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Disproving the Four Themes Behind Gold Bearishness

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Where Does the Gold Trade Stand?

May 26, 2015

by Trey Reik

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We have all read the latest crop of media articles challenging gold’s investment thesis. The typical approach by bears is to attribute hypothetical fears to gold investors, and then point out that those concerns have failed to materialize. But the investment thesis for gold is more complex than the simplistic motivations commonly cited in financial press. Gold’s methodical advance since the turn of the millennium has had less to do with investor fears of hyperinflation or U.S. dollar collapse than it has with persistent desire to allocate a small portion of global wealth away from traditional financial assets and the fiat currencies in which they are priced.

I am amazed that gold’s role as a productive portfolio-diversifying asset is still questioned by so many. During the past decade-and-a-half, gold has posted the most consistently positive performance of any global asset, yet it is still scorned by consensus. Which part of gold’s track record is so difficult to understand? Figure 1 outlines performance of spot gold in nine global currencies during the past 15 years. Despite widely divergent monetary and financial conditions, the performance of gold since 2000 has significantly exceeded any asset class with which we are familiar.

How could such an admirably performing asset continue to elicit such broad indifference?

Now that the S&P 500 index has more than tripled from its March 2009 low, the investment world is once again replete with portfolio gains from U.S. equities. Few asset classes can challenge the pedigree of the S&P 500 index, and even fewer investors would consider gold on par with the S&P 500 as an important portfolio building block. However, as shown in Figure 2, even at its current level of 2,112 (4/23), the S&P 500 index is trading today 68% lower in gold terms than at its 2000 peak. During the past two corrections in the S&P 500, during which the index declined 50.50% (2000-2) and 57.70% (2007-9), gold provided unparalleled protection of real purchasing power in all global currencies.

The next correction in U.S. equities will prove no different. I am not sure what percentage in the cumulative relationship between gold and the S&P 500 will finally earn gold its deserved profile as a mandatory, diversifying portfolio asset, but we are about to find out.

Gold is a unique asset due to the sheer number of investment perspectives leading to its ownership. Some perceive gold as an inflation hedge, others as a deflation hedge. During times of financial stress, some view gold as an asset to own, while safe-haven U.S. dollar traders see gold as an asset to short. Many view gold as the ultimate “risk off” asset, and just as many view gold as the ultimate “risk on” trade. What can then explain gold’s meticulous advance versus prominent fiat currencies in all but one (2013) of the past 15 years, despite the myriad of economic, fiscal and monetary conditions which prevailed during those years?

Gold Trade

After all, since 2000 the world has witnessed at least two deflation scares (2002 and 2009), various periods of inflationary concern (2005 and 2008), exceptional U.S. GDP strength (2004) and weakness (2001 and 2009), rising (2004 and 2005) and falling U.S. short rates, rising (2003 and 2006) and falling (2002, 2008 and 2011) longer term Treasury rates, multiple roundtrips for equities, bonds and commodities and a euro trading range of US$0.83 to US$1.60. In other words, every popular variable to which some people attribute strong gold correlation has oscillated repeatedly during the past 15 years, yet gold has increased in every year but one. Isn’t there something here that defies simple categorization?

There is indeed one overarching theme to gold’s performance that escapes popular reporting: gold’s consistent 15-year performance was due to the methodical migration of global wealth from the immense pile of outstanding financial assets (roughly $300 trillion) to the comparatively tiny stock of investable gold (roughly $2.4 trillion). In essence, gold performance is increasingly about global unwillingness to hold paper assets. Given the gaping disconnect between global paper claims and underlying productive output, as well as the unwavering penchant for global central bankers to debase fiat currencies in their attempts to bridge this chasm, the gold thesis remains in its early innings. Don’t worry that these arguments may appear detached and academic in light of recent price movements. No matter what one’s individual investment perspective may be, the world’s monetary system is becoming increasingly dysfunctional. For these reasons, gold’s most dramatic advances remain ahead of us.

Four themes behind gold bearishness

The resurgent bear thesis for gold currently rests on four key assumptions:

  • protracted U.S. dollar strength,
  • significant Fed tightening,
  • escape velocity U.S. economic performance,
  • further increases in U.S. equities

Because each of these assumptions is already in the process of being disproved, Western investment demand for gold will surge dramatically in coming years.

Let’s examine each of these themes in turn.

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