Ever since I began this blog in late 2008, I have been an advocate for investing in gold. While the massive support provided by the Fed in the wake of the collapse of Lehman Brothers helped forestall a complete financial meltdown, I thought the unprecedented monetary stimulus injected into the system would ultimately prove inflationary (admittedly this doesn’t seem to have played out yet, though the recent rise in gold and other industrial commodities suggests we may not be too far off).
With a near 60% return over the last two years, I think it is prudent to reevaluate my thesis and consider the merits of maintaining a position. The rampant media attention given to gold’s ascent above $1300/ounce suggests that my thesis is hardly unique and that the yellow metal could be migrating into bubble territory.
As an unrepentant contrarian, I always grow nervous when my thesis is shared by the broader investing community. Asset prices tend to climb a wall of worry and I am afraid that we are reaching a point where even the most hardened skeptics have thrown in the towel (See the A1 Section of the September 28th WSJ "Gold Vaults to New High."
Despite a growing unease, little has changed since my original purchase, and I intend to hold my position for the time being (hopefully, you can sense the waning lack of conviction in that statement!). Underlying my thinking are the following points:
1. Central banks across the globe continue to aggressively counteract strength in their currencies. The Bank of Japan is selling yen in order to hold down its currency. The US Federal Reserve gave a clear indication in its last statement that it stands ready to support the economy should evidence of a double dip begin to take hold (i.e. “QE2” – whatever form that will come in). Never mind that a second dose of stimulus implicitly proves the ineffectiveness of the first round (when the Fed purchased $1.75 trillion of treasuries and mortgage backed securities); Bernanke and crew remain willing to do whatever it takes to avoid a deflationary debt spiral and I believe they are willing to err on the side of too much stimulus rather than too little.
Just as investors doubted Paul Volker’s ability to arrest the pernicious inflation of the late 70s (a battle which took over 2 years to win), the common refrain from today’s “experts” is that Bernanke is fighting a loosing battle. Talk of the US mirroring the path of Japan is almost as prominent as talk of gold being in a bubble.
While I believe the Fed’s campaign may ultimately undermine the US dollar’s status as a reserve currency (hence my investment in gold!), I have read the transcript of enough Bernanke speeches to know that he remains committed to the task at hand. Until the Fed takes its foot off the accelerator, it’s difficult to turn bearish on gold. Conversely, once the Fed credibly lays out an exit plan, I will be the first to exit my position, no matter how much money I end up leaving on the table.
2. Despite less media attention given to the situation in Europe, the PIIGS remain in deep financial distress. The situation in Ireland can only be described as a crisis, with the Irish government estimating that up to €50 billion may be needed to stabilize its banking system. Even more staggering, the country is anticipated to run a deficit of more than 30% of GDP this year!
On the other side of Europe, Greek CDS spreads suggest that default is highly likely despite China’s commitment to buy up to $5 billion of the country’s government debt. Even credit default spreads in Spain and Portugal have edged up over the last few weeks, with investors skeptical that announced austerity measures will be enough to get their fiscal houses in order. While this would have been front page news in May, concerns over the PIIGS have receded to the background, as US investors focus squarely on the improving macro data. Despite the best September for the stock market since 1939, little has changed in Europe and investors ought not to forget the fears that existed earlier this year.
3. The mounting problems in the $2.8 trillion municipal bond market are slowly starting to play out. While a discussion of this issue will have to be saved for another post, suffice to say that the recent default by the city of Harrisburg (which was forced to be bailed out by the state of Pennsylvania) will be the first of many defaults by a municipal borrower. Just as the bankruptcy of New Century in April 2007 served as the canary in the coal mine for the subprime debacle, so too will Harrisburg’s default for the municipal bond market. I wouldn’t be surprised if we begin talking about a TARP for state & local governments as we enter the next stage of the credit crisis.
4. As mentioned before, while the market experienced a strong September, this move was hardly confirmed by financial stocks (many of which hit 52 week lows during the month). This lack of confirmation from the leading financials is eerily reminiscent of 3Q 2007, when the stock market seemingly ignored the mounting problems in the credit markets to rally to all times highs in October 2007.
A slowdown in trading activity, flattening yield curve, declining loan growth, and potential for another wave of home price declines/foreclosures, suggests a very challenging environment for the banks over the next few quarters. While the Obama administration is currently taking a victory lap with the apparent success of the TARP program (which is estimated to ultimately cost US taxpayers less than $50 billion), the stalled rally in financials suggests that we shouldn’t quite yet break out the “Mission Accomplished” banners. This is particularly the case as the heightened regulations emanating from the new financial bill begin to take effect.
5. Surplus countries, primarily China and India remain underinvested in gold (with less than 5% of their assets in the yellow metal). While China talks publicly about their commitment to both the euro and the dollar, I have to believe that behind closed doors they are growing increasingly nervous about their currency holdings. Should China and India step up their purchases of gold over the next year, the move from $800 to $1,300 may only be the beginning.
In summary, while gold is on the throes of becoming a crowded trade, I don’t think we have reached the euphoric stage that often characterizes market tops. Similarly, I contend that the fundamentals underlying my original thesis (as noted above) remain firmly intact and that there is still decent upside from today’s levels. As long as central banks remain stubbornly committed to seemingly unending monetary stimulus and competitive currency devaluations ("Beggar the World"), gold should continue to climb to new highs.