February 9, 2012

Gold in a Financial Crisis

In what can only be called comic timing, the President's latest State of the Union was scheduled back-to-back with the latest Fed policy meeting. One day, the President painted a rosy picture of a nation on the rebound, and the next, the Fed doused it in the bitter acid of economic reality - and proceeded to make an unprecedented pledge to keep rates near-zero for at least another two years! Gold immediately spiked to about $1,710 an ounce on the news.

Over the past 6 months, gold prices oscillated and many investors lost sight of the long-term fundamentals supporting the monetary metal: the western world remains mired in debt, and the easy way for governments to tackle this crisis is to print money and keep interest rates low.

I started investing in gold when I first calculated the inescapable reality of the global debt trap several years ago. I became a gold bull, yet I did not fully understand why gold performs the way it does. At the time, I made the classic assumptions that gold is a hedge against lackluster stock market performance and general financial stress.

While these assumptions can prove true at times, one must dig deeper to understand the primary drivers behind gold's performance - gold's relationship with stock prices and financial stress is merely an indirect side effect. In fact, despite the classic assumptions, the gold price can rise during bullish stock markets and fall during periods of financial stress. Put the assumptions to rest: what really drives gold is the value of fiat currency.

Let's take a look at the major secular trends of the last decade:

Trend 1: January 2003 to December 2007 - Equity Bull Market
  • S&P 500 gained 69%.
  • Gold gained 153%.
  • The US dollar index lost a quarter of its value.
Trend 2: January 2008 to March 2009 - Equity Bear Market
  • S&P 500 lost 52%.
  • Gold gained 9%. (At the height of the financial crisis, gold lost 16%.)
  • The US dollar index gained 18%.
Trend 3: March 2009 to April 2011 - Equity Bull Market
  • S&P 500 gained 86%.
  • Gold gained 66%.
  • The US dollar index lost 18%.
As you can see from Trends 1 & 3, gold tends to perform well when the dollar doesn't. Gold is effectively a hard currency, and as a currency, it's a mirror against other currencies. And the same easy-money policies that cause the dollar to lose value and gold prices to rise also tend to cause the stock market to rise. Technically-speaking, inflation has driven real interest rates so low that they are negative, pushing investors away from the dollar and into other assets. Many investors already understand this.

The real confusion arises when a financial crisis occurs. As we see in Trend 2, while the S&P 500 lost 52%, gold only gained 9%. In fact, during the height of the Lehman Brothers implosion, gold was at one point down 16%.

Again, the real driver behind gold's performance during this example was the US dollar, which gained 18%. At the time, the US seemed to be the safest house in the economic ghetto. When financial shots were fired, investors ran to the perceived safety of the US dollar and US Treasuries.

Gold reflected the dollar's strength by declining in price. Tellingly, gold priced in euros and Canadian dollars declined by far less.

This safe-haven role for the dollar will not last forever. In fact, from 1900-2010, the US dollar lost about 95% of its purchasing power. As $120 trillion of unfunded liabilities come knocking at the US Treasury's door, aggressive debt monetization could eventually lead to a hyperinflationary spiral.

While gold price declines during times of financial stress can be worrisome to gold investors, they should remember one thing: the larger the financial calamity, the bigger the monetary response by central banks (i.e. money printing). As shown in the chart above, the Federal Reserve's November '08 response to the crisis sent gold prices skyrocketing in all currencies from their crisis lows.

Investors should look through periods of financial stress with the expectation that central banks are likely to make more announcements like the Fed's latest zero-rate pledge, ultimately sending the price of gold back upward. As long as this gold bull market lasts, every dip in gold caused by temporary spikes in the US dollar is a potential buying opportunity. In fact, gold is now up over 10% from the recent dip caused by financial stress over Europe.