Gold hits $1000 -- Third time lucky?
I guess any time one contemplates investing in gold, either taking a long position or a short one, we leave the value investing arena and move into the purely macro battleground. Many mistakenly think that you can compute the intrinsic value of gold--or commodities for that matter--whereas my opinion is that it cannot be done. It is nothing more than a speculative macro bet.
Gold surpassed $1000 for the third time within two years. In the prior two cases, it quickly fell back below $1000 and stayed there. Is this a bubble being formed? Or is it simply representing fair value based on the world economy?
One of my big bets this year was going to be shorting gold--likely through one of the inverse ETFs--so I have been trying to develop a bearish case. I know I said an year ago that I'm not going to be shorting anything ever again after my questionable experience shorting the TSX (which was a bearish bet on commodities.) I'm still uncertain but I think it may be something that is attractive given the investing climate. My goal this time around, if I do pursue this short, is to bet on a longer time frame and to only enter the position when price rises parabolically. Hedge funds and other speculators are clearly moving into gold but I would wait until it becomes a 'heads I win, tails I win' bet for them (kind of like how oil was such a bet for them early last year.)
National Post--Canada's equivalent to The Wall Street Journal but not as sophisticated--has an article written by Levi Folk touching on the bullish and bearish case for gold. It's a good article covering both sides and let me pull some of the key points.
(source: Gold next bubble, by Levi Folk, Financial Post. Published: Friday, February 20, 2009)
The Bull Case for Gold
Many top economic analysts believe that current monetary policy will be highly inflationary and that view has led to widespread purchases of gold. "Not only is there no modern precedent for this wholesale money printing," writes Jim Grant in Grant's Interest Rate Observer, "but, also, so far as we know, there is no theory."
There is a fixed supply of gold in the world, but money knows no bounds, and investors are now acutely aware that current central bank policies, especially in the United States, could be the forerunner to high inflation.
It used to be that the Fed would increase the money supply through purchases of U. S. government bonds. Money was the liability of the Fed and treasury securities were its asset. Those monetary operations have been abandoned for far more heterodox initiatives.
Not only has the Fed doubled its asset holdings on its balance sheet, thus expanding the money supply, but it has also reduced the quality of those assets by buying mortgages and other complex securities created by Wall Street, assets of such dubious quality that no one but the Fed will hold them.
The money supply is expanding at its fastest pace since 2002, notes Jim Grant, because the Fed is "stuffing the banks with dollars." The question is when the economy recovers whether central bankers will affect an orderly winddown of the money supply. Grant for one doubts it.
Part of the problem the Fed will have with reducing the money supply when the economy recovers is that the securities it has to sell are less liquid than its typical holdings of U. S. treasury bonds. Shrinking the money base by selling treasury securities is a breeze compared with selling, say, the structured investment vehicle (SIV) called Maiden Lane III LLC, a current holding of the Fed's. This SIV is stuffed full of "multi-sector collateralized debt obligations," which happen to be the former toxic mortgage assets of insurer AIG.
There are many bullish arguments for gold, including ones ranging from the end of the world, to the end of the US$ or Canadian dollar or whatever you are measuring gold in, to declining gold supply/increasing demand, and so on. The one that I am interested in, and the one that is likely driving gold higher right now, is the one that is quoted above. Namely, the view that the capital injections into economy by the FedRes and other central banks, will lead to high inflation.
Ben Bernanke argues that the FedRes can withdraw most of the injected money quite easily:
In a rare appearance before journalists at the National Press Club, Bernanke said the Fed will be able to quickly reverse much of what it's done to expand credit, once the economy improves. Read his full remarks.
"A significant shrinking of the balance sheet can be accomplished relatively quickly," Bernanke said.
Many of the programs are designed to automatically disappear once market conditions improve, he said, while others will require more active intervention by the Fed.
(You can read his full speech here. Professionals and those interested in details should refer to his numerous other speeches that have dealt in detail what the FedRes can do.)
IANAE and don't really know the technical difficulties of withdrawing liquidity. My amateur investor view is that I have little reason to suspect what Bernanke says may be incorrect. Some of the money that the FedRes has injected seems to be short to intermediate term obligations that will be paid back if the FedRes ever decides to stop rolling them over. A lot of the rest will also likely end up simply replacing destroyed capital, rather than adding to the existing capital base.
I suspect that the FedRes will be late in withdrawing liquidity, when we do get out of the deflationary abyss, but that will likely lead to higher inflation rather than perpetually high inflation.
One other thing is that, nearly all cases involving high inflation were due to a purposeful act by the government. Typically this has been to finance wars, pay foreign debts, and the like. I am building my case with the view that the US government will not do that (many gold bulls also share my view and aren't betting based on such a low probability event.)
The Case Against Gold
The current wedge between the gold price and inflation is a weak banking system. If banks are not lending, money supply expansion is unlikely to be inflationary. There is in fact a real danger of a "prolonged bout of deflation" in the U. S. economy, according to Paul Dale of Capital Economics, which is the current preoccupation of the Fed.
The current economic recession is global in scope and demand-pull inflation pressures are absent. More than 20 million migrant workers in China are out of work, due to weak exports and excess supply. China was a major exporter of deflation earlier in the last decade and is likely to be again.
Moreover, the fall in trade balances in surplus nations -- Japan, China and OPEC countries --is also deflationary. In recent years these trade surpluses represented dollar earnings that were bought by foreign central banks and recycled into U. S. treasury bonds. This process was inflationary for all participating countries. As it slows or even reverses, money growth also slows or is sucked out of the system.
The quoted sentences pretty much captures my thinking. The world had inflation in the last 10 years but given how everything is almost the exact opposite now, we will likely get deflationary currents blowing across the planet.
I also take the view (not widely accepted) that China's banking system is partially insolvent and that it has massive overcapacity in manufacturing, and possibly a real estate bubble (although small and only in major, coastal, cities.) Chinese banks have reduced their NPLs (non-performing loans) in the last decade but I just wonder how reliable the numbers are. One may recall a theory that I referenced a while ago speculating that Chinese firms do not factor in depreciation properly into their businesses (i.e. companies not profitable if worn down machines had to be replaced.) If so, there will be massive wealth destruction in China and it will be deflationary.
I also see some gold bulls argue that gold will do well in deflation. Well, I don't buy that. If gold does well during high inflation and it does well during deflation, then does it ever do poorly? I suspect these investors will say it never does poorly. Anyway, we'll see how events unfold. My feeling is that gold may hit a peak in April and then fall in May/June; or it may keep rising until fall due to the rising popularity of stagflationary views (this could easily happen if inflation ticks up for a few months while the economy is weak.)
Tags: China, gold