What's Going on With Gold?

In the beginning, which, for the purpose of this analysis, we would point to as mid-July, when the credit crisis began laying waste to markets around the world, gold closely tracked equities.

As the Dow was plummeting from 14,000 to less than 12,500 (nearly an 11% haircut), gold was also dropping, though not so steeply. The metal fell from a high of $683.50/oz on July 20 to an intraday low of $640 on August 16, a decline of 6.4%.

For a while, the correlation remained tight as investors rode alternating waves of optimism and pessimism about stocks and gold. Equities up, gold up. Equities down, gold down. Set your watch.

This correlation was due to a number of factors.

For example, the need for hedge funds and other institutions to sell anything with a bid – for instance, gold – in the scramble to build liquidity in suddenly (and surprisingly so) illiquid bonds and commercial paper.

Pressure on both equities and gold at the time can also be attributed to the dawning realization that (a) the credit crisis was real and, (b) it probably wouldn’t be terribly helpful to the global economy. Of course, when one worries about recessions and such, one thinks less of holding either stocks or gold. The former for the obvious reason that bad economic conditions make for bad business; the latter because anything that is supposed to be an inflation hedge can’t also be a deflation hedge, can it?

Though admittedly impatient to see the gold show get on the road, we were largely unconcerned by gold’s behavior. That’s because our eyes remained firmly fixed on the perfect trap set over the years for Bernanke’s Fed.

Like hunters of antiquity watching large prey grazing toward a large covered pit, the bottom of which is decorated with sharpened sticks, we watched the handsomely attired and well-groomed Bernanke and friends shuffle ever closer to the edge, their attention no doubt occupied by pondering the flavor of champagne to be served with the evening’s second course.

One minute pondering bubbly, the very next standing, wide-eyed and hyperventilating, on thin cover with decades of fiscal abuse cracking precariously under their collective Italian leather loafers. We can’t entirely blame Bernanke for the dilemma he now finds himself in; it was more about showing up to work at the wrong place at the wrong time.

Regardless, all of a sudden the Fed and many of the world’s central bankers found themselves faced with the rock-and-a-hard-place scenario we’ve been warning readers of for some months now.

Namely, raise rates – or even just do nothing – and the whole shaky structure of debt comes crashing down, pulling the global economy with it. Swing in the opposite direction by cranking up the printing presses to full speed and risk alienating foreign holders of an unprecedented six trillion in U.S. dollars, triggering a monetary crisis, also with global implications.

Watching the closely correlated moves between gold and the broader stock market in the early days of the crisis, however, had us wondering just when it would be that other purportedly intelligent market observers would figure out the nature of the Fed’s dilemma, and the inevitable implications of same. To wit, that when push came to shove, the Fed would almost certainly sacrifice the dollar.

The reasons for that conclusion are, at least in our thinking, obvious.

While the Fed and the world’s central banks could, after the initial round of rate cuts and cash infusions, switch course again and decide to simply sit tight, allowing a deep recession – or perhaps even a depression of 1930s depth – to clear out the monumental excesses now in the financial system, we don’t think they’ll find that option attractive, especially in the midst of a presidential election cycle. Instead, the law of relative unpleasantness strongly skews the odds in favor of the printing press option.

Specifically, they are now well aware of what sort of unpleasantness will almost certainly occur if they fail to feed the beast with greenbacks by the helicopter load. Collapsing real estate prices, closing factories, soaring unemployment and, given the size of the problems, a clear possibility of things spinning seriously out of control from there. Returning to my earlier metaphor, we’re talking a sure trip onto the sharpened sticks below.

Against that probability, they have the possibility that, by setting the printing presses on high speed, the Fed might alienate foreign dollar holders who, theory has it, have as much to lose from a falling dollar as anyone. So, maybe, just maybe, the foreign holders will hold tight, preferring to see their many trillions depreciate by, say, 10%, rather than taking a deeper loss by heading for the exits en masse.

And that provides the Fed just the intellectual cover needed to do what is, after all, its default mode – depreciate the currency. For the truth of that observation, look no further than the fact that the U.S. dollar has lost over 96% of its purchasing power since the creation of the Fed in 1913.

But there are additional reasons for the Fed to opt for a loose money policy. To name one, the U.S. is in the aforementioned presidential election cycle. Foreign dollar holders don’t vote, but heavily indebted Americans do. For another, a weak dollar will help make U.S. manufacturers stay more competitive (hey, it worked for the Chinese!). Finally, a weaker dollar benefits the government by allowing it to pay down its many debts in depreciated dollars.

Most people don’t fully appreciate how poorly the Fed has managed the currency since

cancelling the dollar’s convertibility into gold in 1971. That brazen act cut the ties between the dollar and any fundamental value, leaving only political restraint to underpin the dollar.


David Galland
for The Daily Reckoning
November 11, 2007

P.S. Since its low in 1999, the price of gold bullion is up about 200%. By comparison, the American Stock Exchange index of gold stocks is up 556% in the same bull market phase! That’s profit-boosting leverage of better than 2-to-1… financial rocket fuel.

P.P.S. You can continue reading Mr. Galland’s essay, below…

— The Daily Reckoning Book of the Week —

The Demise of the Dollar – and Why It’s Great for Your Investments
by Addison Wiggin

This acclaimed book spent over a week in the #1 slot on Amazon’s bestseller list – knocking Harry Potter to number two. It then showed up on Barnes and Noble’s bestseller list and debuted on The Wall Street Journal’s Business bestseller list last week at #8!

The only logical next step was for the book to get on the New York Times bestseller list…which it and sat strongly at #5!

The Demise of the Dollar examines the reasons for the dollar’s slide – including the nation’s historic trade deficit, the euro, government spending habits, globalization, and other international factors – and offers an up-close look at the Federal Reserve’s attempts to “manage” the dollar’s value.


THIS WEEK in THE DAILY RECKONING: The past seven days have been chock full of interesting tidbits from the markets…Ron Paul takes his public enemy number one, Ben Bernanke…the dollar hits another all-time low…and oil reaches an all-time high. We have all these stories catalogued for you, below…

11/09/07 – Question Marks Return for Investors
by Bill Bonner “It seemed too easy. Too obvious. Markets don’t usually work that way. People rarely get what they expect, because what they expect is already reflected in current prices. Instead, markets usually surprise us.”

11/08/07 – A Good Recipe for Bad Finance
by Bill Bonner “As near as we can tell from the news reports, what really happened is that the company’s erstwhile very profitable finance arm – GMAC – didn’t make as much as it had planned. Then, GM’s attempts to cook the books blew up in the kitchen.”

11/07/07 – Bedazzling Chumps with Fancy Formulae
by Bill Bonner “It was obvious to even a freshman math student that you can’t compute real risk…and that markets have feedback mechanisms than tend to short circuit any kind of broadly followed modeling technique.”

11/06/07 – Contractions Only Dollars Apart
by Bill Bonner “We are witness to something that doesn’t happen very often – like the eruption of a volcano…or the collapse of a bridge – the first stage of a credit contraction.”

11/05/07 – Pounds of Robust Flavor
by Bill Bonner “How come the pound is so strong? The English are spendthrifts too – just like Americans. They’ve loaded themselves up with debt – just like their yankee cousins – and now have the lowest disposable (after debt service) income in 10 years.”



Awakening Day
by David Galland

The market finally seemed to see the light on Thursday, September 6, when a major divergence in the paths of gold and the broader stock markets occurred. On that day, the Dow dropped over 125 points while gold shot up more than $13 an ounce. And it continued up on Friday, Monday and Tuesday, with gold breaking through the $700 mark even as equities did little or nothing. That was the first time the two marched to different drummers since the crisis hit.

Since then, gold has gained a new appreciation in the investment milieu. When the stock market soared after the Fed lowered interest rates, so did gold. And when the market retraced, gold pushed higher still.

Even more cheering for readers of our monthly editions of BIG GOLD is that the market didn’t just come to its senses about the role that gold had to play in the unfolding crisis, it also remembered that gold stocks were, in fact, related to gold.

While still baby steps in terms of what we expect, this is exactly the sort of price action we’ve been expecting… an early indication that institutional investors are starting to move into large-cap gold stocks, the investment class that pops first to mind when the Wall Street crowd decides that gold belongs in the portfolio.

No matter which way things go, gold – as it has been for thousands of years – is the ultimate hedge in times of crisis. And the recent shift into the metal, and now to gold stocks as well, is a sign that increasing numbers of investors are learning to see it as such.

Editor’s Note: David Galland is the managing editor of the BIG GOLD advisory from Casey Research, one of the nation’s oldest and most respected organizations providing unbiased research on natural resource investments.

BIG GOLD is designed for conservative investors looking for an easy and lower-risk way to participate in gold markets through producing and near-production precious metals companies, ETFs and mutual funds you can buy and sell through your favorite discount broker.

The Daily Reckoning