Is Gold Still Cheap?

We addressed the above question last year and arrived at the answer: no, gold left bargain territory long ago. We remain bullish on gold not because we think gold is still cheap, but because we expect it to get a lot more expensive.

This isn't a "greater fool" game that we are playing, in that our belief that gold will become a lot more expensive over the years ahead isn't based on the expectation that people will be silly enough to pay a much higher valuation in the future for an asset that is already over-valued today. It is, instead, a position based on the observation that the world's most important central banks and governments remain committed to a course that ends in catastrophe for their economies and currencies. To put it another way, gold may well be expensive relative to the current economic backdrop, but it is cheap relative to what the economic backdrop will be 5 years from now if the current policy course is maintained. And at this stage there are no signs that the current policy course will not be maintained.

Evidence that gold is no longer in the bargain basement is provided by the following long-term monthly chart of the gold/commodity ratio. Relative to commodities in general, gold hit a 50-year high late last year. In fact, last December's peak in the gold/commodity ratio could have been an all-time high. This tells us that the gold market has fully discounted the bad policies of the past several years. As an aside, it also tells us that the fabled gold market manipulators are doing a lousy job and should be fired (gold's excellent performance over any reasonable investment timeframe is no doubt why promoters of gold-suppression theories tend to focus on timeframes that could only be of interest to daytraders).

Evidence that the gold market hasn't yet discounted the effects of continuing along the current policy path is the general lack of understanding of the damage that these policies cause. Almost everyone in power or in a position to influence those in power believes that the economy can be helped by the artificial lowering of interest rates, the creation of money out of nothing, and increased government spending. And almost everyone believes that the government is responsible for creating jobs and managing the international trade balance. This means that almost everyone is oblivious to the fact that whenever the government intervenes in the economy it causes distortions that impede real economic progress. As long such beliefs are dominant, economic weakness will lead to counterproductive policy responses, which will lead to additional economic weakness, and so on.

The gold bull market is being driven by the vicious cycle whereby bad policy begets economic weakness, which provides the excuse for more bad policy. It won't end until there is an economic and monetary catastrophe or there is widespread understanding of the root of the problem, because one or the other will have to happen before a major constructive political change will be possible. Hopefully the latter will happen first, because living through the former wouldn't be fun even for those who had taken all the right protective measures.

How would we be able to tell that widespread understanding of the root of the problem was developing, and, therefore, that the gold bull market was in its final phase?

There would be many indicators. Of greatest importance, the Fed would be demonstrating the resolve to severely restrict growth in the money supply regardless of the short-term consequences for equity prices and GDP growth. Also, politicians that were genuine advocates of small government (along Ron Paul lines) would be taken seriously by the mainstream media and would be frontrunners in elections, whereas advocates of Keynesian economic policies (along Paul Krugman lines) would not be taken seriously.

Above is an excerpt from a commentary originally posted at www.speculative-investor.com on 22nd April 2012.

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