Gold May Take a Breather
By GENE EPSTEIN
September 2, 2011
September 2, 2011
In addition to being a commodity, gold is also a cause. As the latter, its recent surge to record highs stands as an indictment of the paper money system that helps underwrite the fiscal and monetary irresponsibility of government, and the need to replace that system with the discipline of sound money—literally, money that actually makes a sound.
I support that cause, but what we sound-money advocates would prefer to see must be distinguished from what is likely to happen. The roaring bull market in gold seems ripe for a downside correction—assuming it didn't already begin with the $100-plus selloff from Monday's high.
According to the metals-consulting firm CPM Group, if gold were bought only for its industrial and ornamental uses—the attributes that make it a commodity—its price would run about $600 an ounce today. The last time gold saw $600 was nearly five years ago (see chart below), so other factors must have propelled the price to highs of more than triple that level. The main factor has been net buying by investors, aided by the advent of exchange-traded funds that make it easy to acquire the metal.
What exactly are these investors investing in? Mainly the concerns that help make the metal a cause: the lack of confidence in the ability of governments to manage their monetary and fiscal regimes, causing a flight out of paper money—including dollar, euro and yen—into the only major safe haven left, gold.
Despite the justifiable lack of confidence, recent price behavior to the record high of $1,897 early last week might give any gold bull pause. Even if prices recover from the subsequent selloff, chances are that further peaks will be short-lived. Look for prices to remain in a holding pattern at best, with the next major move probably favoring the bears.
One such bear is Steve Briese, publisher of the Bullish Review of Commodity Insiders newsletter and Website. Having strongly recommended long positions in the metal early this year, Briese (pronounced "breezy"), recently put out a virtual S.O.S. to his subscribers. In the Aug. 15 issue of the newsletter, he called the daily gold price chart "as close to straight up as you can get without going vertical," and then warned, in uncharacteristically emphatic language: "These charts always, always, always end with prices going down, down, down for a long, long, long time. Always."
BASED ON EXTENSIVE research he did for Barron's about the performance of similar roaring bull markets, which rose and then collapsed, Briese believes a 33% correction from recent highs, to about $1,250, is quite plausible.
Bolstering his conviction that the gold chart illustrates a classic speculative bubble, Briese further points out that the long side of the vast futures and options market has been in "weak hands." Based on the Commodity Futures Trading Commission's weekly "Commitments of Traders" report, he notes that the net short position of traders whose business involves dealing in actual gold has been at near-record levels over the past few weeks. In other words, the smart money, while not always right, has been voting with its dollars that gold will fall. It has mainly been the speculators who have been voting for a continued price rise.
But not wishing to overly bug the gold bugs, he recommends only that they consider taking profits and then wait to buy back eventually at what he believes will be much lower prices. This is a similar prediction to the one Briese made for commodity indexes in the March 31, 2008,Barron's cover story. In that case, he was proved right by year end.
Whether or not this view does prove right, caution about the upside does seem in order. Take, for example, a frequent argument made by the bulls that gold should at least reach an inflation-adjusted high of $2,330, a figure derived by taking the January 1980 peak of $850 and upwardly adjusting it for the rise of the consumer-price index over those 31 years.
But if the gold price really should track the CPI, why, for example, did it fail to do so from 1985 through 2000—which saw a 15-year decline in gold, while the CPI rose by 60%? The answer is that gold responds not so much to inflation as it does to economic instability in general—and these were 15 key years in the two-decade era of the Great Moderation, when the economy was relatively stable. Of course, economic instability often includes price inflation, but mainly when it's accelerating or running annually in the double-digits.
Moreover, even if gold does try to play catch-up with the CPI, its ability to do so is hobbled by the tax on capital gains, which debits the bulls whenever they turn the gains back into dollars.
Finally, even if the gold price is fated to match its inflation-adjusted 1980 peak, the short-lived Jan. 21, 1980, spike of $850 is not the sort of benchmark economists would use. A more appropriate benchmark would be the 12-month average through December 1980. Over that period the price averaged $612, which was not exceeded until the 12 months ended February 2007.
Accordingly, what would gold have to average for 12 months in order to match that $612 in inflation-adjusted terms? Answer: $1,680. Against an August 2011 average so far of $1,747, and a Thursday close of $1,774, the price could trend down from here, and then remain in a trading range for another 11 months.
Result: It would realize the 1980 inflation-adjusted high for the 12 months of 1980, just as the gold bulls should expect.
READERS OF Barron's who dissent from this bearishly inclined view might fairly point out that a feature published last fall ("A Golden Era for the Yellow Metal," Oct. 11, 2010), could have been more prescient about the bull market that followed. The story recommended that investors "go for the gold," with a target price of "$2,000 an ounce or more," but only if they thought the economy was going "to hell in a handbasket."
Otherwise, the core prediction was that the bull market would "slow its pace," peaking at around $1,500, while suggesting that gold mining shares might be the more profitable play. The six gold-mining stocks we flagged rose 15% as a group, while the S&P 500 remained about flat. But far from slowing, the bull market in the metal itself accelerated, appreciating more than 30% over that same period.
Where the story went wrong was in underestimating the rather hellish performance of the economy, including the historic downgrade of U.S. Treasury debt, turmoil gold bulls essentially anticipated. As CPM Group managing director Jeffrey Christian, who also underestimated the bull market, comments: "I thought there was a 25% chance that the politicians in Washington would behave stupidly, when I should have put it at 75%."
Christian does not foresee a sudden surge in political brainpower. But on the matter of dealing with the federal debt, he believes the 12 members of Congress empowered to come up with further proposals will deliver real results and not just rhetoric. He also believes the economy will not unravel, but will resume a modest growth rate of about 2% annually.
Factors like these should slowly alter the perceptions of gold investors, and weigh on the price. On the other hand, if "to hell in a handbasket" is still your answer to where the economy is headed, then $2,000 an ounce or more should still be your price objective.
IN HIS 2007 MEMOIR, The Age of Turbulence, former Federal Reserve chairman Alan Greenspan wrote that he favors the gold standard for its "price stability," but admits that he has "long since acquiesced in the fact that the gold standard does not readily accommodate…the propensity of Congress to create benefits for constituents without specifying the means by which they are funded [which] has led to deficit spending in every fiscal year since 1970…."
Greenspan also predicts that by 2030, "as Washington strives to make good on the implicit promises made in the social contract," price inflation might soar, causing a "trudge through economic and political mine fields before we act decisively."
Perhaps that decisive action will be a new gold standard. In any case, even if gold is poised for an extended pull back, the bull market should persist for a long time to come.