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History has taught investors to expect a sustained advance in stock prices this time of year, as the so-called Santa Claus rally takes effect.  Indeed, returns in December have been positive almost three-quarters of the time over the past 100 years and, more than 80 per cent of the time since 1990.  However, Father Christmas does not appear to be in a generous mood this year, as all of the world’s major stock market indices languish below their 200-day moving average.

Santa’s tight-fistedness has not just been confined to risk assets, and even gold, a traditional safe haven, has been caught up in the turmoil.  Indeed, the precious metal has dropped some $300 or 16 per cent from the all-time high registered in early-September and, dipped below its 200-day moving average last week for the first time since January 2009, which brought to an end the longest ever streak – 732 days – of consecutive closes above the psychologically important level.  Not surprisingly, the breakdown has prompted the precious metal’s many detractors to declare that the more than decade-long bull market in gold is over.

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The many critics, who have been schooled to believe that gold is nothing more than a ‘barbarous relic’ with little if any intrinsic value, have consistently portrayed the precious metal’s price action as dangerous asset bubble, since it bottomed at little more than $250 per troy ounce in the summer of 1999.  The misguided thinking fails to explain why gold has been ascribed value by humankind for at least the last 6,000 years and, has never become worthless.  Could the long sweep of history truly be wrong?

More than a decade later and the non-believers’ message remains the same, yet investors who heeded such advice have missed the opportunity to reap a near sevenfold increase in capital invested in the precious metal over the period.  Of course, past returns are no guarantee of future performance and, it is fair to say that the bull market in gold is closer to an end than it is to the beginning.  Nevertheless, the underlying fundamentals suggest that there is still plenty of time for the precious metal to shine.

It is important to note that the precious metal’s stubborn critics are not the only ones to demonstrate a complete lack of understanding of gold’s attributes, as even the occasional bull has advocated investment in gold on the premise that all the ‘money-printing’ by central banks will eventually lead to unacceptably high inflation.

Such thinking is dangerously misguided, as quantitative easing and the associated increase in banking sector deposits held at the central bank will not necessarily lead to a concomitant increase in the money supply.  The traditional multiplier model taught in ‘economics 101’ is wrong, since banks do not make loans according to the level of reserves in excess of statutory requirements but, on the basis of adequate levels of capital and the availability of profitable loan opportunities.

The evidence from both Japan and more recently in the US demonstrates that quantitative easing does not work through the lending channel when the banking sector is capital-constrained and the private sector is reluctant to borrow.  Simply put, the large increase in consumer prices anticipated by the naïve bulls that view gold as nothing more than an effective inflation hedge, is unlikely to materialise, as deflation remains the clear and present danger and, particularly so in the euro-zone following the latest summit, which hopes to enshrine pro-cyclical fiscal policy.

Fortunately, the historical record demonstrates that gold performs equally well, if not better, in the presence of a destructive debt deflation.  The logic is easy to understand.  Individuals scramble for liquidity and flee financial assets during deflations, but the deteriorating credit quality of currency issuers and the resulting loss of confidence, mean that gold is typically preferred to paper currency as a hoarding vehicle, simply because the precious metal is no-one’s liability and always pays off.  In essence, gold is an effective insurance policy against a black swan event such as debt deflation.

It is important to appreciate that the precious metal does not require a black swan event in order to perform well.  The gold market thrives on uncertainty, something that the equity markets abhor and, typically attracts investors during periods of increased risk aversion.  It is said that the only thing that rises during bouts of market turbulence is correlations but, the historical record demonstrates that gold’s correlation with stock prices turns decidedly negative when equity markets stumble.  In other words, the precious metal acts as an effective portfolio diversifier and helps to mitigate losses in uncertain times.

The precious metal also serves as a viable currency alternative, which means that it competes directly with the world’s major currencies.  Since gold is a non-interest bearing asset, its relative attractiveness is determined by the return available on short-term government debt instruments in each of the major currencies.  As the real interest rate falls, the opportunity cost of holding gold decreases and consequently its relative appeal rises.  Near-zero interest rates across the developed world combined with quantitative easing programmes that place downward pressure on the associated currencies, means that the hurdle for gold has seldom been so low.

The gold price has come under pressure in recent weeks, which has seen the stale bulls declare an end to the precious metal’s spectacular run.  A closer examination of the facts however, reveals that gold is likely to glitter in 2012 and beyond.  Far-sighted investors should act accordingly.

Previously posted on www.charliefell.com

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