Understanding the Gold Bull
Below is an extract from a commentary originally posted at www.speculative-investor.com on 14th May 2006.
We think the gold bull market that began during 1999-2001 is widely misunderstood, even by some of the most avid gold analysts. For example, the annual deficit between mine supply and fabrication demand is regularly cited as a major driver of the gold bull market even though the total aboveground supply of gold is more than 200-times greater than this so-called deficit. Also, we often read that a more precarious geopolitical backdrop is a reason to own gold because gold is, apparently, a safe haven during uncertain times. But why should this be so? Traders have been conditioned to buy gold futures whenever the prospect of military conflict looms large, but why on earth would military conflict lead to a SUSTAINED increase in the gold price? After all, gold is no longer money in the true meaning of the word (it is not the general medium of exchange) so there would be no reason for it to rise in value during a period when there was a rush to cash.
There is actually a valid reason for gold to rally in response to the increasing probability of war, but the reason isn't the war itself; it's the inflation of the money supply that invariably occurs when the government increases its borrowing in order to finance a war. If not for this inflation and its effect on the perceived value of the official money there would be no reason at all for the gold price to rise in response to war.
The current gold bull market, like the gold bull markets that came before it, is about falling confidence in the currency of the realm, which is, in turn, linked to falling confidence in central banks and governments (the purveyors of the official currency). Falling confidence in the official money, falling stock market valuations and the increasing purchasing power of gold are all part and parcel of the same trend, and once a major trend begins with relative valuations at one extreme it will continue until relative valuations reach the opposite extreme.
When, during 1999-2001, the S&P500's P/E ratio reversed lower after reaching an all-time high and the gold price reversed higher after reaching an all-time low (in real terms) it became inevitable that new trends lasting at least 10 years had begun. Furthermore, there is no chance that government manipulation can prevent these trends from running their course. Empirical evidence that this is so was provided during the 1970s when concerted attempts by governments to stem the rise in the gold price failed dismally despite the fact that the official sector controlled a much larger proportion of the aboveground gold stock then than it does today.
During 10-25 year secular bull/bear markets there are shorter cycles that may or may not be consistent with the longer-term trends. In this regard, the cycle that began around this time last year is, in some important respects, a deviation from the long-term trend even though it has featured a rising gold price. Over the past year the gold price has not been driven higher by a general decline in confidence, but, instead, by a rising sea of liquidity that has also pushed many other prices upward. At least, this is our view and it is a view that is consistent with a) gold's poor performance relative to most industrial metals, b) the substantial narrowing of credit and yield spreads, and c) the concurrent sharp rises in the prices of investments that normally aren't positively correlated.
To illustrate the idea that an increase in liquidity has been the major driving force in the markets in recent times we've included, below, a 3-year chart comparing the stock price of investment banking behemoth Goldman Sachs (NYSE: GS) with the gold price. We've chosen GS for this comparison because this company is supposedly the 'ring leader' of a cartel that is working to suppress the gold price and is, as a result, heavily short gold. Notice the positive correlation between the two entities and the fact that the upward acceleration in the gold price that began last September was accompanied by an upward acceleration in the price of GS. We seriously doubt that GS benefited directly from the higher gold price, but the fact that these two investments have moved in lockstep supports our view that a general rise in liquidity has been the primary driving force in the markets.
A similar chart to the one above is shown below, but in this case we've compared the stock price of GS with the stock price of Newmont Mining (NYSE: NEM). We find the GS-NEM comparison even more interesting than the GS-gold comparison because it not only reveals a strong positive correlation between the world's premier unhedged gold mining company and one of its natural enemies, it shows that NEM has been leading GS by 3-4 months at intermediate-term turning points. This suggests that if NEM continues to hold below its 31st January peak then an important top is now being put in place for GS.
Because gold has been a beneficiary of the rising sea of liquidity over the past year it will almost certainly be hurt once liquidity starts evaporating, but any downturn in the gold market associated with declining liquidity is likely to be much less in terms of both duration and magnitude than the corresponding downturns in industrial metals, emerging market equities, and other markets that were the more natural beneficiaries of the rising liquidity.