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Pinpointing Gold’s Peak and Disregarding Noise

|Includes: SPDR Gold Trust ETF (GLD), PHYS, SPY

 As gold hits new nominal records (again), we at find ourselves consistently defending our thought process to bulls and bears alike. The resurgence of gold has brought about a new and interesting conversation that now broaches the topic of alternative currencies and gold as real money—a topic once thought too taboo to bandy about in normal conversation. But still, gold as an investment remains a polarizing proposition—some believe that gold is in a massive bubble, and some believe that the bull market is just beginning to stretch its legs.

The Financial Times Lex Column, bearish on gold since 2007, has issued a new missive—this time an attempt to warn its readers that the stampede out of gold will be faster and more lively than the stampede in. 

Gold’s relentless ascent may continue -- a wonderful investment opportunitystemming from the spreading loss of faith in fiat money. Or the fourfold price rise in seven years may be the result of fearful and naive buyers putting their faith in a barbarous relic.
That faith could eventually be crushed, bringing hefty losses (as happened 31 years ago).
These clashing world views were displayed last month in the U.S. Congress. Representative Ron Paul, hard money advocate and the Tea Party’s favourite intellectual, asked Federal Reserve chief Ben Bernanke whether gold is money. Told “no,” Mr. Paul asked why central banks held so much of it. The answer: “It’s tradition.” That tradition is not dead; the Bank of Korea just made a small purchase of the yellow metal.
…One classic warning of a peak -- a rush of what professionals call dumb money -- is already evident. Look at iShares’ gold trust, which holds 12 million ounces. It has seen a disproportionate rise in small buyers: the number of accounts with fewer than 1,000 shares (100 ounces) has trebled in the past year while large ones have barely budged. Morgan Stanley expects global exchange-traded product holdings of gold to exceed 2,700 tonnes by 2012, more than Italy, the fourth largest government holder.
The rush for the exits, whenever it comes, will be lively.

What Lex ignores is that we have yet to see a rush for the entrance. Fiat currency is still gospel around the world, and central banks and politicians are still clinging to the sad notion that fiat currency is as good as gold.

The trend, as Lex highlights, is that emerging markets like South Korea are beginning to use their central banks to diversify their foreign exchange reserves. The Bank of Korea just announced today that they had bought gold for the first time in 13 years—nearly tripling their reserves. China, in secret, has nearly doubled its gold holdings, from 600 to 1,054 tons—all in just 5 years. Central banks in aggregate have transitioned, after 20 years of dumping gold, into net buyers—a trend that won’t reverse as long as fiat currencies draw skepticism.

If the “dumb money” indicators usually work fairly well, why should it be different for gold? “Dumb money” investors are the people that use currency on daily basis. When the general populace begins to learn about the truth behind what the government has done with their money, that will be the point when the real stampede into gold has begun.

The current price of gold is still 35% below its inflation-adjusted peak, and when you use ShadowStats Alternate CPI, which tracks prices the way that we did before the Boskin Commission, gold needs to rise 434% to catch up to the growth of prices.

We don’t disagree that gold will eventually find its way into a speculative bubble—it’s nowhere near that level yet.