Gold Makes New High While Stocks Fall, Dollar and Bonds Up

* Gold made a new high yesterday, and is still higher this morning in at 1239. I want to repeat a comment I made yesterday about Gold’s correlation with other asset classes. Over the past week, gold has risen, while:


1> Stocks are down

2> Bond prices are up (rates down)

3> The dollar is up


The movement in each of these markets is typically associated with falling gold prices, not rising prices, yet gold has risen 6% in the last week. This tells me that something else is afoot. 


In the latter half of 2008, I introduced the premise behind owning gold, as an alternative currency, as the trends in printing money and credit inflation have the risk of ultimately undermining the value of all fiat currencies. I used to think that some currencies would do better than others. And while that might be true to a certain extent, I have since come to realize that the inter-connectedness of the global economy will even cause the stronger currencies to devalue their currency so they do not put their export industries out of business. Even the Swiss Franc, which should be much stronger than the Euro, has had only a modest appreciation to the Euro, as the Swiss National Bank has vowed that there is a limit to how much they will let the Franc rise. Last week on CNBC, George Dowd commented that the dollar (which was rising in value relative to other major currencies), was “the best looking horse at the glue factory”. What a great line. I wish I had come up with that. So this brings us back to precious metals which have served man as an alternative currency for millennium. In response to last Monday’s blog (May 3rd), in which I made a strong case for gold as a core part of any investment portfolio, a reader writes in with the following question:


“Rick, here’s my problem with gold (I may not be alone in this): to my mind, it is virtually entirely an artificial investment construct as it has no intrinsic value (setting aside what I expect is a relatively miniscule demand for gold jewelry). Commodities, it seems to me, have intrinsic value:  people and cows eat corn; people, at least for the near future, need gasoline for their cars.  Gold just sits there.  Granted, it has maintained its value for a long time and a lot of people have agreed on it as a store of value.  But still?


Can you help me out with this, or am I just going to have to get over it and accept that’s just the way it is and there is no good substitute.” (end of readers question)


Here is the idea behind gold: Gold has been man’s store of value for millennium. It has always been there for mankind… unless of course, you have lived in the US over the last 40 years. (That is why most US citizens do not understand gold). As recently as the Bretton Woods agreement after WWII, gold was used as a way in which countries settled their international debts. Leading up to 1970, the US found itself shipping too much gold overseas to settle its foreign exchange debts, and that eventually led Richard Nixon to abandon gold as backing for the dollar. From there on in, the price of gold began to float freely, but was not used as a way for foreign central banks to settle their balance of trade. Since 1971, gold has risen by more than 30 times. 


In terms of coming up with an expected, 10 year target for gold, here is my math: Over the last 25 years, the US has run a cumulative deficit of $7.5 trillion. If foreigners wanted to redeem their dollars against the US’s gold stockpile of 264 million ounces, then gold would convert at a rate of $28k an ounce. And if the US decided to back the 2.3 trillion Fed balance sheet with the 264 million ounces of gold, that comes out to $8,700 an ounce. While the cumulative trade deficit is a more appropriate way to value gold, it is hard to envision gold selling for $28k an ounce. Instead, I will go with the idea that as the world returns to a gold standard, which I think it will, then gold will be worth more than 5k an ounce, and perhaps a lot higher. 


And if that happens, there is going to be bedlam in Bedrock, and whatever else your savings is doing, it is going to get devalued dramatically, and will be subject to confiscation. Confiscation has happened time and again through the history of failing government regimes seeking to reset the clock and the fortunes of the nation. Consider the situation in France in 1711, or England 9 years later. We saw a similar confiscation scheme in the US in 1933. While I am not an expert on Chinese history, I know there are many instances during which the Chinese government confiscated the gold of its citizens. History is replete with these examples. If you are going to go through the motions of owning gold, you need to own it in a form which will transcend the political needs of the government where the gold is being held, or the government where you live. This is why I do not like exchange traded ETF’s. As these vehicles increase in popularity, they will set themselves up for forced redemption by the US government. The GLD ETF now has over 38 million ounces with a $46 billion of market value, and it continues to grow. While the ETF will capture the rise in gold for another $1,000 or so of appreciation, but when the government decides they need your gold, then you might get cashed out at $2,500 an ounce, before it doubles to $5,000 an ounce.


To the extent that gold goes parabolic, then that means that all sort of political problems are brewing. The potential consequences are so dramatic if this happens, that there is no way you want to be sitting on the sidelines, like everyone else will be. This is why I consider gold a buy and hold asset, and not a trading asset. The logic expressed in the readers comment is exactly how you how most people view gold. My way of looking at the subject of wealth preservation is to set a portion of your savings aside, and consider it a static, non-earning insurance policy. It could be your best performing asset. And if it does nothing, well, so what? If you need the money you would invest in gold for other purposes, then gold is not what you are supposed to invest in.


Following my piece on why you should own gold and establish non-US accounts, in the May 3rd blog, a reader writes in with the following:


“Frightening thoughts and I agree and sit here like a deer in the headlights with my US stocks and JPM bank account as the insatiable beast in D.C sizes me up like a yummy morsel.”


My comment is that you should do something, even if in modest baby steps. Buy 5 or 10 ounces of gold, take your assets off the grid a little bit at a time. You will feel better. Then do more, and eventually you will decide that you need to get a serious amount of your savings outside the US. Start small, see how it feels. I promise you will do more….


Let me share with you another reason why you should own gold: A friend in the business who actually went to the trouble to purchase a few small gold bars (100 grams, or 3+ ounces each), when gold was around $900 an ounce, mentioned to me on Friday, that he was getting ready to sell his gold. The reason why you own physical gold is so you do not sell it! The fact that someone who I considered to be insightful in his purchase is now looking to cash out, highlights the skepticism which most people have towards gold, as it makes new highs in almost every currency. Another friend in the business who was so deep into gold when it was below $1,000 an ounce, through thick and thin, and lots of pain watching it go side-ways for extended period of times, sold his gold around $1,050, and has since been awaiting for a pullback to re-load. There is so much skepticism about gold, that there is a tremendous amount of buying potential which will eventually propel gold higher.


In contrast to the anecdotal comments about folks who I know who have owned gold, investor enthusiasm is running rampant on the futures exchanges, where the bullish consensus numbers have been 95% for the past few days. As a contrary indicator, this is bearish, and the only bearish sign which I see.


Let me direct your attention to the first chart on the attachment, which shows gold futures over the last three years. On the bottom panel of the chart, is the open interest in gold over the same period. The dashed vertical line shows where the open interest peaked in 2006, yet gold kept rising. As gold rose, open interest dropped, indicating that we were in a liquidating market. When open interest is building, that is usually favorable for the direction of the trend, as was the case in 2006. When the open interest subsequently started to fall, as gold continued to rise, then that was a warning sign that the strength underlying the trend was waning. In today’s context, open interest is rising as gold makes new highs. This keeps me bullish on gold over the near term, despite the 95% bullish consensus. Aside from the futures exchanges, where many hedge funds play, there has been considerable buying away from the exchanges too.


In contrast to the rising open interest on Gold futures, you can see from the second graph of silver futures, that open interest is declining, which makes me less enthusiastic about the rise in silver. And when you compare the two metals, it should be noted that silver has yet to rally above its March 2008 high of 21.12, while gold is 20% above its March 2008 high of $1,033. From an intuitive sense, silver has uses as an industrial metal, and if the economy is about to enter a new down-cycle, which is what I think will happen, then it makes sense that silver is lagging gold, and is in liquidation, while it makes a new recent high. I still own a small amount of silver, relative to gold, but consider gold my main vehicle.


In terms of gold, as denominated in other currencies, I have attached graphs of gold in Swiss Franc and Yen terms, which both show that gold is at all time highs. (Actually, in 1980, when gold hit $880 an ounce, and the Yen was 240 yen per dollar, gold in Yen terms was higher than today, because the Yen has since appreciated by a factor of 3). In terms of the metal currencies, (Australian, Canadian and New Zealand dollar), gold is rallying, but not yet up to its early 2009 highs, as the last graph illustrates. Since these currencies tend to rally with the price of metals and the oil complex, it would be expected that gold would have the smallest appreciation in terms of these currencies. If anything, it suggests that these might be the best alternative to gold, if you have to pick a currency other than the dollar.


I will cover the various ways in which one can buy gold later this week.