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