Gold Continues to Deliver

The S&P500 finished the week virtually unchanged. Volume was still light, but somewhat higher only because volume jumped on two days when the S&P sold off. Volatility, while also unchanged, remains near multi-year lows. In the past, when volatility jumped higher, it was usually from low levels similar to the ones we see today.

In macro news, US economic data started to soften. Durable goods orders plunged, instead of dipping slightly, as expected. The Case-Shiller home price index came in below expectations—not only are home prices falling, but they’re falling at an accelerating rate. Chicago PMI was better than expected. Personal spending and personal income both came in well below expectations. And core PCE (the Fed’s favored measure of inflation) came in at virtually 2.0% on an annual basis. Why does that matter? Because the Fed has recently announced that it would justify more QE if core PCE was below 2%. This means that—per the Fed’s own rules—it’s going to be more difficult to announce QE3 anytime soon. Finally, the big surprise of the week was a very disappointing ISM manufacturing index. Not only did it miss badly, but this is a very critical leading indicator in the US economy, and it’s headed down.

Overseas, in Euroland, the most recent numbers were disastrous. EZ unemployment rose to 10.7%, the highest since 1999, and manufacturing PMI’s contracted for the seventh consecutive month. In short, Euroland is in a recession, and the recession is deepening. The repercussions to the rest of the world are strongly negative. China, the US, and other regions of the world depend on Europe as a huge market into which they sell their products and services. With a deepening European recession, these regions will suffer from diminished exports, which will in turn, diminish their economic growth.

Over two years ago, we made a case to go long gold. After making this recommendation—to buy on a pullback—gold did fall back down slightly to $1,050.

Sure enough, one year later, in January 2011, we followed up with a recommendation to continue to hold gold, and to buy more. At that time, it was trading around $1,350. This represented a 28.6% jump from the prior year’s buy signal.

A few weeks ago, almost exactly one year after the January 2011 recommendation, gold closed near $1,750. This represented a 29.6% jump from the 2011 buy and hold recommendation.

So now two years and 67% after first recommending gold, what are prospects for even further appreciation?

The answer is fairly simple, and can be measured by assessing real interest rates, and more precisely prospective real interest rates, or the nominal (or headline) interest rates on Treasuries less the inflation rate.

Very few factors track the price of gold (in dollars) better than real interest rates. And the relationship is inverse—when real rates fall, the price of gold rises.

Where are real rates today? They’re negative! When using the 5 year or the 10 year Treasury rates, and subtracting the appropriate inflation rates, the yields are less than zero.

So if investors lose value by buying “risk free” 5 and 10 year Treasuries, they figure—correctly—that gold offers a better store of value.

And since the most important point about real rates is what investors expect them to be going forward, well the Federal Reserve has already hammered home the message—ad nauseum—that not only will the Fed Funds rate be zero for several more years, but that if economic conditions deteriorate, then the Fed will very likely print more money (create more reserves via Quantitative Easing).

So unless there’s a reason to think the Fed is lying, that it will not do exactly what it has already done over the last several years, or that the US economy will somehow spring back to life without curing the underlying cancer that afflicts it, then investors can rest assured that real rates will be negative for several more years.

As a result, gold should continue to rise for several more years.

Could the price of gold dip during this period? Of course. It “dipped” over 20% last fall, only to bounce back and recover most of the drop in only two months. And if there’s a big risk-off phase later this year, gold (and silver) will almost certainly get sold off too.

But instead of panicking, consider any pullback as a surprise “clearance sale” offered by the markets for a “limited time only”….and buy, buy, buy all the gold you can comfortably afford. Chances are, you will not be disappointed.


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