Tuesday, August 19, 2008

Time to Reconsider the Gold Trade

Marry a spouse, never marry a trade. - A. Burns

Gold, to paraphrase Chico Escuela (an S.N.L. character played by Garrett Morris) has been bery, bery good...to me. Despite the 20% decline in price from its most recent peak, my investment in Gold is still well in the black. Yet, the price of Gold has lost 20% from its peak, falling through the $800 support level. Since my trading loyalties are to profits and not the investments themselves, I think it's time to take a fresh look at the Gold trade.

Primary Considerations: There are, it seems to me, 2 essential factors which denote conditions favorable to gold price appreciation: 1) substantial malinvestment - misallocation of investment capital into unprofitable ventures 2) policies and institutional biases which favor inflationary resolutions of the problems caused by said malinvestments.

Back in 2000-2001, when I put on the bulk of my Gold trade, the, to my mind, malinvestment, was a function of global over-optimism on profit opportunities in US securities. Projections of fiscal surpluses as far as the eye could see back in 2000, which, in hindsight, proved very fleeting, had attracted large private sector inflows to the US Bond market while, in the equity market, faith in technology based productivity gains, which proved equally fleeting, had attracted even more capital to the US.

These inflows fed not only the Treasury and Equity markets, but also the Mortgage markets, and thus the housing markets.

Initially I "played" this analysis by shorting mainly equity securities in the Tech sector. However, as the equity market began to decline, financial authorities, led by Alan Greenspan, demonstrated their new view that the job of the Fed was no longer to "take the punch-bowl away" but to mitigate, via liquidity additions, the effects of the hang-over which inevitably followed.

But the hang-over was long in coming, and may not even have arrived in full force yet.

Additional Factors: The attacks of 9/11 and policy choices in response thereto (i.e. military action in Iraq and Afghanistan, covert support of "revolutions" in nations which had previously been part of the Russian sphere of influence, and attempts to block Iranian attempts to develop nuclear power) opened up new avenues for what has thus far proven to be malinvestment.

As private sector funding for the US began to decline, international monetary authorities picked up the slack and the stock of externally held US debt exploded, most notably in China.

China's shift from Maoist autarky to significant international trader, which allowed such huge inflows of US debt, has accelerated, and, according to this FT article they will soon overtake the US as the world's leader in manufacturing.

Russia, helped, in large part, by a rapid rise in oil prices, emerged from its 1998 debt defaults quickly. Under Vladimir Putin, Russia expelled the Oligarchs and brought commodity exports back under national control. They too now hold significant quantities of US debt.

Oil prices, which had, for much of the 80s and 90s, been trading, on average, under $20, began to move higher due to, inter alia, fears of peak oil, increased international demand, especially from China and the failure to increase Iraqi exports.

This rise in oil prices has exposed additional malinvestments in US suburban housing investment. The suburban lifestyle, exemplified, for our purposes, by the SUV, predicated on a perpetual supply of cheap oil is fast becoming non-viable for many.

While the change in relative prices between US equities and goods and services in general has resolved some of the initial malinvestments (but not all) that process itself and the expansion of the fiscal deficit to pay for, inter alia, the wars, has exposed additional malinvestments which also need to be resolved.

Further, US global dominance in economic and military affairs has been eroded. The wars in Iraq and Afghanistan are still ongoing and the covertly sponsored revolutions in the old Russian sphere have inspired blowback, most notable recently in Ossetia.

The decline in US dominance and expansion of the Chinese economy in particular and the emerging world in general calls into question (in my mind at least) the ability of the US to issue the world's reserve currency. Just as the expansion of the US economy beyond the UK's in the early part of the 20th Century led to a shift from the GBP to the US$ as world reserve currency, China's growth beyond that of the US and the more general decline of Western Economic output relative to the rest of the world will, if continued, lead to the emergence of a new reserve currency.

While China hasn't yet complained about its continued subordination to the US in the currency arena, now that the Olympics are winding down the complaints may soon be voiced.

So why is Gold down?: Bull markets are always prone to significant corrections. Intervention in support of the US$ combined with a correction in oil prices (and other commodities) during the slow trading days of August have weighed on Gold prices. This correction, as George Soros would argue, engenders its own arguments.

Some, I call them radical mean reverters, believe that all bull markets eventually resolve back to original prices. Thus, just as equities and houses, to name two, have seen price declines so too will commodities. How one explains the Dow's current price- which is at the same level it was in late 99, 5 times its late 80s price, with this view is beyond me.

Others believe that demand is the only cause of inflation and thus a slowdown in the US will reduce inflationary pressures. Yet this view does not explain the classic "currency crisis" periods when demand contracts rapidly while prices jump.

The US has avoided such an outcome so far because it issues the world's reserve currency. In my view, if the US was just a part of the system and not the driver, the US$ would already have fallen prey to a crisis similar to that seen in, for instance, Asia in the late 90s. A US economic slowdown which is more than offset by growth in the rest of the world leaves the US$ particularly vulnerable.

What would it take to dump Gold?: Back when I put the trade on a period of high US real rates would have been sufficient to signal a need to move back into US$ and I'll stick with that view. However, the decision to allow the net investment and external debt position to grow over the past few years since leads me to think the path of higher rates involves a much lower US.

In sound- bite form, we haven't seen a Volcker-like guy get appointed Fed Chairman.

Of course, I could be wrong on, inter alia, my sense of the degree of malinvestments. A price of $700 would certainly make me nervous, so if that happens, check back.