Nothing Shines Like Gold

The S&P 500 is making new bear market lows today. The Dow Jones Industrials did that last week. There's only one risky investment doing well: gold.

A week ago gold traded above $1,000 per ounce, coming within spitting distance of the all-time highs made last March. It's pulled back now to about $940. But still — what other investment other than riskless government bonds can you point to that's so near all-time highs?

Amazingly, just a month ago, gold and the S&P 500 were trading at about the same price — gold at $854, the S&P 500 at 840. From there, stocks have fallen 10% to near their bear-market lows of last November, while gold has risen as much as 16%. That's a divergence of more than 25%, in just a single month.

Readers of this column know that I've been touting gold for quite a while. I think the bull case for gold still holds, and I would be a buyer of any pullback. I think it's highly likely that gold will be at new all-time highs within the next several months.

If that happens, it will be great for my portfolio. But you have to be careful what you wish for. The force driving gold is the prospect of inflation. So if gold breaks new all-time highs, the bad news is that it will be a scary signal of inflation to come.

It's a mistake to think of gold as a barometer of global wealth. Sure, when people get rich they like to buy more gold jewelry. But global wealth is collapsing now, and yet gold is near all-time highs. So there must be another explanation.

It's also a mistake to think of gold as a panic asset — something that people hoard because they think the world is going to come to an end, and gold will be the only thing left of any value at all. In the all-out financial panic that started last September and climaxed at the stock market bottom in November, the price of gold collapsed, too. It fell almost as much as stocks. The real panic asset is cash, not gold. When things get scary enough, people will sell their gold to get it. So now with stocks back to the same levels as last November's lows, there must be another explanation for why gold is near all-time highs.

As Sherlock Holmes said, when you rule out the impossible, whatever's left — however improbable — must be the solution. Thus: inflation.

I admit that seems improbable. Yet it is the answer.

I say it seems improbable because all the other evidence all around us is pointing to deflation, not inflation. That is, falling prices, not rising prices.

The simplest evidence of that is the Consumer Price Index. It's been showing deflation more intense than that experienced in the middle of the Great Depression. You have to go all the way back to 1921, the great deflation that followed the end of World War I, to find the equivalent.

Yet still, gold is signaling inflation. I think the reason why is that the gold market understands that Federal Reserve Chairman Ben Bernanke will do everything he can to keep deflation from worsening or persisting. Bernanke knows that in times like ours, when households and institutions are struggling with dangerous debt burdens, deflation is the worst thing that could possibly happen.

The reason why was first explained in a 1933 paper by the famed economist Irving Fisher, in an attempt to understand why the Depression was so severe. Fisher noted that when investors hold assets financed by debt — whether its banks holding toxic securities, or individuals holding expensive homes — deflation destroys in two ways at the same time. First, in a deflation the prices of assets fall — so the value of your portfolio, or of your home, collapses. At the same time, your debt burden gets worse, because you are committed to make loan payments in dollars which are becoming increasingly valuable in deflation-adjusted terms.

Bernanke is a student of the Depression, and knows Fisher's work well. So he'll do anything — including causing a lot of inflation — to prevent deflation. And that's exactly what he's doing. Never before in history has the Federal Reserve printed so much money so fast.

It's not showing up in inflation indexes like the CPI, because banks and households are so terrified right now they're just hoarding all that money the Fed is printing. But at some point, the fear will ebb, or just stop getting worse. And all of a sudden everyone is going to decide to do something with all that money — like spend it. And then we're going to see extremely bad inflation.

But if the alternative is deflation, then extremely bad inflation is actually extremely good inflation.

But it's still inflation. Which is why gold is testing the $1,000 level again, and why I think it's highly likely to punch through it.

When gold does that, and the threat of deflation is replaced by the reality of inflation, then the economy and the stock market should stabilize. So if you agree with me that gold is destined for new highs, that ought to at least make you a cautious optimist on stocks at this point, even as stocks make new lows.

But don't get carried away. Inflation is only good because the alternative — deflation — is unspeakably worse. Inflation is still bad. And if financial history teaches us anything, it's that stocks do poorly in general during periods of inflation — such as the 1970s — and well during periods of stable prices, such as the 1990s.

Then when you add to all that the reality that the new president is trying to take America back to the 1970s in other ways — more regulation, bigger government, higher taxes and all the rest — it's not exactly a formula for excellent long-term equity performance.

I think it's time to set aside all the religiosity about “stocks for the long run,” because right now the long run doesn't look so great. Maybe now's the time for “stocks for the short run.” And gold.

http://www.smartmoney.com/Investing/Economy/Nothing-Shines-Like-Gold/