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Gold – Is The Great Under-Owned Asset In A Bubble Now?

By  |  Commodities  |  Nov 25, 2012 07:01AM GMT  |   Add a Comment
 
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Gold investment worldwide has grown dramatically in the last few years, but compared with the total stock of financial assets, gold bullion investment is still just a tiny proportion. Sales of gold jewelry across Asia are seen surging as the local economies boom and private investment grows.

Among the many reasons for the steadily rising gold prices, gold mining companies worldwide also have had a substantial role as they have failed to meet the growing demand from gold jewelry and gold investment buyers, pushing the gold price steadily higher. The world’s No.1 gold mining nation, South Africa, has seen its annual gold output halve since 1998, and new operations in China and Russia- though growing – have failed to pick up the slack.

The World has waged a War against Wealth:
Financial innovation in the last few years has been extremely strong and powerful. We’ve seen bubbles in complex and novel investments bite back. These instruments thrive in the opaque, off-balance-sheet environment of modern financial engineering. Transparency in investments is important. When investment stops being open and transparent, reverts to cozy secret deals, complex contracts, and big executive bonuses, it is the general investors who always get cheated.

In stark contrast to the burgeoning complexity of modern securities markets gold Investment remains uniquely simple and – if dealt the right way - uniquely transparent. A solid gold investment sets you free from the risk of credit default or banking failures. Many people now thinking about gold investment should also consider the currently high world food prices, which will rise further as an extraordinary Heat wave of Inflation brews just around the corner.

Raw material prices are expected to zoom up sky high. Rising demand for better housing and durable goods from Asian consumers is certainly a factor adding to the prices. Add all this to the already high cost of living we already exist in. Record low interest rates for prolonged periods and a massive rise of huge and repetitive money supply (QE) in the US and many western nations, including China and Japan is bound to trigger a super inflation. Simply add record unemployment you have a full fledged WAR on Wealth.

Gold: The superior monetary asset that is no-one’s liability, that is outside the banking system and outside of political control. Its share in global portfolios is miniscule. It plays hardly any role in institutional asset management. As the US dollar has slumped gold investment has outstripped the gains in all major world currencies. In the five years to 2008 buying euros to defend against the dollar’s decline has returned 47%.

Gold investment, on the other hand, has returned 131%. It is often argued that equities and real estate are also good inflation hedges and there are many people who prefer them to gold. One can see the rationale but would disagree with the conclusion. Gold may no longer be cheap because what I explain here has been a powerful force behind gold for a decade.

But I would argue that equities and real estate are in general much more overvalued as the current financial infrastructure is designed to channel new money into financial assets and real estate but not into gold, and our financial infrastructure has been operating on these principles for decades. How many people do you know who not only own gold but bought it on loan from their bank?

Now ask yourself the same question with respect to real estate. Almost no one. In fact while buying gold, one tends to under buy even while buying with own money and not borrowed. Thus gold has always been an under-owned asset for ages. Try this: Suppose you had bought a property or stocks worth a million, say in 2002. After you calculate its present day market worth, try the same amount and calculations with gold. BOOOOM. You have the value answer for the highly under-owned asset – an opportunity missed. In India, the generations old love for gold, though has kept investors and buyers happier as compared to investors in other nations.

Paper money is always a political tool but gold is hard, inelastic, apolitical and truly international market money. Paper monies come and go, gold is "eternal." Gold is hard, apolitical, and global money, supported by an unparalleled history and tradition. Gold is a store of value and medium of exchange of almost universal acceptance. Any risk of a more extended period of deflationary correction poses a much bigger problem for equities, and by extension real estate, than for gold. If you consider any major economic crisis, whether inflationary or deflationary, gold beats equities and real estate.

Whenever paper money dies, eternal money – gold and silver – stage a comeback.
We have already seen a major re-monetization of gold over the past decade, as the metal again becomes the store of value of choice for many investors.

BUT – Is Gold in a Bubble?
Gold is a monetary asset that has functioned as a medium of exchange and a store of value for thousands of years, around the world and in almost all societies and cultures. Many modern economists believe that gold has now been successfully replaced with state paper money, such as paper dollars, paper euros, paper yen, and so forth. Holding gold is therefore redundant. The present crisis is a stark reminder that this faith in fiat money is misplaced.

Over long periods of time gold has done an extraordinary job at preserving purchasing power. Not surprisingly, it has beaten all fiat monies as a store of value. Since the dollar came off the gold standard domestically in 1933, and in particular since it came off the international gold-standard-light in 1971, massive quantities of new dollar currency units have been created, thus substantially reducing the dollar’s purchasing power. Given gold’s historic role as money and its superiority as a store of value over longer periods of time, it is not unreasonable for the owner of gold to expect that – on trend and in the long run – he should be compensated for inflation.

1974 was also the first year since the late 1940′s that the US registered official annual inflation rates of double-digit figures. Gold was in demand because ever-higher inflation seemed inevitable. Gold began to trade at a premium. Be that as it may, gold moved up relentlessly and in the late 70′s did so at an even faster pace than the dollar’s purchasing power was plummeting, which was already pretty fast to begin with. In 1980, US inflation reached a peak of 13% p.a.; the gold price reached a then all-time high of over $800 and an average price for the year of $613.

Gold was trading at a substantial spread over its inflation-protection price because the public feared that inflation could spin out of control any minute. Having a pure paper dollar with no anchor in any commodity suddenly appeared to be a bad idea. The fiat money concept seemed to be failing. The market began to contemplate imminent paper money meltdown and monetary regime change.

Jimmy-Carter-nominated Fed Chairman Paul Volcker who gave the paper dollar another lease on life. He stopped the printing press, allowed short rates to shoot up and liquidate the mis-allocations of capital from the inflationary boom. The US went through a biting recession – then the worst since the 1930′s – but inflation was crushed, so were inflation expectations and the gold price. Paper money collapse had for once been averted.

The gold price went down in the late 1990′s and for the first time since the early 1970′s gold traded at a considerable discount due to various technical factors, such as massive gold sales by certain central banks, in particular the Swiss National Bank and the Bank of England in the late 1990′s, and the growth of the gold-lease market, which gave mining companies cheap tools to sell gold production forward using again the substantial gold hoards of the central banks. Then there came a new belief in entrepreneurship and innovation, particularly in Information Technology. NASDAQ boomed.

Productivity gains seemed high and there seemed to be no limit to growth. The business cycle was declared dead; the New Economy had arrived. In any case, growth was not manufactured by the government through deficit spending and money printing. The US was at the top, politically, economically and ideologically.

In 2000, the US had a budget surplus for the first time since it had severed its last link to gold in 1971. In 2001, the gold price reached a low of $272 an once and thus traded 43% below its PPP price, its largest "undervaluation" since 1972. Then the wheels came off the US Economy and economic policy-making became outright bizarre.

From 2001 till today- Crisis, Deficits and Cheap Money:
The NASDAQ boom turned out to be a bubble and it ended like all bubbles eventually do. The record bankruptcies of Enron and World Com in 2002 exposed recklessness and even fraud at the top of America’s New Economy. The 9/11 attacks in 2001 put America on a war footing. The Gingrich-Republicans were replaced with the neoconservatives, and instead of closing government departments many new departments and agencies were created, most infamously the Department for Homeland Security. As the "War on Terror" had from the start no clearly defined enemy and no clearly defined objective it promised to be an instance of "never-ending peace through never-ending war." The budget deficit exploded.

Short-term economic growth was now engineered through easy monetary policy. Greenspan kept rates at 1 percent for 3 years and blew a massive housing bubble, and when that popped in 2007, a much worse financial correction than in 2001/2002 commenced. Lehman and AIG collapsed and a run on the entire system seemed imminent. The new policy tools included TARP, nationalization, massive stimulus packages, zero interest rates and repeated rounds of debt monetization – The Quantitative Easing or QE.

Through Greenspan’s 1-percent policy phase the gold price had already begun to recover and by 2006 gold was again trading at a premium to its inflation-protection price, for the first time since 1990. Since the financial crisis commenced in 2007, gold moved up relentlessly, the market-price-to-PPP ratio moving from 1.25 to 2.64 last year. At its present price of $1,600 per ounce gold is trading at 2.6 times its PPP price, a ratio that is close to where it was in 1980.

So what happens to Gold then?
That gold is trading at an inflation premium similar to 1980 should not surprise us. Just as in 1980 there is again a clear and present danger that the authorities are losing control over their fiat money. There is a risk of monetary regime change, just as there was in 1980. That the authorities managed to pull this thing back from the brink thirty years ago does not mean they will succeed this time too. In 1980, the key point of concern was high headline inflation. This is not the reason for concern at present, at least till now. Back then the official inflation rate was almost 14%.

By contrast, last year’s CPI-inflation in the US was slightly more than 3%. Massively inflated monetary base and the out-of-control budget deficit are the two areas of grave concern now. The former is a clear indication of how sick the financial system is. Since 2007 the Fed injected $1,800 billion in new reserve money into the financial system, or more than twice the amount of reserves that existed in 2007 when sub-prime fell out of bed, and more then ten times the amount of reserves that existed in 1980.

This money is not circulating through the economy; hence inflation is still fairly low. But this money is needed by somebody. It is evidently required to keep the banks in business or at least to prevent them from shrinking and from selling assets that nobody wants to buy at present prices. In short, all this money is needed to sustain – A mirage of solvency of the financial system issues and an illusion of "recovery."

At the same time, there is no self-sustaining recovery that would allow the Fed to reduce its balance sheet. Quite to the contrary, the weak employment reports have triggered the latest round of Quantitative Easing – The QE3 which unfortunately has been kept unlimited by nature. The Fed is boxed in. Without their massive support the chimera of recovery and of solvency would quickly disappear. At the same time, the hyper inflated monetary base is a gigantic powder keg. When this money starts dripping into economy, inflation will go up and then what? Will the Fed be able to hike rates and stop the printing press to restore faith in paper money, just as they managed to do in 1980?

The key difference between 1980 and 2012 is this: In 1980 inflation was high but the Fed had room to maneuver. All that was needed was the political will to stop the printing press, to allow rates to go up and to allow a painful but cleansing recession. I am not saying that it was easy but it only took will. Paul Volcker had that will and resolve, and Reagan managed to sell it to the public. Today, inflation is still fairly contained and without the Fed’s ultra-generous reserve policy there would even be deflation.

But the Fed has no room to maneuver. The Fed has to stay super-easy to support an incredibly overstretched and bloated financial system, a system that is addicted to cheap credit much more than anything in 1980. If this easy policy leads to rising inflation or even rising inflation expectations, the Fed will be in a heap of trouble. If they hike rates they pull the rug from under a system that is on constant life support.

The disappointing recovery has also keep unemployment numbers high which has compelled the Fed to become even more accommodative, via the QE3 or more to come, and that increases the risk that things will ultimately slip out of their hands. Then there is the gigantic budget deficit. In 1980 the US budget deficit was $73.8 billion in 1980 dollars, or $206 billion in 2012 dollars. In 2012 the deficit is likely to be $1,330 billion. In 1980 public debt was 33% of GDP, in 2012 it is 100% of GDP.

Already the Fed is the largest buyer and the single largest owner of the government’s debt. Last year, 61% of new Treasurys were placed with the central bank. Strangely, US Treasurys still seem to enjoy safe haven status in the private capital markets. Should this change and should investors begin to demand a higher running yield on these bonds, then the Fed would have to step in and buy even more in order to avoid a rise in the state’s funding cost and to mitigate the hugely deflationary impact on the inflated financial infrastructure that higher yields would have.

Everywhere we look things seem unsustainable and fragile, and everything seems to point in the direction of more accommodation rather than ‘exit strategy’. The printing press has become the last line of defense for a hopelessly over-leveraged financial system and an out-of-control government. And the gold market knows it!

In summary, gold is not cheap but its high price does not seem unreasonable either given the current policy predicament. If the Fed refrains from further easing measures and if there are no shocks to the system, the gold price could drift lower as the market decreases the premium. That would mean a gold price of about $1000 to $950. This would also constitute a retracement of 50% from last-year’s all-time high, a fairly brutal correction but one that also occurred in previous bull markets.

On the other hand, any additional measures from the Fed to "stimulate" the economy, or any "accidents" in the financial system, and the premium could even expand further. Additionally, any rise in inflation from still fairly low levels should also feed through into a higher gold price.
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