This fall has meant that everyone who has been recommending gold (including this writer) have ended up with egg on their faces. But every forecast cannot be right all the time. There are situations when a forecast is wrong till it is proved right.
Allow me to explain. Every bull market has a theory. So why has the price of gold gone up over the last few years? The answer is very simple. Central banks around the world have printed a lot of paper money. This money has been pumped into the financial system with the hope that banks will lend it to people and businesses, who will then spend this money and thus help in reviving the economy.
The fear was that with all this extra money chasing the same number of goods and services, there would be a great rise in prices. To protect themselves from this rise in price and loss of purchasing power, investors around the world had been buying gold. This pushed up its price. Unlike paper money, gold cannot be created out of thin air by the government and thus is looked upon as a hedge against inflation.
But, here’s the point, the inflation is still to come. And so this theory which drove up the price of gold doesn’t seem to be working. As a result the price of gold has taken a beating. With no inflation there is really no reason for people to buy the yellow metal and protect themselves against loss of purchasing power.
As Gary Dorsch, Editor, Global Money Trends, points out in a recent column: “So far, five central banks – the Federal Reserve, the European Central Bank, Bank of England, the Bank of Japan and the Swiss National Bank – have effectively created more than $6 trillion of new currency over the past four years, and have flooded the world money markets with excess liquidity. The size of their balance-sheets has now reached a combined $9.5-trillion, compared with $3.5-trillion six years ago.”
But even with so much money being printed there has been very little inflation. So money is being diverted to other asset classes rather than buying up what John Maynard Keynes referred to as the barbarous relic.
Also this lack of inflation has made central bank governors and politicians around the world victims of what Nassim Nicholas Taleb calls the great turkey problem. As he writes in his latest book Antifragile: “A turkey is fed for a thousand days by a butcher; every day confirms to its staff of analysts that butchers love turkeys ‘with increased statistical confidence.’”
With the butcher feeding it on a regular basis, the turkey starts to expect that the good times will continue forever and the butcher will continue feeding it. That is what seems to be happening with central bank governors and politicians around the world. The fact that all the money printing has not produced rapid inflation till now has led to the assumption that it will never produce any inflation.
Ben Bernanke, the Chairman of the Federal Reserve of the United States, the American central bank, has even gone to the extent of saying that he was 100 percent sure he could control inflation.
And using this conclusion central banks are printing even more money. This is like the lines from La Haine, a French film released in 1995: “Heard about the guy who fell off a skyscraper? On his way down past each floor, he kept saying to reassure himself: So far so good… so far so good… so far so good.”
But the person falling from a skyscraper has to hit the ground at some point of time. The good days of every turkey being reared by a butcher also comes to an end. As Taleb writes: “The butcher will keep feeding the turkey until a few days before Thanksgiving. Then comes that day when it is really not a very good idea to be a turkey. So with the butcher surprising it, the turkey will have a revision of belief – right when its confidence in the statement that the butcher loves turkeys is maximal and ‘it is very quiet’ and soothingly predictable in the life of the turkey.”
Or as the line from La Haine goes “How you fall doesn’t matter. It’s how you land!”
Similarly, all the money printing has to end up somewhere, some time. As Taleb puts it: “Central banks can print money; they print, print and print with no effect (and claim the “safety” of such a measure), then, “unexpectedly,” the printing causes a jump in inflation.”
Or as James Rickards author Currency Wars: The Making of the Next Global Crises puts it: “They can’t just keep printing…All major central banks are easing…Eventually so much money will be printed that this will lead to inflation.”
There is a reason why inflation is taking time even with governments around the world printing money rapidly. Henry Hazlitt has an explanation for it in his brilliant book, The Inflation Crisis and How to Resolve it.
In the initial stages of inflation, the man on the street does not know that the government is printing money and hence he has confidence in the paper money he is using. He does not think that the paper money is going to lose value anytime soon, and does not rush out to spend it. Gradually news starts to get around that the government is printing money and this is when there is some rush to spend money before it loses its value. This is when prices start to go up at the rate at which money is being printed. In the final stage, as the central bank, backed by the government of the day, continues to print money, people start to feel that this will continue indefinitely. And hence they try to get rid of paper money as soon as they get it. This, in turn, leads to prices rising at a rate even faster than the rate at which money is being printed.
This is how most inflation evolve whenever governments print money at a very rapid rate.
Once the market starts discounting the idea of inflation, the price of gold will rise at a very rapid rate. But till that happens, people like me, who have and continue to recommend investing a portino of your savings in gold, will look stupid. Also it is important to remember that every bull market has its bear runs. In the middle of the bull run in gold prices in the seventies, gold prices fell by nearly 44 percent. The price of gold as of end of December 1974 was $186.5 per ounce (one ounce equals 31.1 gm). By end of August 1976, it had fallen to $104 per ounce, or nearly 44.2 percent lower. But prices rallied again from there and peaked very briefly at $850 per ounce on 21 January 1980.
So as I said at the beginning, forecasts can be wrong for a long time till they are proven right. And when they are proved right, even for a brief period, its then when the ‘real money’ gets made.
Taleb talks about people who had been predicting a financial crisis in the developed world. There predictions were wrong for a very long till they were proven right. As he writes: “You were wrong for years, right for a moment, losing small, winning big, so vastly more successful than the other way.”
Hence, I would still recommend buying gold, limiting it to around 10 percent of the overall portfolio or even lower, depending on how much money you are willing to back what is a particularly risky trade. Investment in gold has to be looked upon as a speculation on the continued printing of money and the eventual arrival of rapid inflation. This strategy can prove to be tremendously beneficial. As Taleb writes: “If you put 90 percent of your funds in boring cash…and 10 percent in very risky, maximally risky, securities, you cannot possibly lose more than 10 percent, while you are exposed to massive upside.” Gold has to be played like that.
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