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A Response: Gold vs. Inflation/Deflation, and why it's not that simple

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July 11, 2010 – Comments (9)

checklist34 wrote an excellent post recently: The 210 year trend of the market and where we are at with respect to it. And (probably surprising to most) I agree with the theme of his post. While I disagree with the bulls regarding the direction of the stock market for the next 5-10 years, I am very much in agreement over the long haul. This is precisely why I wrote this post: Why I hold Gold: Why I am a Long Term Optimist and consider holding gold and Optimistic Endeavor, and Why I think the Stagflationary Scenario is more likely Macroeconomically in the Intermediate term (next several years) - http://caps.fool.com/Blogs/why-i-hold-gold-why-i-am-a/402614.

From that post:

Why I am long term optimistic and certainly no permabear:

The problem is that there are no straight lines. Not in nature and not in the systems that humans create. We as humans want to see linear realtionships, but they are a myth by and large. The world is inherently nonlinear. But more importantly, the world is cyclical. The are all kinds of very long cycles in nature: the fast 11 year solar cycle, 13 year cicadas, 26000 year precession cycle of the North Pole, etc.

There are also economic cycles that last a very long time, such as the 33 year Long Valuation wave cycle, or the 40 year Kondratiev Wave cycle.

But humans are *very* bad at picking out cycles that last more than 1 year. And we always want to extroplate linearly.

So I agree, the next several years will be marked by economic contraction. We were on a broad upswing for many decades and now we will contract for a long time as well. It does not make sense that we will just grow indefinitely with only brief pauses (1975, 1982, 2000, 2008).

But this is PRECISELY the reason why I am *NOT* a PERMABEAR

Because the world is cyclical. Nothing goes up forever, and nothing goes down forever.

Uptrends need to be corrected down. And once those corrections are complete, in both size and duration, the human race goes back to making progress.

The human race will always make net progress in all of it endeavors.

This is why the stock market will *never* go to "zero".


Every advancement, whether it is with the market or economy or any other endeavor, there is a hiatus and an appropriate retracemnet, but then the next wave will advance.

It is the reason why I am very optimistic for the future. Because after the current correction plays out (and I have layed out my case for why it is not over many times. Others don't agree with me and that is fine) the next bull run will be truly awesome.

Because it has to do with this idea of net advancement.

We do have a finite world with finite resources. But we have *unlimited* potential in how efficiently we use them. The advacements we have made in the last 100 years in all areas of science, but most importantly materials science, is nothing short of astounding.

As long as humans have the creative will to continue to learn and grow, we will never become extinct. We will face our challenges and come up with solutions. Our fate is very literally in our own hands. And I have no doubt whatsoever of the outcome.

Which makes very very long term bullish on the prospects of humanity. It also makes me very long term bullish on the prospects of human endeavors. And yes, that includes the stock market. I am not bullish for the intermediate term. Like I said above, we are in a long cycle, and that cycle is not over. But it will not go down forever.


But regarding the subject of Gold in his next post 210 year trends part 2: Gold, I disagree with his characterization. Because I think the argument for why one would (and should) be bullish on gold right now is just a little more nuanced that what was discussed.

From his post:

When I first began permusing the blogosphere, gold was touted as the ultimate inflation hedge, as fiat currencies were worthless it would ultimately preserve your wealth as fiat's went to $0.  In the last 3-6 months and ONLY, in my reading, in the last 3-6 months its become touted as a deflation hedge as well.  Basically the current sentiment, as touted by gold bulls, is that gold will win no matter what.

While this statement is true, that Gold's response to inflation or deflation has been touted recently ... it's just not that simple.

Inflation or deflation and how any asset responds to it does not happen in a vacuum. There is absolutely nothing in economics that has only one cause and one effect. There are primary causes and secondary causes (and always multiple ones), and the primary cause at one time might become a secondary cause at a later time!!

I have made the case that we have a highly debt deflationary environment while behind the scenes we have extreme monetary inflation. Based on this gold could either drop or respond vigorously, and it is not a simple question of "inflation or deflation, and what is it hedging against"

It the 1980s, we had massive inflation. However gold dropped. So there is a contradiction right there. Why? Because Volcker's policies returned confidence back to the financial markets. And the future outlook, even though it was inflationary at the time, was deemed to be bright enough that people poured back into equities and left the safety of gold. (An example of a primary cause and a secondary cause switching importance).

So even if the overall outcome is inflationary or deflationary, Gold will do well. NOT because the environment is inflationary or deflationary, but because of how the government is likely to handle the continuation of this crisis!

The primary reason why Gold is rising now, just as it did in the 1970s, is because it is a vote of no-confidence in how the government is handling the economic situation. When Volcker introduced extreme monetary and financial reform in the late 70s / early 80s, confidence began to return to the marketplace.

A huge reason why the market is bullish on gold is because of how poorly the government has handled the crisis so far and how it is likely to continue to handle it. There is too much debt, it desperately wants to and needs to contract. But the Fed and Treasury are doing everything in their power to stop it. On top of that the national deficit is *increasing*, state and local governments are increasing, the generational / demographic issue of baby-boomer retirements are coming to a head, the unsustainability of health care, social security, pensions, the increasing size of government relative to the private sector, decreasing tax revenues, unemployment, etc. Based on the current and proposed rhetoric and policy plans, these problems are likely to get much worse. All of the solutions so far are to borrow and spend our way out of these issues, which were caused by too much borrowing and spending (i.e. it is not a solution at all)

Until and unless there is serious reform that actually tackles these issues in a meaningful way, gold will be a bull market. The argument of inflation vs. deflation with respect to gold in this environment is nowhere near as relevant as this observation.

Inflation vs. Deflation will change the relative trajectory of gold and other assets, but based on a lot of studies that I have done, including this one The Dow / Gold Ratio, I have made the case the the DGR will bottom around 1 on this cycle and that I think the Dow will go down and gold will go up. (I am *not* in the camp that thinks the Dow bottoms in triple digits)

checklist goes on to make this observation:

Never in history has buying something in a secular bull and far above its historical price yielded better long term (think alot of years) returns than buying something in a secular bear well below its historical trend.  

Buying gold now is betting on, basically, a bubble, or super-bubble.  It is far above its historical trend.


This I completely agree with. But you need to understand why it is in a bubble now, and why it is likely to continue. I wrote a very similar statement in this post of mine binve's Gold Foil Hat Zone: More Thoughts on Gold's Massive Bull Market - http://caps.fool.com/Blogs/binves-gold-foil-hat-zone/403421

And this sets up the final bubble ... the Gold Bubble.

Now I don't mean this pejoratively. And I am not casting a negative connotation on it. Bubbles are what they are. When Central Bank monetary policy forces all of us to become speculators by not rewarding savers, then bubbles are formed.

Gold doesn't care that it is in a bubble. It is quietly and quiescently preserving wealth. Again Gold is NOT about price, gold is about value.

I don't hold gold because I like shiny objects. I don't hold it because it makes the world go round. I hold it because it will be the last currency standing that preserves wealth as the world's economy goes through this painful deleveraging process.

No fiat currency will preserve wealth. Certainly not when this crisis has run its course. Some will fare better than others (many will fare much better than the US Dollar), but all will pale in comparison to gold.


Now, I don't mean the the US Dollar will implode / become defunct / become extinct (at least not within most of our investing lifetimes). Nor do I think the the world returns to a gold standard. But I do think that the Dollar will be a weaker currency that it is today, and I do mean this with respect to other fiat currencies and also with respect to Gold. And I do think the odds are not trivial that the Dollar does lose its Reserve Currency status.

All said, I agree quite a bit with checklist's position on the long term direction of equities. I even agree with the characterization that gold is in a bubble. But I think the reasons given for why gold is in a bubble miss the mark.

As always, this is just my $0.02. 

9 Comments – Post Your Own

#1) On July 11, 2010 at 6:21 PM, checklist34 (99.70) wrote:

hey binve,

    I guess I didn't mean to offer a reason as to why gold is in a bubble, although a poster in that threat gave a characterization like yours, and that characterization I can easily agree with.  The price of gold acts as a disapproval indicator.  A reflection of disgruntlement with situation and government. 

    As I mentioned somewhere in that thread (mine, that you linked to above), I think a straddle on gold may be a good play.  Long a put and long a call.  I can see it going to 2000, and I am comfortable owning the put as the stuff is well above its trend.  

 

 

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#2) On July 11, 2010 at 6:47 PM, goalie37 (91.45) wrote:

Great post. 

While I hope for a healthy economy, for the sake of my friends and neighbors, I also see a prolonged period of weakness.  My investment outlook is very long term.  Over at least the next 10 years I see myself doing significantly more buying of stocks than selling.  A period of depressed equity prices is in my favor.

Keep up the good work.  I usually find CAPS players to be a much better source of information and commentary than anywhere else in the financial media.

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#3) On July 11, 2010 at 7:35 PM, binve (< 20) wrote:

checklist34 ,

Hey man!

>>    I guess I didn't mean to offer a reason as to why gold is in a bubble, although a poster in that threat gave a characterization like yours, and that characterization I can easily agree with.  The price of gold acts as a disapproval indicator.  A reflection of disgruntlement with situation and government. 

Gotcha. I guess the thing that caught my attention was the pointing out of the inflation / deflation aspect, and I wanted to highlight that while this is an important factor, it is not necessarily the most important factor.

>>    As I mentioned somewhere in that thread (mine, that you linked to above), I think a straddle on gold may be a good play.  Long a put and long a call.  I can see it going to 2000, and I am comfortable owning the put as the stuff is well above its trend. 

I think that is a very reasonable long term postion. Again, thanks for the original post, I really did appreciate the effort in describing the long term view, and I definitely agree with it. Thanks!

goalie37 ,

Thanks goalie!

>>Over at least the next 10 years I see myself doing significantly more buying of stocks than selling.  A period of depressed equity prices is in my favor.

I totally agree. In probably about 5 years, I will be buying lots of stocks (good solid dividend plays), and we I get long term confirmation that a sustainable bottom is in both technically, fundamentally, and from a macro perspective (which will probably happen in the midst of extreme negative sentiment), I will be the biggest bull anyone has seen.

>>Keep up the good work.  I usually find CAPS players to be a much better source of information and commentary than anywhere else in the financial media.

Will do! Thanks man!..

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#4) On July 11, 2010 at 9:13 PM, outoffocus (23.09) wrote:

I recced both posts. I was kinda curious what checklist thought about silver. Though silver has risen, it doesnt seem to have hit the "bubble" territory that gold has.

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#5) On July 11, 2010 at 9:51 PM, checklist34 (99.70) wrote:

outoffocus:

the ratio of the price of silver to the price of gold has alot of historical data.  I just plotted it from the 1600's until today and found this:

until about 1870 it was about 15, +/- 1 or so.  Starting in about 1873 it began to rise.  It reached 40 in the 1910's, falling back under 20 at the end of WWI

It then went to 100 during world war 2 before falling all the way back to below 20 by the late 60's.  It then shot back up starting in the70's, peaking at near 90 in the mid 90's, and sits around 70 in 2009.

So I assume that silver was legally bound to gold at some ratio until around 1870 or the consistency wouldn't have been that great.

I am not quite sure how to interpret the rest of it.

I like Silver for these reasons:

1.  it has far more industrial use (we need it)

2.  it isn't conserved nearly as greatly as gold (we throw alot of it away, all the time)

3.  the ratio to gold prices is historically high

 

But, if we hit a huge panic and gold super-bubbles, will silver follow?  I have no idea.

Maybe silver isn't the "disgruntlement barometer" that gold is.  

There may be supply and demand dynamics I know nothing about.

I'm not sure I can answer your question at all

 

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#6) On July 11, 2010 at 11:12 PM, Tastylunch (29.29) wrote:

>>The human race will always make net progress in all of it endeavors

You sure about the Binve?

I'm not. :)

If nothing else the eventual Heat Death of the Unvierse ought to be fairly challenging for us. :)

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#7) On July 12, 2010 at 5:14 AM, uclayoda87 (29.24) wrote:

Binve, to Tastylunch's point, besides our sun eventual death, there have been human cycles between good and bad times ranging from the many periods noted in the old Testament to the more recent Dark Ages and Renaissance.  It is not a given that a recovery has to occur in a very short time frame of a few years or even within our lifetime.  We have just become accustomed to changes and fixes occurring very quickly, but as you pointed out if the current fixes are not helping the problem, why should we expect a recovery to quickly follow.  Since the process is political, it will not occur quickly and may take more than a generation to truly correct.  So I may not be as optimistic in the short term as you are, I do believe that people have an ability to adapt and some even have the ability to learn from their mistakes.

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#8) On July 12, 2010 at 8:51 AM, binve (< 20) wrote:

Tastylunch ,

>>If nothing else the eventual Heat Death of the Unvierse ought to be fairly challenging for us. :)

Okay, you got me on that one :)

uclayoda87 ,

>>there have been human cycles between good and bad times ranging from the many periods noted in the old Testament to the more recent Dark Ages and Renaissance.

I totally agree. I am a student of cycle theory and have discussed it in many posts including this one: http://caps.fool.com/Blogs/why-i-hold-gold-why-i-am-a/402614.

>>It is not a given that a recovery has to occur in a very short time frame of a few years or even within our lifetime. 

True enough, but I do think we have a recovery in our lifetime, and I document the thoughts here: http://caps.fool.com/Blogs/the-long-view/314202. The jist being that the last major economic cycle ended in 1933 and the peak occured in 2000 (not 2009, this can be seen in the Nasdaq or inflation-adjusted representation of either the Dow or SPX). Bear markets tend to be faster and more violent than bull markets. So we are 10 years into our bear market and based on K-wave cycle theory we have another 5-10 years to go (a bottom being in ~2016). This fits with my primary Elliot Wave count.

Now, is that "the" bottom? I don't know, there are even longer cycles at work (always wheels within wheels). But K-waves are lifetime waves and I think the one that will hold the most sway.

So if I were a betting man (and I am). I bet we start getting our act together in the next 5-10 years and begin to sustainably rebuild our economy. I am and I will continue to be a very long term optimist (just not one in for the next few years).

>>Since the process is political, it will not occur quickly and may take more than a generation to truly correct.

Maybe. But politics 'as ususal' has utterly failed us the last few decades, and I think we will see a sea change near the bottom. This crisis is not just economic, but political as well. And major changes happen and major crises. My $0.02. Thanks!..

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#9) On July 13, 2010 at 7:55 PM, EllenBrandtPhD (< 20) wrote:

I'm a gold bull, not a bug, meaning I see the sector as a positive one, based on world growth, not a negative one, based on defensive principles.

I truly believe 80 percent or more of the longs in this sector are gold bulls, not gold bugs. Unfortunately, the very loud gold bugs, more than half of whom generally go short, not long, are played up to by the  financial media, because it jibes with their Emperor Dollah thesis.

The Emperor Dollah thesis is about supporting a small oligarchy of extreme wealth against 99.99999 of the rest of the world's people. It is both anti-progressive and anti-conservative. Empires benefit almost no one but a small cadre of Emperor-designates, and those too scared or too stupid to think for themselves are the only ones who support them.

Gold, seen in a positive sense as a growth sector, represents the extraordinary emergence of a middle class, a bourgeoisie, in those parts of the world that have always been most gold-centric, since as long as there has been a human history: Asia, Africa, the Middle East, most of Latin America. Russia and Europe are fairly gold-centric, too. The only countries which are gold-averse, in fact, are the US and the UK. Even Japan, which pretends to be gold-averse, isn't.

Since Gold is a positive, not a negative, force in terms of fairer distribution of wealth, it is anti-elitist, anti-oligarchical, and should appeal to both progressives and conservatives. The unions should be pro-gold, for example, as should the churches and small business.

Alas, the positive aspects of the sector have been camouflaged by the gold bugs - purposely, since Dollah, Dollah, Dollah is imprinted on their brains, whether they generally talk from the long side, like Peter Schiff, or the short side, like Dennis Gartman. A gold bug is a gold bug is a gold bug, whether short or long. It's their general thesis that is wrong, and they seem to be trapped in it.

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