Author Bio

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

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

Author Bio

As the ends history unfold itself, where will humans be? Will we have gone out to claim and colonize other planets with peace among our fellow humans? Or, will we be wiped out because of our own reckless stupidity? The longer I’m alive, the more convinced I am that we will be the end to ourselves. A biology major studying nature would learn the complex and delicate balances of sustainable life on this planet. For us humans to grow and mature as an international society we all have to realize the mistakes we have made in history and to never repeat them again. We apparently suck at this. The current economic backdrop will show that we have failed miserably. Its great how Ben Bernanke is our current FED chairman since he is the expert on the Great Depression. Its not so great that Alan Greenspan Fed Funds Rate (FFR) from 6.5% to 1.0% during 2001-2003 and allowed credit to flow freely. So banks lent away, and consumers borrowed and spent away on new homes. Now we all get to see the wave of idiocy (from money strapped citizens who like to buy houses they can’t afford to the former Fed Reserve Chairman) crash and destroy us all.  Bernanke has tried the best he can in trying to prevent this all from happening, but its not in his hands at this point.  Although Bernanke has tried to make plenty of money available to banks for lending, they cannot force them to. The banks don’t want to lend money they think they’ll lose. Individuals feel the squeeze and are cutting credit and so businesses get backhanded twice from consumers not spending with their credit cards or their cash.

Our biggest threat: Deflation

Deflation could be described as falling prices across the board.  Inflation is zero. Stores and services are selling everything cheaper to attract customers, customers want to hold their money, banks aren’t lending despite the amount of dough the government gave them to sit on, pretty soon those customers are losing their own jobs since no one is buying from their company. The jobless rate is 8.5% the highest in 25 years.  Check out the heat map from Slate to see it how much trouble we’re in http://www.slate.com/id/2216238/ Deflationary spiral, here we come.

How could we ever fix this?  When the Great Depression occurred, we got out primarily because of WWII;  the New Deal was a bit of a temporary bandaid for us. But what was added to legislation to prevent it from ever happening again? The FDIC,  and the Glass-Steagall act. With the passing of time, regulations to prevent capital markets from becoming violent were unravelled. Glass-Steagall was repealled in 1999.  I guess one real way of getting banks to lend is to stuff them with money, let them to bid up the prices for the empty houses they are holding, and hope that not marking to market makes a real difference. Guess what? Not everyone is a fool. This accounting method is basically illusionary. If you’re not selling something at the price others are willing to pay for it then why are you selling anything? Banks are just gonna buy between themselves to make it seem like the houses are worth much more than they really are. What happens when real demand picks up again but the prices are still set artificially high relative to real demand?

Our next threat: Hyper-inflation

What happens when everything actually gets better?  At first everything will seem fine and dandy if Obama can effectively add the jobs we lost and re-regulate the financial system. The banks all start lending again and consumers start spending again. But what happens when the velocity of money goes from 0-100? The FED better contract monetary supply when it sees this coming or I’m 100% sure we’re all doomed by stupidity.

Internationally:
If the US is going down the drain, so is the world. A very real possibility is the use of SDRs (Special Drawing Rights) from the IMF as an international currency. This unlikely now but much more likely if the whole world goes through an international depression. It will if the US does so, and I’m just waiting, hoping, praying that it doesn’t happen because forex trading won’t be what it is now.

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Be sure to read the full risk disclosure before trading Forex.  Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results.