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May 19, 2006
Gold is a financial crisis call option
By Brady Willett

I own precious metals. My investment outlook for gold may be entirely different than yours. Please keep this in mind.

I donít want to argue that gold is about to rally to $______ an ounce because the stars are going to align a certain way. Quite frankly, if you purchase anything that goes up in price by 250% inside a short period of time and you expect to gain say another 250%, you must either have insights into the fundamentals or you are relying on the greater fool theory (the belief that someone will pay more for what you buy/own in the future).  The majority of extremely bullish precious metals forecasts today are based solely on greater fool theories. Moreover, with the so called Ď
fundamentalsí open to bias and interpretation, you could ration that all forecasts today are, at least partially backed by greater fool theories.  I am not knocking the speculator trying to latch on to something that is hot and could get even hotter.  Rather, I simply donít wish to partake in the experiment of precious metals forecasting.  What was only a few years ago an ignored asset class has come to be an adored asset class - the opportunity to be a bullish contrarian in precious metals is dead. If you are not a contrarian you are simply running with the herd. 

Will the herd run even faster isnít the question.  What happens when the herd stops is...

Is gold still a hedge against inflation?

With economic activity in America softening, commodity prices perhaps already peaked, and more central banks in favor of maintaining USD dominance rather than ending it, there may not be enough inflation expectations in the pipeline to add fuel to the precious metals rally. Note the word expectations: precious metals rally on the expectation that inflationary pressures are around the corner.  However, when, and if these pressures actually manifest it is entirely possible that gold becomes a sell the news event. You could argue, and I am, that whether or not inflationary pressures actually arrive in the data is irrelevant to precious metals today. Goldís non response to this weeks CPI report is an example of this phenomenon.

There are historians that would disagree with this viewpoint and instead argue that when inflation really hits, like it did during the 1970s, gold is the best choice for the investor.  What these individuals may be overlooking is that in an attempt to try and circumvent financial disasters from repeating themselves, Fed policies are in a perpetual state of evolution.  The M3 may be missing and Mr. ĎPrinting Pressí may be in charge, but, save a special event* I still do not see Bernanke and company allowing things to get as out of control as they did during the 1970s.

As for the Fed not be able to stop inflationary pressures from coming online, I think that two decades of falling interest rates have lulled some investors into believing that the Fed is always their best friend. Forgetting for the moment that the Fed is the one that creates inflation in the first place, the Fed will not allow inflation to run amuck. Rather, the Fed is trying to talk down and set new standards on bank/mortgage lending, the Fed continues to raise interest rates, and the Fed will push the US economy into recession to beat inflation.

Incidentally, remember that any increase in traditional inflationary pressures suggests that either economic activity will slow and/or the Fed will continue to raise interest rates.  Both of these scenarios is potentially bad news for precious metals.   In short, my conclusion is that gold is no longer an attractive hedge against traditional inflationary forces because such forces will not arrive, at least not in the same manner they have historically.

Is gold still a hedge against a USD crisis?

Despite being potentially overoptimistic when it comes to inflation, I nonetheless believe that gold still serves as an important hedge against a potentially devastating decline in the US dollar. Longer term alternatives to USD, be it petro-euros, a return to a gold standard, or a new Asian currency basket, are slowly coming into focus.  This is reason enough to own some precious metals for the long-term.

The Dangerous Allure of The Gold Option

Given that its status as an inflation hedge is not appealing and that as a long-term USD hedge gold at current prices is over bought, the speculation to be made is that gold has rallied strongly and morphed into a financial crisis call option. What this means is that investorís are purchasing gold on the expectation that some disastrous financial event will arrive and spark more investors to rush into gold for cover. Such an event could include another LTCM, a stock market crash, a USD crash, Middle East upheaval/skyrocketing oil prices, etc.   And yes, some special events*, like peak oil, could lead to inflationary pressures, and challenge the Fedís control.

As with all options the payoff in gold is potentially huge, but so is the risk.  For example, if Iran tensions build and the bombs start dropping gold could skyrocket  But if Iran tensions ebb gold could fall.  I read the premium on gold calls as being extremely high and the expiration date of the options as being shortly after the Fed is positively done tightening, and/or as economic slow down takes hold.

Conclusions

Gold is the best investment when US dollar hegemony is being tested, and it is only obvious investment for when US dollar hegemony ends.  However, when buying gold at nearly $700 an ounce you are not only making a timely gamble that end days are near, but you are also making this bet at the same time a lot of other investors are as well.  When the herd stops a lot of people get trampled.

If the gold calls donít pay off soon I fear a precious metals correction the likes of which has not been seen since the early 1980s.  Not coincidentally, this was when Volcker was showing the world how influential a central banker can be when he is stubborn enough to do what is right.  This brings us back to the main reason why gold has become event driven rather than inflation driven: Bernanke and company will not allow things to get as out of control as they did during the 1970s. If central bankers are not about to lose control this implies that skyhigh gold is waiting for the inevitable period of creative destruction for something to go terribly wrong.  The wait may soon be over...

 

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