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November 6, 2009

What next for gold?

It took some SMI readers by surprise when we started writing positively about gold in our May cover article, then came right out and suggested buying it in August's A Dollar in Danger Leads Many to Gold. Some believed it was too late to buy at that point, having seen gold rally from roughly $250 at the beginning of the decade all the way to nearly $900 at that time.

Now, with gold up another 20% in the six months since those articles were written, any such concerns of being too late to the party have only grown. Many are still wondering if it is too late to be buying gold.

A lot of this "is it too late" questioning reflects the split between the two approaches to gold that Austin discussed in the August cover article. The "short-term trader" mentality sees gold's recent run and thinks it may be due for a correction soon. The long-term accumulator sees the reasons for long-term appreciation in the years to come and recognizes those are still intact regardless of whether the price of gold corrects here.

What is the long-term case for gold? In a nutshell, it's a safe haven against poor stewardship of the world's fiat currencies. Most of us are focused on the dollar, given that we live here and conduct most of our business in dollars. But gold is also gaining popularity as an alternative to the British pound, the Euro, the Yen, and other currencies. The dollar isn't the only currency in trouble, it's just the biggest and most prominent.

One of the big dilemmas facing investors right now is the question of inflation vs. deflation. It's a tough call. On one hand, we see the dollar devaluation, the huge expansion of the money supply and easy money policies of the Fed, and signs of life from the economy. It's not a difficult task to connect the dots and construct a high inflation scenario.

On the other, there are all sorts of catalysts that could tip the world economy back into recession again, which would be distinctly deflationary (at least for the short-term). It's even easy to concoct a scenario where inflationary forces (like the rising price of oil) cause another deflationary recession. If you feel a little overwhelmed trying to sort through the possibilities, you're not alone.

The troubling part of all this as investors is that what works in an inflationary environment is typically the opposite of what works in a deflationary one. Bonds should do well with deflation and poorly with inflation. Stocks are the opposite.

Which brings me back around to gold. This Minyanville article quotes David Einhorn of Greenlight Capital with one of the better insights into gold that I've seen this year:

I have seen many people debate whether gold is a bet on inflation or deflation. As I see it, it is neither. Gold does well when monetary and fiscal policies are poor and does poorly when they appear sensible. Gold did very well during the Great Depression when FDR debased the currency. It did well again in the money printing 1970s, but collapsed in response to Paul Volcker’s austerity. It ultimately made a bottom around 2001 when the excitement about our future budget surpluses peaked.
Prospectively, gold should do fine unless our leaders implement much greater fiscal and monetary restraint than appears likely. Of course, gold should do very well if there is a sovereign debt default or currency crisis.

In other words, while another deflationary round of recession may temporarily bring gold prices down, providing better buying levels for traders and accumulators alike, in reality it's the decisions being made regarding the fiat currencies that are going to drive gold's future prospects.

In one major respect, this makes the gold question much easier. Rather than having to figure out whether we're headed for inflation or deflation next, you really only have to decide whether those calling the shots are going to make decisions that are in the long-term best interests of the dollar and other currencies, or whether they will likely continue to make short-sighted decisions that put the future value of these currencies at risk.

Given the "fix it now, and worry about the consequences later" mentality so prevalent in this generation, that seems to be a relatively easy call.

To recap then, it's entirely possible that gold pulls back from these levels, perhaps even significantly if we slip into a double-dip recession (or if it looks like we may). However, longer-term, we still think the prospects are quite strong for gold.

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