Gold And The Super Bubble

Includes: DGZ, GLD, GLL
by: Larry Trefz

Gold prices are largely a function of broader market uncertainty. This is evidenced by the low and steady gold prices (about $300-$500 per oz.) from the mid-1980s through mid-2000s. This time period correlated with the DJIA gaining about 1000% when much of the developed world experienced a long period of relative economic certainty (other than the dot-com bubble which did not cause major systemic risk).

Prior to this period of relative calm, gold prices experienced a massive spike to over $800 per oz. in the inflation scare of the late 1970s and early '80s. This spike was in response to extreme broad-market uncertainty where the Federal Reserve had considerable difficulty choking off skyrocketing inflation.

The current price of gold has risen from about $500 per oz. in 2005 to nearly $1,700, as of now. Some background needed as to what caused such great uncertainty that fueled this rise and whether this period of uncertainty is just beginning or almost over.

Modern currency (money) is little more than a unit of measure which is used to facilitate the exchange of goods and services. Currency is now almost all digital, this carries significant differences from past times when money was tied to a physical commodity such as gold, silver, copper or even paper.

The major central banks in the developed world have been doing unprecedented monetary easing (somewhat inaccurately called "printing money") since the 2008-09 financial crisis.

The Federal Reserve (U.S. Central Bank) is in charge of the monetary supply and is charged by Congress will a dual mandate: Price stability and full employment (generally considered around a 4% unemployment rate).

The U.S. Federal Reserves' dual mandate is unique to the U.S. The European Central Bank has a single mandate: Price stability (this would indicate that the ECB more concerned with controlling inflation than deflation).

Price stability relates to maintaining the currency as a stable unit of measure. The Fed's target is around 2% inflation per annum in an attempt to keep the economy growing.

The U.S. was the first to set up the modern version of a central bank in 1913. This was in response to the 1907 financial crisis where the stock market lost about half its value in a few days. JP Morgan personally came forward and started buying stocks hand over fist. This injected sufficient liquidity into the market which helped restore confidence and turned the crisis around.

Prior to this there was a major boom/bust cycle about every ten years. In 1893 there was a huge financial crisis. In the 19th century most of the boom/bust cycles were brought on by agricultural supply and demand imbalances. The farmers would have a good year and would plant more the next year and yet more the next, until there was an oversupply. Then the prices of the commodity would drop and the farmers, not understanding economics, would plant still more to try to make up for the lower prices (deflation) by producing more volume. This eventually would lead to a collapse in the commodity price, which in turn would cause a significant portion of the farmers to lose their farms. This reduced the supply of the commodity and then the price of the commodity would start to recover.

There was very little the government could do about these boom/bust cycles because the currency was tied to a commodity gold (NYSEARCA:GLD) of which there is only a limited quantity.

Now that the currency has been unpegged from a commodity it can be expanded and contacted at will by the central bank. The danger with too much expansion of the monetary supply is inflation. The danger with too much contraction of the monetary supply is deflation. These both describe a lack of price stability. The monetary supply can be expanded (example: buying bonds, mortgage backed securities, etc) or contracted (raising interest rates, selling bonds, mortgage backed securities, etc) at will by the central bank, literally at a keystroke.

As money has become digitalized (starting in about 1960s) the dangers of runaway inflation have become significantly reduced due to the control that the central banks have over the money supply.

The situation that the German Wiemar Republic faced after WWI was complicated by their lack of control over their money supply. They attempted to inflate their currency to diminish the debt burdens from WWI. Since they were using paper money (which is tangible, though not of any significant value in and of itself) it was easy to print the money (expand the monetary supply) but it was not possible to recall all that paper currency once inflation took off and the currency eventually collapsed as the authorities were unable to maintain its stability as a unit of measure.

The power of a stable digitalized currency has allowed the developed world to experience a boom cycle that started after WWII (partly as a response to the great depression) and ended with the housing crisis bubble bursting in 2007 which led to the credit freeze of 2008-09. This half-century boom cycle coordinated with the demographic tailwind of the baby boomer generation.

The relative absence of any serious bust cycle in that 50 year boom timeframe led to the creation of a super-bubble. The super-bubble is now in the danger of deflation (at the same time that the baby boomer generation is retiring at 10,000 per day). This potential bursting (a crash over a relatively short period of time) of the super-bubble, which started in 2008-2009 has the potential to lead to the biggest deflationary threat ever faced.

This deflationary threat is what the central banks are currently attempting to fight by adding huge amounts liquidity to the financial system. This causes imbalances and bubbles of its own. The biggest problem right now is that wages have experienced deflation while commodities and assets are being propped up by the Fed's monetary easing actions. This causes poorer people to struggle even more and seek government assistance, which further burdens the government's finances with debt and requires higher taxation, which in turn leads to a slower economy --.a potentially vicious cycle.

If the central banks were not practicing monetary easing to the extent that they currently are there is little doubt that the financial system and the current form of civilization would collapse and would need to be rebuilt. This scenario carries many unknowns.

Given the current track that the central banks are on, the U.S. and the world at large are likely to experience very slow growth over the next several years as the monetary and regulatory authorities attempt to tackle the deflation of the super-bubble in a manageable way.

Since gold is clearly affected by broad-market uncertainty and has historically responded most violently to an inflation spike (late-1970's) it is fair to assume that these factors will likely be the norm again.

Should the central banks succeed in gradually deflating the super-bubble and contain any rapid rise in interest rates, it is unlikely that gold would experience nearly the price appreciation that it could in the event of a rapid rise in rates.

Central banks have never had more control over economies than they do at this point. However, there has never been a super-bubble of this nature before. The are many unknowns and the list of things that could go wrong is long.

In the near-term, it is quite possible that gold will spike higher given that stock indexes are near all time highs and the housing bubble is being reinflated. However, at any sign of trouble the full fire-power of the coordinated central banks of the developed world will likely be brought to bear.

In the case a major gold spike, entering a short position in the ETF or purchasing a short gold ETN such as, (NYSEARCA:DGZ) or the double levered, short ETN, (NYSEARCA:GLL) (keep in mind that levered products are designed for very short-term use) could yield significant returns.

In the meantime, long positions in the GLD could be in favor as gold has been trading in a channel for over a year and when it breaks out the move could be significant.

Disclosure: I am long GLD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. I am long GLD via options.