Monday, 19 July 2010


I'm prompted to take another look at the shiny stuff by this thought-provoking article in The Economist.

The graphic which particularly caught my eye was one showing a sharp contraction in retail purchases (ie. jewellery) which was more than compensated for by a big pick up in investor interest.

Although 'investors' would here include central banks as well as institutions and individuals, that doesn't make it any less speculative: gold is a speculator's instrument by its very nature.  The only reason to buy is if you think its value is likely to rise or at least outrun inflation, since it pays no income like a bond, no dividend like a stock and it sure ain't gonna pay you a rent.

So the only question worth asking with gold is whether the price is set to keep rising.  Here's my latest answer: 

We've probably not yet seen the denouement, but there are clear signs that gold's great bull market is entering its final act.


Take a look at the nominal (dollar) price of gold since 1971.

Looked at objectively, we see two parabolic moves: one took place in the three years between 1977 and 1980, the other has been accelerating gradually since 1999.  The first saw the yellow stuff multiply in price eight-fold.  And since the 'Brown Bottom' in 1999*, gold's price has quintupled.

*British former Chancellor Gordon Brown notoriously sold the UK's gold reserves at the absolute trough of the market.  Alas, his timing skills never did improve.

Yet gold bulls are not satisfied with a 500% move.  They say there is every reason to expect another surge higher, and count among their reasons the following:

  • Continuing debasement of major currencies eg. the recent euro plunge and a presumed dollar plunge to come

  • Fears of major sovereign debt default

  • Fears of an outbreak of inflation, or even hyper-inflation

  • Increasing industrial and jewellery demand, particularly in emerging markets

This is, of course, a shortlist.  There are many and more esoteric reasons the bulls can cite for their gold lust, but these are the main ones put forth by the saner types.

Indeed, here's a chart covering the same period as the one above, but this time the gold price is adjusted to take account of inflation.

Different, huh?  This is the favoured chart you'll find littering the gold-bug blogs, with accompanying blurb suggesting that because the spike in 1980 reached an inflation-adjusted $2000, the puny five-fold rise since 1999 has plenty of headroom yet for a blowoff top.

This is of course a blatant non-sequiteur masquerading as common sense.  The price doesn't 'have to' rise to fulfil a gold bug's wet dream.  And in fundamental terms there's no comparison to be made.


The last great bull market in gold began in the 1970s when the 'Nixon shock' ended America's adherence to the gold standard.  

As the flames of inflation started to fan across the western world, gold began to glister as many currencies including the dollar took on the allure of toilet paper.  As we old gits remember well, widespread inflation in developed economies took hold to an absolutely unprecedented degree: the decade culminated in an oil-price spike, the Iranian revolution and the US invasion of Afghanistan - a cocktail of oil-price risk and insane wage and price inflation which sent gold into orbit. 

Inflation peaked along with gold in 1980.
Recessions (grey bars) are inflation-killers
Today, the situation could not be more different.  

Inflation in the US and Europe is doing a great impression of William Holden in Sunset Boulevard: talking persuasively whilst dead in the water.

Until we see this measure rising significantly in the western world, the gold bulls' inflation argument remains pure fantasy.  Yes, stock prices are inflating, bond prices are inflating, gold prices are inflating as investor money swills around the world desperate for a return - but the price of everyday goods and services stubbornly refuses to follow the script.  And that's because deflation has now taken full control and will remain in charge for the forseeable future, reflected in the fact that broad money supply (so-called 'M3') is currently falling at its fastest rate since the Great Depression.


As the top chart makes clear, we can demolish another widely proclaimed pillar of the bullish argument: jewellery and industrial demand. In fact jewellery demand has been falling in developed countries for years and emerging market demand has stayed steady.  This is not surprising folks - at the risk of stating the bleedin' obvious, the price has skyrocketed.   Industrial demand is also static.  So where has the only expanding interest in gold come from?  Speculation.

Yes, it's a bona-fide gold bar vending machine, in Abu-Dhabi.  Could there be a more blindingly clear red-light signal?

This is an absolutely classic warning sign that we are approaching the end-game.  The story, as with any bubble, goes like this:

  • Fundamental demand weakens from within as prices rise and the 'dumb money' investors get suckered in.  

  • A great narrative takes hold of the public imagination: 'x' can never go down because of 'y' fundamental reason, (usually, we've entered a 'new paradigm')

  • The market rises parabolically, seemingly confirming the dumb-money thesis, as the last investors rush to buy in

  • The last investor buys in...

The last time gold's price went parabolic, 1979 - '80.  If it happens again, I'll be watching the charts for similar signs of buying exhaustion as the rocket goes vertical 

This parabolic behaviour in gold is actually less surprising if one realizes that, throughout history, the greatest effect on gold's price by far has come from investor speculation rather than supply/demand fundamentals, as this article on Mike Shedlock's blog neatly explains.  

Arguments about the fundamentals cloud the truth - that gold's price is all about perception:  perceptions of the stability and value of paper currencies and perceptions about the future direction of interest rates, beliefs which are then reinforced, like a feedback loop, through the mechanism of pure price speculation.

Shifting investor perceptions, sentiment and beliefs are therefore of absolutely central importance in knowing when to buy in and, more importantly, to get out of this bull market.


Sentiment recently hit an all-time bullish extreme on one important measure, the Daily Sentiment Index published by  Highlighting this, here is the updated gold chart which I originally posted in June's Outlook.  This setup has consistently led to reversals in the past and has begun to do so again - where, then, does gold's correction end?

A cursory look suggests it should at least fall back to its 200-day moving average, currently around $1140, some $50 below here.  But as the chart illustrates, there is an additional weakness this time: upward momentum has waned significantly.  Also, in recent weeks gold has failed to take advantage of big falls in the dollar, which is highly unusual.

That would lead me to be much more cautious about gold's short-term outlook, even if there is a blowoff top brewing in the longer term.  

Although it's loosened over the past few months, gold's tight inverse correlation to the US dollar over decades will not be broken

Check the last time sentiment came close to this extreme in early 2008.  Gold is so often touted as the insurance policy against a monetary meltdown.  Yet at that time, despite an end-of-the-world scenario unfolding in the financial system, gold underwent a near-30% collapse in price.  Why?  Because hedge funds, institutions and individuals who held it were desperate to raise cash, so everything not nailed down was sold hard.  

And since (despite protestations of rude health) the banking system, especially in Europe, is highly vulnerable to shocks from deteriorating economic and credit conditions, another crisis and flight to safety in cash and the US dollar is entirely possible.  Such a scenario would involve selling all liquid assets, including gold.

The truth is that until beliefs change, until investors begin to perceive that cash itself may become seriously devalued, gold remains a second-fiddle alternative and vulnerable to a sell-off in any flight to safety.

Not so fast, Fernando...


So the real question is, could we see a change in perception in which cash is rejected as a safe-haven, igniting a full scale blow-off spike in gold?

Let's go back to the two gold-bug arguments outlined above which remain un-debunked.  

  1. Currency debasement
  2. Sovereign debt default

These are of course two sides of the same coin - in one case a currency is deliberately debased by a government printing money to fight deflation, the other sees a flight out of the currency by investors terrified of losing their shirts.  

An example of the latter was the recent flight from the euro during fears over Greece, a flight which may only be half way done:

Much of the cash recently fleeing Europe went into gold - 
without much of a boost to the gold price

Now, although a scare over US sovereign debt may eventually come to pass it is probably not a near-term risk, suggesting that, for now, such crises will continue to originate mostly in Europe.  This implies that any further flight to safety will again be to the world's reserve currency, the US dollar, knee-capping gold's gains (assuming there are any) and relegating them to the silver-medal position.  This is clearly what happened during the Greek crisis: but for the surge in the dollar during April and May, gold would have likely enjoyed a rocket rise higher.  

As things stand, then, the euro can go down the swanee without gold making very much more progress. Not what the gold bugs ordered.

The key to gold's fate, therefore, lies once again with the dollar.


There is only one way I can see perfect conditions for gold arising in the foreseeable future - but it doesn't start with inflation as most gold-bugs imagine.  It starts with a serious deflationary slump across the developed world, a slump severe enough to bring on a massive new round of Quantitative Easing - not just in America but worldwide: in the US, the UK, maybe Japan and, most interestingly, even in the Eurozone.  

QE, in which central banks create money at the push of a button (no printing required) and buy $billions in assets from the banks, stuffing them full of cash, is the last resort of monetary authorities once deflation takes hold. It is the last stop before running the printing presses Zimbabwe-style, yet, as we've seen in QE round 1, that money has so far been hoarded by the banks and is not being lent out into the real economy.

However, the belief of many in the markets remains that this money will eventually flood out into the pockets of consumers and businesses and create inflationary havoc.

That's why, with a second round of QE, especially if it were a worldwide phenomenon, perceptions would indeed be shifted: investors would now expect a substantial fall in the dollar and, if the European Central Bank starts QE in the midst of deflation and recession (they recently flirted with it, but only briefly and in 'vanilla' form) there would be just as much concern over the euro.  

With few realistic alternatives, investors would thus be caught in a currency 'pincer movement' in which gold would be an almost certain beneficiary.  

The gold price could then become a projectile missile and we would appear to have entered a 'new paradigm'.  It wouldn't last - but for gold-fondlers, it sure would be fun while it did.

Since my view is that a serious deflationary slump is very much in the cards, I'm bound to say that a modest investment in gold can only be a sensible move, the critical question for late-to-the-party-Jimmy being, when?  

Answer...not yet, kid.  

If there is to be a deflationary scare - and I think we're already in its early stages - the gold price should fall initially, perhaps to $1000 or below.  Central banks will, as they so often do, make a hollow show of confidence... before the markets tank and they bow to the inevitable.  Remember, fiscal stimulus packages are now a political or economic impossibility for many governments, so the Fed, the ECB, the BOE etc. will be all that's left between you, me and an all-out Depression.

At the point of maximum fear I'd anticipate a joint announcement of multi-$trillion Quantitative Easing by the worlds' central banks - and that, ladies and gentlemen, is when I shall buy gold.