Gold will glitter despite recent pressure


SERIOUS MONEY: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 the world’s major stock market indices languish below their 200-day moving average.

Santa’s tight-fistedness has not been confined to risk assets. 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. It 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 many detractors of the precious metal to declare that the bull market in gold lasting more than a decade is over.

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 its price action as a 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. 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 metal to shine.

It is important to note that its stubborn critics are not the only ones to demonstrate a complete lack of understanding of gold’s attributes.

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, 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 bulls who view gold as nothing more than an effective inflation hedge, is unlikely to materialise.

Deflation remains the clear and present danger, 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 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 gold does not require a black swan event to perform well. The market thrives on uncertainty, something that the equity markets abhor and that 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.

It also serves as a viable currency alternative, competing 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 the hurdle for gold has seldom been so low.

The gold price has come under pressure in recent weeks, which has seen bulls declare an end to the spectacular run of the precious metal.

A closer examination of the facts, however, reveals that gold is likely to glitter in 2012 and beyond.

Far-sighted investors should act accordingly.