Wednesday, November 18, 2009

Why Gold Bubble Advocates Could Be Wrong

Gold has risen to an unprecedented $1140, causing some to conclude the market is a bubble about to burst. Moses Kim makes a case for resisting the urge to short gold as political tensions, particularly class conflict and concerns over taxation, will cause instability, volatility, and an increased demand for the security offered by gold. See the following post from Expected Returns.

That is, if you want to survive as a trader. Anyone who has been trading actively for a reasonable period of time knows that gold and silver move to their own unique rhythm, and that shorting gold over the past decade has been a losing proposition. I know there are many investors "dollar cost averaging" their short positions in gold, praying for a correction that never comes. The formula for making money in this bull market is simple: buy the dips and sell the rips.

I am amazed at the total change in sentiment from investors towards the gold market. Just watch how investors react to any pullback in gold; my guess is that all dips will be bought aggressively. The pattern over the course of this bull market has been clear: a multi-month consolidation followed by a huge breakout. We haven't come close to going parabolic yet, and until we do, this bull market is well intact and is not at bubble levels. Keep your television tuned in to CNBC so you can do exactly the opposite of what they are recommending. Currently CNBC is telling you to sell gold because it is a clear bubble- this means you should be buying.

Anyway, what is $1140 gold telling us? I'll try to give you an idea of my thought process when I invest, which is heavily dependent on politics.

Political and Economic Dislocations Ahead

If you study history, you realize that the majority of truly seminal events happen in the shortest span of time. While most people are stuck in the mindset that events move in a predictable, steady, linear manner, what's actually happening right now politically, economically, and socially are huge changes that will affect the lives of everyone globally. Political tensions will likely escalate in the coming years, and there will be a sudden change in global dynamics. The catalysts for major events will only be obvious to most people in hindsight. The job of the successful investor, however, is to understand how current actions dynamically influence future events. This allows you to foresee events and to adjust investment decisions accordingly.

Class Warfare, Increased Taxation= Recipe for Disaster

It's not surprising, but class warfare is already beginning in America, as politicians try to enforce equality on the population. If your company can't compete globally, don't worry, Uncle Sam will be there to take capital away from productive individuals and funnel it to unproductive companies. State taxes are already rising for the "rich", and as a result, capital will flow out of the U.S. More than people realize, capital flows have an enormous effect on the growth of economies. Further, as unemployment benefits get extended once again, jobs remain scarce, and "too big to fail" becomes the official mantra of government, we are developing an economic model that is more socialist than capitalist. We will learn once again that enforced equality is contrary to the idea of freedom, both economic and political, and that economic growth will suffer as a result. Why is this important as an investor?

Likely Government Responses to Insolvency

Lets look at the range of possible actions the U.S. government will undertake to stay solvent and delay the inevitable path to bankruptcy. If I were a greedy politician, where would I look to confiscate wealth? Besides gold, which acts as a check against government ineptitude, I would be looking at 401k's. Just look at what the government has done with the Social Security "Trust Fund"? It has replaced money taxed from the population and replaced it with worthless government IOU's. I wouldn't be surprised in the least if 401k's were replaced with U.S. Treasuries, all in the name of stabilizing portfolios. Of course this will be a smokescreen for criminal confiscation of the hard-earned wealth of Americans, but what about the handling of this crisis hasn't been criminal under the surface? The point of my little rant is this: eliminate counterparty risk, especially if you are approaching retirement. If you own a 401k, you are a sitting duck in my opinion.

What's the other option? Inflation. This form of confiscation is obviously much harder to escape. Most lower and middle class Americans will understand the curious feeling that standards of living are going down even in the midst of supposed growth in our economy. The idea that our government would purposely manipulate economic statistics to further their agenda is, surprisingly, repugnant to some people. The truth is, government statistics misrepresent the true state of our economy, which should be obvious to anyone who actually thinks. Why do we need such tremendous stimulus if our economy is recovering? Use your common sense and don't buy into flawed Keynesian propaganda.

My point is that in a time of total disregard for the rule of law and an ad hoc approach to administering justice, the free market just can not operate. This is incredibly bearish for our economy. Why do you think so much money is flowing to gold? You never know when the government will do something truly nutty like ban short-selling or impose ridiculous taxes on capital gains. People are buying equities in the short term, but I don't think anyone in their right mind believes equities are undervalued. Everyone has two hands on the exit.

What is Gold Telling Us?

A move to $1500-$2000 gold, especially in the next year, is a frightening possibility. Don't expect business as usual with gold at those valuations. I have repeatedly stated that gold is a purveyor of truth in a time of lies. You have heard our government officials talk about a "strong dollar policy" for years and years, yet the dollar has lost about 50% of its value in the past decade against a basket of global currencies. The dollar's performance against gold is even worse. At what point does this relatively controlled decline in the dollar become chaotic? I can assure you that smart money is stealthily moving out of the dollar and into gold. When there is mass recognition that the dollar is going way down, good luck trying to head for the exit.

Like it or not, we are approaching a time of volatility both economically and socially. Gold is the only true hedge against instability. The coming volatility is already embedded in the system, whether it is in the form of complex derivatives, insane debt levels, unprecedented unemployment statistics, or a fundamentally flawed global currency arrangement. Be sensitive to the message gold is relaying right now- the worst is definitely not behind us.

This post has been republished from Moses Kim's blog, Expected Returns.


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November 29, 2009 at 6:06 AM Anonymous said...

What the author fails to mentions is that the same was true for the real estate bubble.

Anyone who tried to short the US real estate between 98 and 2006 would have failed.

But didn't prevent the bubble's crash in 2007 and 2008, which probably wiped more wealth directly and indirectly than any other event since the 70's oil crisis.

The average or median trader's life span is exceedingly short and the bubbles have the same impact on the trading community that a big asteroid had on the dinosaurs ...

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