Gold Might Be A Good Trade, But It's A Poor Investment

Includes: GDX, GLD
by: Don Joe

Not many things are certain nowadays. This is usually the type of environment that gold thrives in, and it has certainly been thriving for the past decade. However, after last summer's blow-off peak, gold prices have been in consolidation for over a year. So what's next for the precious yellow metal? A glance at the charts seems to indicate gold is ready for a break out. With the global economy showing signs of weakness and reports of George Soros and John Paulson increasing their bullish bets on gold, going long may seem like the obvious answer, but there are reasons to remain cautious.GLD Gold ETF experienced a blow-off peak followed by a year of consolidationClick to enlarge

One of the main arguments for owning gold is that it provides a hedge against inflation. It is often heard that high inflation is just around the corner. The Fed balance sheet or the actions taken by central banks from around the globe are regularly cited as supporting evidence.

While the future is unknown, we can examine the bond market's expectations for future inflation by the difference in yield between Treasury Inflation-Protected Securities, or TIPS, and regular Treasuries.

TIPS Spread

year5 %1.90
year7 %2.08
year10 %2.25
year20 %2.33
year30 %2.32
Click to enlarge

With the TIPS spread roughly in line with the Feds inflation target of 2%, one cannot deduce that inflation fears are present in the bond market. The following indices also provide evidence that inflation remains low.Inflation remains low.Click to enlarge

Another argument that is often made for owning gold is that it also does well in deflationary environments. After 30 years of disinflation, many are worried the trend may be turning to deflation. However, with the Fed committed to avoiding deflation, and inflation roughly in line with their target, one cannot convincingly say we are currently in a period of deflation. That is not to say deflationary headwinds are nonexistent, but for the time being, the pressures of de-leveraging and demographic issues appear to be effectively counteracted by Fed policy.

Click to enlarge

What can other financial markets tell us about the direction of gold? Gold typically performs best against a backdrop comprised of a falling dollar and falling stocks. While the dollar has been falling for roughly a decade, there are some signs that the downtrend may be weakening or reversing. At the same time, stocks have been climbing for the past three years. However, if the economy begins to falter, as many people fear it will, this will send stocks tumbling and could prompt more Fed action, which will be bearish for the dollar. This type of environment could send gold back up to its highs.

Gold stocks tend to be a leading or coincident indicator for gold prices. The correlation between the two can be seen in the following chart:

Gold stocks have begun to under-perform gold prices.Click to enlarge

However, while gold prices have been in a consolidation pattern for the past year with a firm horizontal support line, gold miners have continued to set new lows.

Gold (<a href=Click to enlargeExamining gold against other precious metals may also prove useful. Gold has firmly held above support while both silver and platinum have showed relative weakness. Even more disconcerting is the fact that gold is currently valued higher than platinum. Typically gold has a difficult time maintaining a higher price than platinum for the following reasons: platinum is rarer, it is more expensive to mine, and a greater amount of it is used for industrial purposes. In fact, the last time gold remained above platinum was in the early '80s in the midst of a gold bubble. In hindsight, it is easy to see that gold was clearly overvalued during this period. The rationale at the time stated that inflation was high and people were shunning paper assets after a decade of poor real returns for both bonds and stocks.

Today's situation may sound very different than the early '80s, but there are similarities. The economy is in a period of crisis and there is little enthusiasm for stocks after a flat decade. In 1980 gold was coveted for its ability to hold up against high inflation. Today, while inflation is low, real yields are in negative territory which means this remains a valid reason to hold gold, as bond yields are failing to keep up with inflation. The confluence of all these justifications for holding gold along with fear, irrational or herd-like behavior, and inability to predict the future can cause gold prices to overshoot to the upside.

While gold appears to be overvalued, that does not mean it cannot go higher or stay overvalued for a prolonged period of time. Gold bears should remember the old Keynes quote, "The market can remain irrational longer than you can remain solvent." Gold bulls have other things to consider. Prices may go higher in the short or medium term, but it is difficult to recommend buying any asset near the top of such a tremendous bull run. Over the long term, as the economy begins heal and fear subsides, gold will likely prove to be a poor investment.

To confirm a solid upward movement in gold (short to medium term), close attention should be paid to silver, platinum and gold mining stocks. A reversal of the downtrends of these three assets would be a positive sign for higher gold prices. This may coincide with one or more of the following: weakness in stocks and the dollar, an economic downturn, or central bank action. In the absence of the above events, gold will likely continue to stay in a trading range or fade slowly downwards.

It is important to remember why one buys gold and what time horizon should be considered. Gold can add value to a portfolio because of its inverse correlation to stocks and the dollar and its property as a hedge against crisis. On the other hand, the fact remains that it has no yield. With 100% of gold's returns coming from price movements, it is bought for completely speculative reasons in the short term. Over the long term, its returns are typically lower than both bonds and stocks. This proves especially true if you are unlucky enough to purchase it during a peak. Remember, the price of gold fell roughly 75% over 19 years after its 1980 peak.

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