise over the past month, as the equity markets were getting crushed.

The fast and furious advance of gold of the last few weeks (14% in August) is also worrisome precisely because of its reach and intensity. Such a near-vertical rise is very similar to that of the NASDAQ (NASDAQ:QQQ) in 1999-2000 just before its peak. The last 3-4 days brought an even faster decline: Tuesday July 24, was the biggest one day decline since July 2010. All these symptoms lead me to believe that we may have just seen the peak of gold prices.

Why would gold peak now as the stock market seems more volatile and scary than at any other time since it bottomed in March 2009? After all, isn't gold a safe haven for investors to escape market volatility? The truth is that gold has never been a hedge for the stock market. For the past two and a half years gold (GLD) and the market have both been in an uptrend together, moving in lockstep. (See chart below.) In fact gold and the stock market have not had a divergence since the end of 2008. The reason the 2 assets diverged back in late 2008, early 2009, is important and deserves closer examination.

(Click chart to expand)
Gold vs. S&P 500Click to enlarge

At the end of 2008 gold reversed its downtrend and began climbing, while the S&P 500 (NYSEARCA:SPY) and the other market averages continued lower and did not bottom until March 2009. As the government took measures to save the US financial system via bailouts, TARP, zero interest rates and the like, it became clear that the Fed planned to inflate the money supply in a tremendous way. Any inflation raises the price of real assets like gold and in lesser way - stocks (which are backed by the assets of real companies). A few months later, as it became clear that the financial system had successfully rebooted, equities followed gold and began to climb. The important thing to note is that gold preceded equities in its recovery. The same phenomenon was observed again in July 2010, when gold and equities both declined, but gold recovered quickly while the stock market made a double low before rebounding.

Transferring this pattern to the recent events, had we seen gold continue to climb while the market was getting beaten down, it would have indicated a temporary correction in equities soon to be reversed. However this time instead of equities strengthening and re-joining gold, we saw the precious metal follow stocks into a correction. It is even more significant that gold is falling just as the market seems to have stabilized at these levels at least for the moment. Gold and equities, inflation bosom buddies for the last two and a half years, have apparently decoupled and this fact carries a major significance.

In normal markets inflation is not considered a positive factor for the economy. However as we almost slipped into a 1930s' style deflation 3 years ago, the Fed and the markets alike consider inflation as the lesser of the two evils by far. Recently, however with the end of QE2 and worries about banks in Italy, France and even fiscally-ironclad Germany, deflation fears have reemerged.

Gold, while a great store of value in an inflationary environment, is not a substitute for currency. When cash is scarce and the banking system is on the ropes (as they were in 2008,) gold becomes just another illiquid asset like real estate, art and the like and investors consider themselves lucky to be able to unload those illiquid assets even at half what they paid for them.

The recent correction in gold prices is likely a long-term peak and signifies the return of deflation worries as a major player. Fed chairman Ben Bernanke can provide a short-term solution by introducing QE3 and that will help. Long-term relief from deflation however, can only come with the stabilizing of the world's banking system and the resolving of the sovereign debt crisis.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.