Gold's Early Warning

Written By Geoffrey Pike

Posted July 24, 2015

The gold price has taken a big hit recently, particularly this past week. With the situation in Greece stabilizing temporarily (emphasis on temporarily), and with the Chinese central bank reporting its gold reserves higher (but lower than some expected), investors seem to be losing interest in gold.

The gold price has dropped below $1,100 per ounce after trading in a fairly narrow range for quite a while.

It is important to realize that we are referencing the gold price in dollars. If you measure the gold price in euros, it just went down to about 1,000 euros per ounce. This is still slightly higher than it was a year ago.

So if you are a European living in Europe and saving in euros, you would have been better off investing in gold one year ago than keeping your money in the bank. And with interest rates near zero and even negative at times in parts of Europe, your euros would not have made any interest of any significance.

The gold price in dollars has not been a good investment since 2011, when it hit all-time highs. It was a great investment around 1999 and 2000, when it was trading below $300 per ounce.

For the last couple of years, the weak gold price has been as much a reflection of the incredibly strong dollar as anything else. Or as I like to say, the dollar has been “less bad” than all of the other major fiat currencies of the world.

In this sense, it is hard to imagine a significantly higher dollar price for gold until we see a weaker dollar. But this isn’t the only thing that matters.

Over time, all fiat currencies tend to lose purchasing power, some faster than others. The dollar has typically held up better, but we don’t know how much of that is due to it being the world’s reserve currency.

However, if expectations for price inflation are high, then the strength of a currency in relation to all of the others doesn’t necessarily matter. If you have price inflation of 10% in the U.S. and 20% in Europe, then the dollar is going to be strong against the euro. But in this scenario, gold is likely to shine even in terms of dollars because of the fear of price inflation.

Consumer Price Index

The latest CPI numbers were recently released for June 2015. The median CPI ticked up to 2.3% (year-over-year) after being at 2.2% every previous month this calendar year. The median CPI tends to be more stable and reliable than the regular CPI numbers.

The year-over-year CPI is now at 0.1%. According to this statistic, there is barely any price inflation right now. If you take out food and energy, it is at 1.8%. Lower energy prices have certainly kept the CPI numbers down.

Some people don’t like the CPI numbers. It is a government statistic that has its biases. Still, I find it useful in looking at trends. And we also have to pay attention to it, if for nothing else, because the Fed pays attention to it.

We have to distinguish between monetary inflation (which the Fed and the banks directly control) and price inflation. The Fed increased its balance sheet about five-fold from 2008 to late 2014. This was unprecedented.

But most of this newly created money went into bank reserves instead of the banks lending out the money and multiplying the supply of money through fractional reserves. The banks have been happy to get 0.25% interest on reserves from the Fed instead of risking it on additional loans. The banks will be getting an even higher rate on these reserves if the Fed does as expected and raises its key interest rate later this year.

These huge excess reserves have kept a lid on price inflation. Prices have not risen commensurate with monetary inflation. In addition, there is still a somewhat high demand for money in the economy. People are still not spending as carefree as they were prior to 2008. This also helps keep price inflation in check.

Right now, the CPI numbers are in sync with what the gold price is doing. Gold is typically a hedge against disaster and high inflation. If inflation expectations are low, then gold is not in demand as much.

Is It Just Gold Investors Who Need to Worry?

The bigger question is whether just gold investors need to worry about the recent drop in price. Perhaps it is simply a temporary downturn that will reverse quickly.

But what if gold is telling us something more about the state of the economy?

I do not believe in the Keynesian myth that there is some kind of trade-off between inflation and unemployment and a growing economy. You can have great economic growth in a time of low inflation, as is what happened through much of the 19th century in the United States.

If you have a stable money supply with expanding production and technology, then prices gradually go down. We can see this with computers today. The prices of many electronics have gone down in spite of an increasing money supply.

The problem with today’s economy is that much of the supposed growth and the rise of stocks are supported by the Fed’s easy money and low interest rates of the last seven years. Does anyone sincerely believe that stocks would be anywhere close to where they are today if the Fed had never engaged in QE1, QE2, and QE3? Three big rounds of monetary inflation almost guarantee higher stock prices in the short term.

The Fed ended QE3 in late October of 2014. It has been just over half a year. Is the economy going to get stronger at this point without the support of the Fed?  Or is the previous misallocation of capital going to be exposed because the stimulus has dried up?

We can’t be sure at this point, but the lower gold price could be a sign of economic trouble ahead. It obviously is not trouble in the form of higher prices, as was seen in the 1970s. The more imminent threat is a recession.

Is gold the canary in the coal mine on this one? Or is the yellow metal just out of favor right now on its own merits?

Owning Gold as Insurance

I believe every investor should own some gold and gold-related investments. If anything, it should serve as an insurance policy. It is a volatile investment, which is partially just a reflection on the volatility of the currency we use.

I don’t really recommend that you speculate with gold, unless you are a day trader and you really know what you’re doing. Gold is something you buy to diversify your portfolio and to collect gains during times of disaster and high inflation.

You should rebalance your portfolio so that you are selling off some of your gold after big gains and buying more after the price has gone down.

In fact, if you are low on gold in your portfolio now, this is probably a great time to buy. It may go down lower, but you will almost never find the bottom. I recommend having around 20% of your financial investments in gold and gold-related investments such as an ETF, but 10% should be your minimum.

You probably aren’t going to get rich owning gold, even if you can time the market well. But it is an essential part of a good portfolio.

If the latest drop is indicating a coming economic downturn, then I fully expect the Fed to step in again and create even more money out of thin air. At some point, this will likely drive gold higher again.

Interest rates are still low at this point and could go lower in an economic downturn. While I think we are in a massive bond bubble, we may see one more bond surge where interest rates drop lower.

I think there is going to be an investment opportunity of a lifetime at some point to short bonds. In other words, it will be a bet on higher interest rates. But that time is not now, with inflation expectations remaining low and a possible economic downturn looming.

Keep your gold as an insurance policy, and buy some more if you are low on it. You can swing for the fences with a bet on higher interest rates at another time down the road. Sometimes you have to be patient for the great opportunities.

Until next time,

Geoffrey Pike for Wealth Daily

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