Wikinvest Wire

Conventional wisdom regarding gold

Monday, December 22, 2008

This morning's Ahead of the Tape column($) in the Wall Street Journal neatly summarizes conventional wisdom regarding gold, beginning with the 'ol "inflation hedge" saw.

As the quintessential hard asset, one that traditionally hedges against rising consumer prices, gold's trajectory these days should be downward. After all, prices for just about every other commodity, from oil to nickel to cotton, have plunged as inflation risks have seemingly abated and as investors increasingly fear deflation.

Yet, gold has largely traded between $750 and $850 an ounce for the last few months, and is up about 8% since the Fed cut interest rates to between 0% and 0.25% last week.

It hasn't been an entirely smooth ride. Gold sank amid panic this fall as investors crowded into the U.S. dollar. And it remains well under its $1,002 close back in March. But the metal hasn't stumbled nearly to the degree many other commodities have. Clearly, deflation worries aren't tugging at gold.
It's probably fair to say that, with what the central banks around the world have been doing over the last year or so, gold owners who are now worried about the recent downward trend in the consumer price index are few and far between.

It continues...
And while inflation isn't apparent today, stimulus packages and bailouts mean much more money in the system. That is classically inflationary. Moreover, despite efforts to sop up this liquidity later, the effects of unintended consequences might mean some portion of the trillions added to the Fed's balance sheet are likely to "stick around" to fuel inflation, says Axel Merk, who recently increased gold exposure in his Merk Hard Asset Fund and personal portfolio.

Says Malcolm Southwood, commodities analyst at Goldman Sachs JBWere in Australia, "I'm telling clients that the environment over the next five years is extremely constructive because of the inflationary risks further out."

Near-term gold could still demonstrate some weakness as the last of the panic trade peters out. And if the European Union cuts interest rates, as some expect, that could boost the dollar's value, which could undermine gold. And U.S. and European Central banks could sell gold to raise cash to pay for bailouts, which would be bearish for gold prices. But Mr. Southwood suspects Asian central bankers looking to diversify reserves would grab that supply, seeing the sales as "an alarm signal about the dollar."

And what if deflation does hit? Even that doesn't necessarily spell doom for gold, as some think. During the deflationary Great Depression, "gold preserved its value," says Matt McLennan, a lead manager at First Eagle funds, which runs a gold fund. "It preserved its purchasing power."
Yes, some of this new money is likely to "stick around" as Axel Merk says - maybe a lot of it.


Chuck Ponzi said...

Great information: I basically agree that the premise of today's monetary inflation will translate into asset inflation in the future.

However, there are some stunning misinformation in there. I'm no historian, but my limited memory reminds me that Gold was pegged to the USD... so Matt McLennans assertion that "It preserved its purchasing power" during the GD would have been either a misquote, or incredibly poorly informed. (as a manager of a gold fund, I'd have to err on the side of saying he must have been misquoted). Of course it retained its purchasing power; it was pegged to a deflating currency.

But, gold looks quite richly valued at the present time. Which, I would estimate has to be more due to it being a security play. I wouldn't be surprised to see prices fall quite a bit in the medium term as the crisis abates, as other commodities have. It's historical relationship to other precious metals has been completely eroded. Either everything else is badly mispriced or Gold is. I have seen no credible reason why we have a decoupling.

Don't take my investing advice, I'm probably wrong.

Chuck Ponzi

Anonymous said...

The dollar derived its value from being redeemable for gold - not the other way around. Today, the dollar derives its value mostly from the ability to collect taxes from US residents against debt obligations. The reason for gold holding its value in a deflation is simple. Gold is acting as money again.


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