The most recent issue of Barron’s contains a negative article on gold, warning that the metal could fall as much as a third from its current level. The article’s argument is encapsulated in its description in the paper’s index:
“Gold Loses Some Glitter: Was that the sound of the yellow metal’s bubble popping?”
The essential thrust is that the extremely rapid rise in gold is typical of a bubble and that bubbles always correct dramatically.
Now, there may be reasons for a bearish view on gold, but this article doesn’t express them convincingly. Indeed, from a contrarian point of view, the fact that so many articles in the news continue to talk about gold as a bubble is a much more bullish indicator than bearish.
Of course, with this summer’s especially dramatic run up in gold to a new all-time high we have not surprisingly encountered an increasing amount of what might be termed “bubble talk,” and we have commented on it before. Our view has not changed:
A good definition of a bubble is an explosive increase in the price of an asset that cannot be justified by underlying fundamentals.
Gold, to be sure, has certainly been on a tear. Since its bottom in August 1999 the metal has risen more than seven-fold. What’s more, since its more recent bottom in 2008 gold has climbed more than two and a half-fold. No one would argue that these are not major, and even explosive, gains. But such gains are hardly unprecedented and by themselves are predictive of nothing.
For example, between late 1998 and late 1999 the OTC market climbed more than two and a half fold – in about one-third of the time it took gold to make the comparable recent move. And from that point in late 1999 the OTC rose another 50 percent in less than a year. Moreover, there are loads of individual stocks that did much better than the OTC market.
So for starters, though the rise in gold might be called explosive, parabolic, you pick the term, there are many other assets that have climbed even faster and then continued to climb much further.
The point here is that the slope of the curve does not define a bubble. The bubble in the OTC stocks (which was true bubble) burst because the earnings underlying the stocks in the index disappointed. In many cases, projections of 20 or 30 percent long-term annual gains turned into little or no gains, and in a lot of cases outright losses. In other words, the bubble burst – as bubbles always do – when the underlying fundamentals no longer supported the gains.
What are the fundamentals that have been supporting gold recently and have supported it in the past? In general terms, it is economic conditions that cause investors to lose faith in paper currencies.
The two types of economies in which the paper currencies lose their luster are inflationary and deflationary. In both cases the proverbial printing presses are working overtime and the world is deluged with paper money well in excess of the goods available or willing to be purchased. In the case of deflation it is an unwillingness to purchase no matter how much money is printed. Perhaps it is more exact to say an inability to purchase no matter how much money is being printed. In America, the massive amount of money being printed is, for a variety of reasons, not finding its way into the pockets of the potential spenders. In the case of inflation, it is a case of too much money chasing too few goods.
America today is an odd mixture of both deflation and inflation. We have experienced more than a decade of rising commodity prices, which has dramatically raised the cost of many of life’s essentials. In an economy driven by financial assets rather than real goods the rise in commodities has served as a heavy tax on that part of the economy that is not experiencing rising incomes, which amounts to about 90 percent of the economy. The average family income of the lower 90 percent of the U.S. is about $32,000. In a sense then, there is too much money chasing an ever scarcer supply of commodities, and too little money chasing products that are part of the American enterprise. Most Americans are getting poorer while commodity producers continue to get richer.
How can America get out of this mess? One way might be to create new industries and to bolster existing industries. Either way we will need to find new buyers for “made in America.”
Martin Feldstein in a recent article on Bloomberg.com argues that exports are the only way to save the U.S. economy, and that the only way to increase exports is to continue to debase the dollar. If the dollar, according to Feldstein, does not depreciate substantially, there is little hope for the American economy. But no matter how you slice it, a depreciating dollar is tantamount to printing more dollars – and relatively more than other countries are willing to print of their own currencies.
In the abstract, the plan makes sense until you realize that a big chunk of America’s trade deficit comes from its reliance on commodities. And it’s not just oil. The number of commodities for which America has to import over 50 percent of its needs has been growing steadily for more than a decade. We are relying on imports for an ever greater amount of our commodity needs as commodities themselves become ever scarcer. Given that many other countries are in a similar boat, for the U.S. to get the dollar cheap enough will require a dollar tsunami, which will likely be matched by tsunamis in other currencies. It is difficult under this scenario to not forecast massive inflation across the board.
Already there are signs that deflation is giving way to inflation. The most recent inflation numbers show the CPI rising at a 3.6 percent rate over the past year. This is well above the long-term yearly average and comes with unemployment at 9.1 percent and many measures of labor participation close to or at all-time lows.
History, at least relatively recent history, suggests that periods of deflation are followed by periods of inflation – not just commodity inflation but inflation across the board. As our chart shows, during the past 80 years the greatest inflation followed the deflation of the 1930s. Indeed, in 1947 inflation peaked at about 20 percent – and that was from the minus 10 percent reading during the 1930s. Of course, the cause of the inflation that followed the 1930s deflation was the Second World War. But we don’t think that is so different from today.
The bottom line is that without an export base, which is nearly impossible to achieve because of our dependence on a growing number of commodities at a time of increasing scarcity of critical commodities like oil, rare earths, iridium, etc., the U.S. dollar is likely to remain under pressure along with other developed currencies.
The downward thrust of the dollar will barely suffice to keep our standard of living from falling at an accelerated rate – never mind setting the stage for the creation of export industries. At a certain point, inflation is likely to break out on a wide basis. The implications for gold, scattered corrections notwithstanding, are that the yellow metal will be one of the only games in town. The much less liquid silver market and resource currencies, including the yuan, will also do fairly well.
The one long-term hope would be recognition of the problem and a massive effort – on a scale probably at least matching WWII in terms of man-power – to develop new sources of energy. Given the recent actions in Washington, we are not holding our breath.Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.