The Economy, the Fed, Gold, and Gold Shares
To clarify where we stand, I think the gold shares might have made THE cyclical low last Wednesday. This conclusion is predicated on a number of factors: the valuation of gold shares relative to gold hasn't been this cheap since the 2008 deleveraging crisis, pessimism among gold equity holders reached a crescendo often marked by bear market bottoms, and the macro roadmap that I foresee which should ignite gold to resume both its cyclical and secular bull markets. While I haven't been particularly accurate over the past year in regards to gold or gold shares, every day of investing is a new day and it's important to recognize a circumstance for what it is, not for what it might have been.
Clearly the world is topsy turvy—hamstrung by a banking system saddled with worthless paper and a real economy seeking to deleverage itself and regain a stable footing. Policymakers are coming to grips with the fact that intermittent intervention alone is insufficient to prevent a domino style collapse. Instead, a prolonged period of negative real interest rates combined with occasional, outright monetization (read: additional QE) will likely be pursued.
Regardless of what the dogmatic purists might contend, we do not and have not lived life in relatively free market for a generation or more. While the beauty of a free market system is that it adapts and floats like a bobber when it faces adversity, the reality of an interventionary system is that it capsizes like a heavily weighted canoe if not perpetually directed. Like it or not, the accumulated debt imbalances in our system cannot be instantly righted without causing painful disruption to our lives. Instead, central planners are searching for ways to increase our incomes relative to the debt burden. Precisely what policies to adopt is a political as well as an economic argument that is being debated by regions around the western world.
For now the greatest mess appears to be the Eurozone which was built on a faulty construct—merely a monetary but not a political or economic union. Hence, the Eurozone has become just another unbalanced and weighted canoe in turbulent waters. The difficulty of investing in an interconnected world of managed trade flows is that one area's challenge can quickly morph into another's attribute. For sure the US economy has benefitted as a temporary safe harbor for capital seeking refuge from the perils of a fragmented and crumbling Euro Zone. Consequently, US bond rates have plummeted and this has bought precious time for an over-levered US economy. But by no means does this imply that the US should be considered a permanent safe haven, at least not until it institutes necessary reforms to ease the debt burden and promote growth in the private sector while shrinking the size of a bloated, wasteful government.
Although it seems that the US economy has been strengthening—certainly on a relative basis to the rest of the troubled world—it is naïve to think that the wealth effect generated by rising domestic equities could prevail over the harsh reality of a shrinking demand for US exports recently caused by both a strengthening dollar and waning global demand for products. Just remember that what has kept the US economy afloat is that it printed early and often in relation to its competitors, many of whom have since embraced austerity and now paradoxically appear all the weaker for doing so. Equally baffling is that by acting irresponsibly from a monetary perspective, the US has attracted even more global capital. Ironically, the success of this flawed printing strategy has made additional money printing politically more difficult as both its critics and its supporters grow confident that liquidity is ample. (And certainly this has adversely affected the price of the precious metals.)
Yet the most imminent danger for the US might be for the authorities to mistakenly conclude this economy to be out of the woods simply because the equity market has rebounded smartly over the past few quarters (the chance of this misperception appears to be dwindling with every down point in the Dow). If nothing else, though, the lesson of 2008/2009 should have taught us never to underestimate either the arrogance or naïveté of a central banker (recall that Mr. Bernanke stubbornly raised interest rates in baby steps until he eventually brought down the fragile financial system). Nevertheless, occasionally even a government bureaucrat can learn from a mistake.
The combination of tame inflationary numbers which have benefitted from moderating commodity prices, the weakening of the Philly Manufacturing Index, disappointing US employment gains, a teetering Europe, and a declining stock market has now set the stage for Mr. Bernanke and his western counterparts to hit their monetary gas pedals before things abruptly unravel. In addition, the recent disclosure of JP Morgan's derivative ails brings to the surface the depth of the rot endemic in our financial system—rot which the Fed might prefer to keep from metastasizing by papering over.
The fact that gold rallied upon the release of last month's Fed minutes which had revealed a leaning toward potential accommodation even when the economic numbers were still quite strong, and that gold bounced hard to complete a triple bottom at $1525 in the face of weakening manufacturing numbers, suggests that the gold market is beginning to discount the inevitable—future easing.
This is not to say that all roads are clear for gold, for if the equity markets do not capitulate, then perhaps the Fed will further delay additional measures. If so, gold might then head down and break support at $1525 and temporarily fall into a vacuum into the mid $1400s or even lower as I had previously suggested. However, in an election year, it's hard to imagine that the Fed would be reluctant to print, especially considering that Governor Romney, if elected, has threatened to change the Fed chair when the term expires.
Another concern for gold might be if the Fed were to merely hint at future intervention or announce a tepid or disguised intervention—one good enough to rally the stock market yet subtle enough not to topple the bond bull. While possible, deciphering precisely what that delicate amount of stimulus might be isn't worth risking—not for a Fed chair sitting in the political hot seat and trying to steer clear of potential black holes created by a broken financial system that depends upon persistent liquidity.
Thus, my best guess is that the gold bull has resumed but that even if I were proven wrong, I suppose any additional downside will be short lived in terms of time but could end in an ultimate washout and create the mother of all buying opportunities. For now, it's safer to remain long gold and its affiliated equities and hedge a bit once this oversold condition rights itself—but that is weeks if not months away. Meanwhile, it appears as though a favorable setup for the gold equities is in place while the general equity market probably has a few days of remaining weakness or perhaps even a final swoon that should prompt Fed action.
Within the coming weeks, I expect the Fed to send out its talking heads in preparation of stimulus to be announced at the June 19th meeting or shortly thereafter. While it's difficult to predict with any degree of certainty the potential actions of a polit bureau, the precarious economic and political condition now favors imminent intervention and the perpetuation of the gold bull market. General equities could benefit too, but given their severe undervaluation, it is the gold equities that should be the ultimate beneficiary of an accommodative Fed.
Regardless of the timing of the Fed's next move and any consequent, wild price-fluctuations that might occur in a world dominated by hot money, the reality is that it is much safer to hoard physical gold and stomach its volatility than to unwittingly endure the gradual diminution in the value of cash in a chilling world of near zero interest rates.