Gold's Missing Monetary Premium
Below is an extract from a commentary originally posted at www.speculative-investor.com on 14th August 2005.
There are very few objective observers of the financial scene who are as bullish on gold, as far as the coming 2-4 years are concerned, as we are. We not only expect that gold will trade at a multiple of its current level in US$ terms before the end of this decade, we expect that it will trade at a multiple of its current level relative to oil, copper, most other commodities, the S&P500 Index, and the average home. However, we don't expect great things from gold over the next 3-6 months, especially in US$ terms. This is partly because we think the US$ rally that began in January is not yet even halfway complete in terms of either time or price, but there's a lot more to it than that.
The main reason we don't think gold's recent advance is the start of the next major upward leg in its long-term bull market is that gold-related investments are rising in price alongside rises in the prices of almost all other assets. Genuine gold bull markets are all about increasing risk aversion and declining confidence in central banks, but the recent run-up in the gold price has occurred in an environment where investors, as a group, have exhibited minimal risk aversion and supreme confidence that the Fed will neither overshoot nor undershoot in its rate-hiking campaign. In particular, inflation expectations have remained low enough to give bond investors that 'warm and fuzzy feeling' at the same time as those playing the "inflation trade" have been having a great time.
Gold trades like money and tends to out-perform other investments when confidence in the official forms of money is falling, but as a result of the current widespread perception of a 'goldilocks' economic environment gold is not receiving any monetary premium. The below chart of the gold/GYX ratio (the gold price divided by the Industrial Metals Index) is evidence of this lack of monetary premium in the current gold price and the generally low level of risk aversion prevailing today in the financial markets. Putting it another way, the low price of counter-cyclical gold relative to the average price of cyclical metals such as copper, nickel and zinc, tells us that most investors believe the economic growth to be real (not inflation-induced)*.
The lack of a monetary premium means that the financial markets are presently not differentiating between gold and other metals (speculators are jumping into gold as part of a general commodity play). This, in turn, indicates that regardless of how high the gold price goes in the short-term the gains will most likely prove to be unsustainable because something that rallies hard along with everything else will probably fall hard along with everything else. Therefore, we don't consider this to be a great time to be INCREASING our overall exposure to gold stocks. Actually, in order to avoid significantly increasing our exposure to the gold sector we will have to do some selling if the rally continues (the recent gains in stock prices have taken the cash percentage in our own account down to about 40% and in the current environment we wouldn't want it to get any lower than that).
Gold, in our opinion, will eventually benefit greatly from downturns in the stock and commodity markets because these downturns will pave the way for the next inflation cycle. Also, the fact that gold is not receiving a significant monetary premium and is, therefore, incredibly cheap right now compared to almost everything else greatly enhances its longer-term upside potential. However, one of the INITIAL effects of a sharp downturn in the stock market and/or the commodity market will most likely be a further decline in inflation expectations and a consequential rise in REAL interest rates, a negative development for gold. As a result, although gold and gold stocks should be eventual standout beneficiaries of downturns in pro-growth investments, they are likely to be initial casualties.
To summarise the above in one sentence: What we are probably seeing in the financial markets right now is the end of something (blow-off moves in the investments that performed well over the past few years), not the start of something.
*One of the main reasons cyclical commodities have been able to rally as much as they have without generating inflation fears is the ' China story'. Specifically, the link between a currency problem and rising commodity prices has not been made in the minds of most investors because they believe that the higher commodity prices can be put down to rapid REAL growth in China (as opposed to a fall in the relative value of fiat currencies). However, China's rapid growth has been fueled by a massive expansion of credit and is no less inflation-induced (no more sustainable) than the growth achieved by the US economy over recent years.