Sunday, January 25, 2009 4 comments ++[ CLICK TO COMMENT ]++

Did gold do well during the deflationary period in Japan? Doesn't look like it...

One of my potentially big macro bets this year (and beyond) is shorting gold. It's just an idea at this point, and I am likely early, but I don't find gold attractive. So, I've been researching and building my thesis. So far early indications are that gold is only worth shorting if it goes past $1000 to, say, $1500. I'm researching some theories I have and will post entries as I finalize them.

The first theory to test is if gold does indeed do poorly during deflationary periods. One of my reasons for considering a short of gold, apart from it doing so well in the last 10 years, is due to my belief that it isn't a good asset to own if we enter a long slump like the 30's and 40's. I'm not expecting a depression but I do think growth will be below potential (3% real growth is roughly the potential for USA.) Most of the world was on a gold standard during, or at least going into, the Great Depression. USA was also on the gold and silver standards during big chunk of the 1800's, including the late 1800's. More recently, USA was on a quasi-gold standard--US$ not redeemable in gold for Americans; but redeemable into gold for everyone else--until 1971 so it's difficult to read the situation during that period.

So I looked at Japan in the 90's to present, another famous deflationary period, to see how gold performed.






This chart is constructed by taking the gold price in US$ and adjusting it by the US$-Yen exchange rate. Ideally, one should just look at the market price of gold trading in Japan but I couldn't find data for that. My thought is that my method should roughly represent the actual Yen gold price in Japan (if we were in a pure free market it would, but given government restructions, arbitrage costs, etc, it may not.)

Before we look at the data, there are several things to keep in mind.

First of all, we are only looking at a single scenario which may or may not be reflective of future environments. Trying to form opinions based on one data point is dangerous but we have nothing else to look at since most of the developed world was on a gold standard or a quasi-gold standard until the 1970's (it wasn't a continuous gold standard but it was mostly a hard currency period, with silver standard being also popular in the distant past.)

Secondly, the BOJ intervened heavily during the 90's and 2000's to keep the Yen artificially down (to help Japanese exporters.) BOJ wasn't really successful but nevertheless, buying US$ and selling Yen would have had some impact, even if it was unpredictable. If anything, gold in terms of Yen should have risen due to the BOJ heavy buying of US$ during that period, yet that is not what we see.

I should also note that I'm plotting the average monthly prices, which isn't the same as the daily spot prices. I also estimated the December 2008 gold price from a different source since it wasn't available in the monthly series data I had.

Observations

Gold in Yen terms seems to have declined throughout the 90's. It also seems that gold in Yen declined more in the 90's (the gap between the US$ and Yen increases) so gold was not a good asset to hold in Japan at that time. Given how the BOJ was actually buying US$ and selling Yen (should be bullish for gold,) the decline in gold against the US$ gold leads me to conclude that gold was behaving poorly.

But it seems that gold in Yen terms is simply tracking gold in US$ terms. Gold in US$ hit a bubbly peak in 1980 and entered a 20 year bear market, and the gold in Yen was following a similar path. This either means that gold in Yen was being driven by the world gold price; or it means that gold was simply being driven by valuation and sentiment. If the latter point was the main reason, that is, gold in the 90's being driven by valuation and sentiment, then the decline in gold in Japan may not be due to deflation. The decline in the 90's in Japan could simply be due to the fact that gold was likely overvalued in 1980 and was in the process of correcting valuations.


So, overall, I have to say that this limited data implies that gold wasn't a good asset to own in Japan during the 90's. But the observations are inconclusive given how gold seemed to be largely impacted by the world--US$ gold and Yen gold tracked each other closely--than the deflation in Japan. The implication of all this--just based on one data point, mind you--is that, if one is going to short gold, they can't rely on the situation in USA alone. It is likely that gold is driven by the world price, which, in the last few decades, was largely dependent on the US but, in the future, it may or may not be influenced to the same degree by the US. Or, it is possible that gold is driven by valuation and not the actual economic scenario (i.e. if gold was undervalued now, it would rise regardless of what happens in the world.)

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4 Response to Did gold do well during the deflationary period in Japan? Doesn't look like it...

January 26, 2009 at 11:43 AM

you wouldn't by chance have a chart of gold vs the amount of $ that the fed pumps out?

that would be quite an interesting chart to see!

January 26, 2009 at 12:07 PM

Hi Jeff...

I was already working on that and it will be one of my posts in the future (thanks for the suggestion.) That's a key thing to look at, especially if you view gold as a quasi-currency rather than a commodity (which is my view.) If money supply increases gold should do well; and vice versa.

FedRes and other central banks have been injecting huge amounts into the economy but I don't think it's accurate, as some that are superbullish on gold do, to assume that the FedRes injections are inflationary. Some of the liquidity injections are really 'swaps', which need to be paid back by the banks. So it's not really equivalent to printing money. Furthermore, what matters is total money+credit in the system. Even if money supply increases, I wonder if it will be more than the credit contraction.

So, the answer to your question is not so obvious because defining the money supply is not easy. On the surface, one may think that gold should be 3x the current price given how the FedRes increased its balance sheet by 3x (it may actually be more given how they keep announcing things every month.) But measuring the combination of credit and money doesn't seem straightforward.

Also, believe it or not, the base money supply does not seem to be skyrocketing. Again, the definition is hard to pin down but we can look at several, including one measure by the Austrian Economists, True Money Supply. If you look at the year-over-year change, nothing much is happenning (plot yoy TMS, MZM, M1, and M2 and you'll see nothing on this chart.)

I'm a fan of an obscure gold investor, Paul van Eden, and his defintion of money supply is not skyrocketing either.

Mike Shedlock, a deflationist, addresses some of the inflation arguments.

The only way I see gold skyrocketing is if the FedRes prints huge quantities of money--and I mean far more than what they have done--and does not withdraw it from the system. I just don't see that happening...

January 28, 2009 at 12:53 AM

another way to look at gold in a deflationary environment is to look at gold mining stocks rather than just the gold as an investment. the costs of mining gold have already been seriously reduced (oil, labor, materials, ...). Unless the gold price pushes down significantly (which seems unlikely), the gold mining stocks will show much greater earnings due to much higher margins. physical gold better in inflation, gold stocks better in deflation.
kwr
bullinachinamarket.com

January 28, 2009 at 10:47 AM

Kevin: "another way to look at gold in a deflationary environment is to look at gold mining stocks rather than just the gold as an investment. the costs of mining gold have already been seriously reduced (oil, labor, materials, ...). Unless the gold price pushes down significantly (which seems unlikely), the gold mining stocks will show much greater earnings due to much higher margins."


Gold stocks should certainly do well for the reasons you cited. In fact, many of them are up significantly from their lows late last year. During the Great Depression, gold mining stocks did really well. So I think your idea is worth contemplating for those interested in gold.

But one, even if investing in mining stocks, still needs to make sure that the gold price doesn't collapse. From a contrarian point of view, gold stocks have done really well in the last decade so I'm doubtful of their merit for the future.

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