Gold Shines in Tough Times

Why it is the Threat of Deflation- not Inflation-
that is Driving the Global Demand for Gold

10/14/2009 [UPDATED: 12/02/2009] by Christopher Neal Wyatt

After thirty long years, the gold bugs have finally been vindicated. With the yellow metal now trading for well over $1,200 per ounce, gold is virtually the only commodity on Wall Street to profit from the worst financial crisis since the Great Depression.

Ten short years ago, few investors could have predicted such a dramatic reversal of fortune. Way back in September of 1999, the price of gold had tumbled to just $255 per ounce, a 30 Year low, while stock markets everywhere were nearing the peak of the greatest Bull Market in history! The challenging decade since then has now firmly cemented gold's reputation as the traditional "safe haven" investment, as illustrated in the following chart. 

While many investors cannot help but marvel at gold's rise, there is also concern about the effect that any further economic downturn might have on demand for the metal. After all, we know that in a recession, cash flow grinds to a halt. With less money to spend, there is less consumer demand for high-priced luxuries, like gold jewelry. If consumer demand should fall, then so in turn must prices- right?

Furthermore, suppose instead that the opposite scenario is true. What if the current crisis is actually over- and we are now at the beginning of a dramatic recovery? If this were in fact the case, then no investor in their right mind would want to buy any commodity, even gold, when it is selling at all-time high prices. The smart thing to do would be snapping up under-valued stocks for pennies on the dollar!

But Wait... Is the Crisis Really Over?

Many armchair economists would view the recent stock market rally as proof that disaster has been averted, and that business on Wall Street is now returning to normal. As Paul Krugman, a columnist for The Guardian, wrote in August of 2009:

"A few months ago, the possibility of falling into the abyss seemed all too real. The financial panic of late 2008 was as severe, in some ways, as the banking panic of the early 1930s, and for a while key economic indicators- world trade, world industrial production, even stock prices- were falling as fast as or faster than they did in 1929-30. But in the 1930s the trend lines just kept heading down. This time, the plunge appears to be ending after just one terrible year." (source)

Mr. Krugman's argument may seem convincing, and I can certainly appreciate his optimism. However, during the Great Depression, the trend lines did not simply keep "heading down", as he claims; in fact, it is well known that the Depression-era Stock Market actually managed to stage many daring counter-rallies, beginning as early as Friday, October 25th- the day following the first "Black Thursday". Each of these brief, deceptive interludes- now known as the "Bear Trap"-- tempted investors with the promise of an early recovery, only to dash their hopes time and time again, before the market finally bottomed out in July of 1932.

Am I claiming that the U.S. is headed for a second Great Depression? While that possibility does indeed exist, I simply wanted to illustrate the degree to which Investors should always be wary of short term price fluctuations in any market.

Regardless of what you choose to believe regarding the coming future, the fact remains that many economic indicators have yet to show any sign of a dramatic turnaround. Despite recent advances on Wall Street, the economic fundamentals on Main Street- such as the soaring numbers of bank failures, or the masses of unemployed workers- remain at, or near, depression-era levels.

Given the sour state of the economy, then, conventional wisdom tells us that gold's present-day resilience in the marketplace can be nothing more than a statistical fluke. After all, faltering economies lead to price deflation- not inflation. Indeed, market values for almost all other assets and commodities- from condos to crude oil- are well below the highs seen as recently as just two years ago, prior to the financial crisis. This has led many investors to ask the question: what is so special about Gold?

Why Gold- Why Now?

The reason for the extraordinary level of demand for gold today is a result of several different factors; for the sake of brevity, however, I shall focus on the two reasons that I feel are the most important.

The first factor is in fact very simple, even though it contradicts what mainstream economic theory has taught us for the past 75 years:

I. Gold is not an ordinary Commodity.

Gold is in fact the supreme commodity- that by which all other assets, commodities, and currencies have always been measured. Understanding this point is absolutely critical.

The second reason for gold's performance is perhaps a little more difficult for many non-economists to understand, but it is actually more central to the situation at hand:

II. This is not an ordinary Recession.

One year ago, the entire global financial system nearly collapsed due to a relatively small crisis, which began innocently enough, within the confines of the U.S. subprime mortgage market. Due to the way that these subprime loans had been divided up and sold off to investors, however, the deflationary fallout extended well beyond the real estate market, resulting in trillions in losses, from which we still have not recovered.

While all of this may seem like ancient history at this point, it is worth remembering, because it serves to illustrate how in today's interconnected global marketplace, one small problem can easily snowball into a very large, unmanageable one. Of course, if residential mortgages were the only type of asset that was in need of devaluation, then there would be no further need to worry; however, the commercial real estate market is now showing major signs of distress too.

Aside from real estate, there are many other assets on the books today which could just as easily trigger a fresh round of deflationary fallout in our capital markets. Many economists, for instance, remain extremely concerned about volatility in the market for credit default swaps. A credit default swap (CDS) is something like an insurance policy against credit default; unlike a traditional insurance policy, however, a CDS can be freely traded amongst parties who have no interest in, or ownership of, the underlying asset or debt. It was the cost of servicing CDS agreements which led directly to the collapse of Bear Stearns, before the firm was finally sold for the fire sale price of just $1.1 Billion, to the investment firm JP Morgan.

The current value of all outstanding credit default swap agreements has been conservatively estimated at around $33 Trillion- compared with just $7.1 Trillion for the U.S. residential mortgage market. Consequently, the deflationary risk posed to our economy by the possibility of a CDS market collapse is many times greater than that which have ever existed for the residential mortgage market. However, the credit default swap is actually just one small subset of a much larger family of capitalized contractual agreements, that are known simply as Derivatives.

Derivatives: The $1,100 Trillion Time Bomb

Wikipedia defines a derivative as "a financial instrument that is derived from some other asset, index, event, value or condition." While this might sound simple in theory, the reality of derivatives trading is anything but. Due to a lack of regulation, derivative trading has evolved into something like a mass financial black market, allowing vast quantities of capital to be easily traded across international borders, with virtually no oversight or taxation.

Warren Buffet, multi-Billionaire CEO of Berkshire Hathaway, once described derivatives as "financial weapons of mass destruction" in a now famous letter to his shareholders, in 2002. At the time, the value of all outstanding derivative contracts was a whopping $100 Trillion dollars- approximately twice the value of World GDP. In the seven years since then, the total value of all outstanding derivative contracts has exploded eleven-fold to approximately $1,114 Trillion US dollars, according to the most recent estimates available from the Bank of International Settlements (BIS).

Needless to say, if the value of even a small percentage of $1,114 Trillion in derivative contracts were to default in the same way that we have seen in the residential real estate market, the deflationary fallout on Wall Street could easily dwarf anything that anyone has ever seen. Such a scenario might seem a long way off- and it is my hope that it will never happen. Nevertheless, it should now be easy to see why even the faint possibility of such an absolutely devastating financial collapse has driven gold to such all time highs. Moreover, any further deflationary panic in our marketplace could easily drive the price of gold many, many times over it's current value, as I shall explain.

The entire quantity of above-ground gold that has ever been mined is estimated to be a little over just 158,000 metric tons, or 5.08 Billion troy ounces. At the market price of $1070 per ounce (as of October 14, 2009), the total value of all of this gold is about $5.44 Trillion dollars. This is a sizeable sum, to be sure, however it is one that is easily dwarfed by the current volume of outstanding derivative obligations, as illustrated below:

CAPITAL MARKET SHARE: GOLD VS. DERIVATIVES

In the case of a widespread derivatives default- as indeed the Chinese Government has recently warned-- it only stands to reason that holders of these contracts would need to act very quickly in order to preserve their wealth. While bonds and currencies have been safe refuges in the past, gold possesses the distinct advantage that it is liable to no one, and is therefore immune to the ravages of both default and inflation.

In the event of a relatively 'minor' derivative crisis, for example, panicked investors might attempt to convert, let's say, 5% of their current derivative assets- or about $55.7 Trillion-- into physical gold holdings. The resulting impact on the price of gold from even such a minor increase in investment demand would be an increase of well over 1000%, to more than $12,000 per troy ounce!

Attempting to predict the price of gold in the marketplace that would result from such an unprecedented deflationary disaster is simply a fool's game; that is to say, even a fool is just as likely to guess correctly as the most experienced commodities trader. There is simply no way that we can predict the extent to which any fiat currency- including the US dollar-- would continue to function as a viable medium of exchange in the face of a total collapse of our capital markets.

Should the $1,100 Trillion derivatives bubble finally burst, however, there is one thing which we can be certain of: in a true crisis of capital- regardless of the final score-- gold will always win.

Christopher Neal Wyatt

President & Founder, Superior Bullion

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