Month: August 2010

In the article Rethinking Gold: What if It Isn’t a Commodity After All? Jeff D. Opdyke at jeff.opdyke@wsj.com talks about what if Gold isn’t a commodity.

Wow, he hit the nail on the head with this one! Dollars are a fiat currency. Gold is money.
Ever wonder why fund managers no longer suggest you purchase Gold as a ‘well rounded’ portfolio? I’m guessing that it is because they do not get a commission each year from you holding physical Gold in your hand.

At the very least all investments (maybe including business also) comes in waves – Ups and Downs – the trick is to A) keep you money liquid and moving. B) catch the wave as it is going up, not as it is cresting and about to go down.

This won’t sit well with some people: Gold isn’t a commodity. There. I’ve said it.

But before you fire off an angry response, hear me out. The facts might change your view of gold’s role in a portfolio.

For a long time, we’ve all heard that gold is a commodity—no different, really, from silver or wheat or pork bellies. Its price ebbs and flows (supposedly) with inflation, which historically drives commodity prices.

Odd, then, that gold’s elevated price hasn’t fallen in response to tepid U.S. inflation numbers. The Consumer Price Index as of July pegged inflation at just 1.2% for the previous 12 months, not counting seasonal adjustments. Nor has gold reacted to what Mohamed El-Erian, Pimco’s chief executive, recently called “the road to deflation” on which he sees the U.S. traveling.

The conventional wisdom holds that neither of those scenarios—low inflation or deflation—should be good for gold. And yet it refuses to abandon record highs in the $1,200-an-ounce range. Something seems amiss.

I recently asked research firm Ibbotson Associates to run a correlation study to determine how closely inflation and gold-price movements track each other. You would expect gold, as a purported commodity, and inflation to move in tandem.

The data, going back to 1978 and capturing an inflationary spike, shows a correlation of, at most, 0.08.

That is low. Really low. Perfect correlation is 1; at minus-1, two assets move in perfect opposition. Near 0 implies gold and inflation barely acknowledge one another, and moves in unison are largely happenstance.

So if inflation doesn’t push and pull at gold prices, what might it be? If you believe correlation studies, the answer is the U.S. dollar.

Going back to 1973—a period that defines the modern, non-gold-backed dollar—the greenback’s movements closely track gold’s direction. The correlation between month-end gold prices and the Major Currencies Dollar Index, as reported by the Federal Reserve, is minus-0.45.

That clearly is a stronger correlation than you find with inflation. But let’s take this a bit further. Let’s shorten the time frame to the period from gold’s 1980 peak to today.

The result: Over the past 30 years, the correlation between the dollar and gold is minus-0.65—a high negative correlation. It means the dollar and gold are effectively on opposite ends of a seesaw. When the dollar is in favor, gold retreats. When it is under pressure, gold prices swell.

Look at the nearby chart. It is like a photo of a mountain scene reflected in a tranquil lake. The rises and falls and horizontal meanderings of gold are nearly the negative of the dollar’s.

The implication is that gold isn’t a commodity—at least not one that hews to the definition of something that people and industry consume.

Instead, “gold is a currency” whose daily price is a gauge of the market’s concern about the “potential diminishment” of the purchasing power of the dollar and other paper currencies, says Paul Brodsky, a principal at New York’s QB Asset Management.

If he is correct, it is the potential longer-term weakening of the dollar that is the real issue for the gold market, not inflation or deflation.

Some will note rightly that gold’s record spike came amid the last great inflation surge. Those folks might be misreading the tea leaves.

Gold’s four-year rally beginning in summer 1976 happened amid a four-year dollar decline. When the dollar bucked up at the end of 1980, gold prices retreated. Inflation was more of a sideshow than a driving force.

The question, with gold hanging around the $1,200 level, isn’t “Is gold in a bubble?” as so many are asking. It’s “What next for the dollar?”

Since its separation from gold, the dollar has been in a long downtrend, punctuated by periodic strength. The Fed’s Major Currencies Dollar Index is down 27% since 1973, and down 45% since the dollar’s peak in early 1985.

For investors convinced U.S. lawmakers and central bankers will successfully manage the budgetary woes and the massive unfunded liabilities of Social Security and Medicare, then gold is overvalued in the long term. Righting America’s national balance sheet would explicitly raise the dollar’s value as investors with money abroad move assets into a more-sound American economy. The selling of euro, yen and pounds would push the dollar higher—and gold lower.

If, however, you worry the U.S. balance sheet is irreparably damaged, then gold currently reflects the likelihood that a weak-dollar trend still has years to run as the U.S. struggles with its financial mess. Investors—and consumers—looking to preserve their purchasing power will gravitate toward gold, since its quantity isn’t easily manipulated.

Invest in gold, then, according your beliefs about the future of the greenback. Just don’t invest based on the idea that gold is a proxy for inflation. You are likely to be played for a fool.

Rethinking Gold: What if It Isn’t a Commodity After All?