The Gold Price Paradox

Taken from the Opening Statement of the March 2013 Intelligent Investor (Part 1)

As forecast, gold and silver have continued their bearish retreat. This bearish intermediate-term trend has baffled gold bugs, who were certain these precious metals would skyrocket with the announcement of “unlimited QE3.”

The confusion in this case points to poor understanding of those factors most responsible for gold and silver pricing. Specifically, as we have continued to insist since our first published treatment on the subject in America’s Financial Apocalypse, gold does not serve as a hedge against inflation. This is a statement of fact.

On the other hand, gold does serve as a hedge against deflation. Deflation typically arises due to widespread economic shocks which are typically associated with crises. Such periods often cause equities markets to experience a large sell off. It is for this reason that gold pricing has been historically negatively correlated with the U.S. stock market, with about a -0.7 correlation coefficient. What this means is that gold largely moves in opposition to the stock market.

Over the past several years gold pricing has been positively correlated with the stock market when the stock market has risen, but negatively correlated when the stock market has declined. As you can imagine, this has resulted in a large amount of appreciation in the price of gold. The explanation for this trend is simple. Gold has been in a bull market since 2001. As a consequence, gold pricing has largely defied characteristic dynamics that one might predict from historical relationships and asset correlation pricing patterns.

During an economic shock or other events that lead to a widespread crisis, as equities markets sell off, gold typically (approximately) holds up in price. Sometimes, it even rises. The reason for this price action is due to institutions shifting from equities and cash into gold in order to mitigate portfolio downside.

However, this phenomenon is usually of short duration. Once the crisis subsides, institutions sell these recently purchased gold positions and move back into equities. Thus, even as a hedge against deflation or market declines, gold really only has utility for financial institutions and large managed funds. It’s just not practical for the majority of individual investors to shift into gold during short time periods in order to avoid a market decline.

This brings us to address the reasons why gold and silver have continued with price weakness despite the persistence of quantitative easing (QE). As mentioned, gold does not serve as a hedge against inflation. And although QE does eventually cause inflation, the degree to which inflation is produced depends upon the nation under consideration, in addition to many other factors. Regardless, because gold does not serve as an inflation hedge, one should not expect to see pricing rise due to factors that tend to increase inflation.

On the other hand, if a sufficient number of investors and/or funds feel that gold does hedge against inflation, this can cause transient increases in gold pricing during rising inflation or the anticipation of such. But ultimately central banks along with Wall Street firms determine gold pricing. In other words, while illogical and irrational price movements may be observed for gold, these prices will not persist. They are part of the illusion that has been created by the real manipulators of gold pricing; the gold bugs.

So why have gold and silver continued to weaken in price? The answer is simple. First, there has been a perception by financial institutions and large investment funds around the world that the so-called “tail risk” of a financial or economic crisis has diminished over the past year. This perceived reduction in tail risk equates to a lower probability of a global economic shock, or a crisis from say the European Union, or even as a consequence of a hard landing in China. We do not necessarily agree with this position. We are merely describing what we feel the consensus of investors is thinking. 

Second, as we have been discussing for a few years now, the amount of inflation that has been generated by the central banks in advanced nations has not been anywhere near the level of inflation expected by gold bugs. Unfortunately, these individuals don’t seem to understand the fundamental forces responsible for inflation. As such, even those who have been misguided to believe that gold serves as a hedge against inflation have come to realize that this inflation they have been expecting due to a period of historic monetary easing has been essentially a non-event.

Of course, the main reason why the massive increase in the money supply has not led to a commensurate level of inflation is due to the fact that the banks have kept the vast majority of this money for themselves. Instead of furnishing credit to consumers, banks have used this free cash to buy U.S. Treasuries, thereby collecting the spread. This has amounted to what could be considered a risk-free and expense-free spread; or free money if you will. This dynamic has been responsible for the impressive earnings registered by the large banks over the past two years. Unfortunately, this has come as a huge price. Pension plans, both private and public have suffered from these persistent, record-low interest rates. Thus, the majority of profits recorded by the banks are actually coming from pension plans indirectly. This is complete fraud.

As well, more aggressive banks have flooded Brazilian banks with cash in order to collect the huge spreads available due to the nation’s very high interest rates. For instance, the money market rate in Brazilian banks was 12.5% just a couple of years ago.

Even after the Brazilian central bank embarked on a wave of rate cuts last year, short-term rates are still over 7%. This excessive flood of foreign capital into Brazil has caused severe problems, as we had warned about nearly three years ago. 

So the central question for those who think that a rise in the money supply automatically mandates an increase in inflation is this. If consumers are responsible for 67% of economic activity, how is it possible for inflation to rise excessively if consumers have not been provided with this credit? It’s quite simple. Inflation cannot rise appreciably if consumers have not been provided with excessive credit.