The last decade has been a bonanza for investors smart or lucky enough to buy gold. From its April 2001 low of $256 an ounce, gold prices soared 640% to the September 2011 peak. While large U.S. stocks slogged through a lost decade, gold returned 21% a year.
Investor interest, long dormant since the age of the gold bugs in the late 1970s, was rekindled as the SPDR Gold Trust ETF (NYSEARCA:GLD) offered a cheap, liquid way to own this most coveted of metals. Even high-profile hedge funds jumped aboard.
But lately, gold’s winning streak appears to have stalled. As I write this, gold is sitting on its 200-day moving average and sells 14% below its all-time dollar price high of $1,895 an ounce.
Gold’s supporters remain steadfastly bullish. But some brave contrarians say the decade of gold is ending not with a bang, but a whimper. They even challenge the conventional wisdom that gold is destined to rise as long as central bankers keep printing money. If all that additional liquidity doesn’t turn into high inflation, why own gold at all?
Mark Williams raised those questions in an op-ed in the Financial Times last fall. He’s a former bank examiner and risk analyst who teaches at Boston University and wrote a book, Uncontrolled Risk, about the fall of Lehman Brothers.
“The last bull market for gold ended in 1980, when prices fell by 60%,” he wrote. “The bubble is popping again. This time, gold could drop to $700 an ounce, more than $1,000 below its peak.”
His reasoning? Economies and banks are slowly recovering from the crash and financial crisis. The Greek debt deal averted a major meltdown in Europe. And despite central banks’ alleged “moneyprinting,” we haven’t seen the inflation that has accompanied big runs by gold in the past.
“Gold is a hedge against inflation,” Williams told me in an interview. “You’ve seen a run up over the last decade and there’s no inflation to speak of.”
Technically, he’s right. From 2001 to 2011, the consumer price index rose on average 2.4% a year, and never topped 4% growth even in 2008, when oil and commodity prices soared briefly.
By contrast, the CPI rose by an average 7.9% annually during gold’s last great bull market from 1971 to 1980, and there were three years when inflation exceeded 10%.
Ah, ask the gold bulls, but won’t all the money the central banks issued to save the banking system eventually cause inflation, if not hyperinflation?
The Federal Reserve increased its balance sheet by $2 trillion in its various rounds of quantitative easing, which involved buying Treasuries and other government securities. That’s led to a similar increase in the reserves banks hold, which is why economist James Hamilton of UC San Diego wrote: "The Fed is creating reserves as opposed to printing money.”
“If you back out those excess reserves, you’re looking at a monetary growth rate at 3% to 4%,” said Professor John Tatom of Indiana State University.
Meanwhile, the velocity of money—the rate at which money circulates—has plunged to its lowest levels in half a century, indicating the money sitting in banks isn’t sloshing through the economy. That has offset most potential inflationary effects of the increased reserves.
The European Central Bank recently emulated the Fed, offering €1 trillion in three-year long-term refinancing operations (LTRO) to help repair European banks’ tattered balance sheets. Don’t expect those banks to start lending a lot of money soon, either, as they and their US counterparts must hold more on their books to comply with tough new capital requirements.
The Fed’s mixed signals on initiating another round of QE also have spooked gold investors. In the wake of QE2, GLD soared more than 50%, vastly outperforming stocks.
But since the market bottomed last October 3, the Dow has rallied 24%, the S&P has advanced 27%, and the Nasdaq Composite has surged 30%. GLD has done literally nothing.
If the trend continues, this might suggest a scenario of slowly recovering global economies, gradual deleveraging, and little inflation in the real world—plus a firmer dollar. All in all, it would be a recipe for higher share prices but continued weakness for gold.
That’s where Williams says the ETFs could have problems. GLD alone has attracted more than $70 billion in assets, so it has become the vehicle of choice for investors to own gold.
Hedge-fund titans who bought GLD with great fanfare a couple of years ago have lightened up. George Soros sold nearly all his GLD holdings last year, though he has bought some back, presumably at lower prices.
John Paulson, who had a rough year in 2011, has pared his big holdings in GLD, while hedge funds run by Steven Cohen, Jeff Vinik, Eric Mindich, and Paul Tudor Jones also cut back, according to Bloomberg.
But Williams worries about what retail investors would do if gold takes a tumble.
“These gold ETFs haven’t been bear-market tested. What will happen when these investors exit?” he asked. “They tend to vote with their feet very quickly.”
And gold’s biggest fans are deeply attached to it. “Gold is one of those emotional asset classes,” Williams told me. “These folks are fanatics about gold. There’s a class of investors who are into gold because it’s a religion, a cult, a political statement.”
I remember when people just loved stocks in the late 1990s. If you dared question the valuation of Cisco Systems (NASDAQ:CSCO) or JDS Uniphase (NASDAQ:JDSU) back then, they were ready to burn you at the stake.
Now, unfortunately, the true believers in gold have gotten their investment decisions all wrapped up with their politics and their fears for the future.
But what if, just what if, the U.S. and world economy are on the mend in ways we can’t fully appreciate now? What if, for instance, circumstances evolve where we can actually reduce the deficit? Likely? No. Possible? Certainly.
We didn’t foresee the transformation in Asia in 1997-1998, nor did people grasp the sea change coming when Jimmy Carter appointed Paul Volcker as Fed chairman and Ronald Reagan was subsequently elected president.
Volcker’s monetary policy, plus the lower taxes and change in direction brought about by President Reagan, broke the back of inflation and set the stage for renewed prosperity and an 18-year stock market boom. They also killed the last bull market in gold, which suffered through a lost two decades until its revival in 2001.
I don’t know if this gold bull market is coming to an end now. I still own a small position in GLD, and I’m not selling. But those of you who have 40% to 50% of your portfolios in gold and silver might want to take some profits.
As Williams puts it: “You should never marry or fall in love with your investment”—even if you can turn it into a band of gold.