Gold tends to
outperform other assets at the two extreme ends of the 60-year economic
"long wave" cycle, namely during the runaway inflation and runaway
deflation parts of the cycle which occur approximately every 20-30 years. The
last time we saw a strong performance in the yellow metal was the late 1970s
when the inflationary cycle was peaking. The latest gold bull market began
roughly 10 years ago with the start of the final deflationary portion of the
60-year cycle. The closer we get to the final bottom of this cycle (due in
late 2014), the more upside pressure there should theoretically be on the
gold price. There are of course some basic some fundamental reasons for this.
The last
several years have caused millions to question one of the most basic of
economic assumptions Americans have always made, namely that real estate was
the single best long-term investment you could make. Clearly that assumption
has been turned on its head and its proven failure caused many Americans to
turn to gold as a long-term investment.
The simplest
way of understanding why gold directly benefits from extreme deflation (as
opposed to mild deflation) is because it results in not only a flight to
quality, but also in widespread fear and uncertainty. The flight to quality
may explain why there is a tendency for U.S. government bonds to benefit from
deflation along with the dollar (when there is panic). Gold benefits not so
much from panic as from the long-term fear and uncertainty generated by the
ravages of deflation. Consider the last decade: a tech stock bubble bust
followed by a real estate debacle and credit crisis followed by economic
trouble in the euro zone and a potential recession in China. All of these
factors have conspired to cause investors to re-evaluate their savings and
investment strategies, making gold a clear beneficiary of this fear.
Another way
of understanding why gold benefits from runaway deflation is to look at the
tendency governments and central banks have of trying to inflate their way
out of a financial crisis. For a time, this monetary inflation results in
rising asset prices and gold is one of the assets that benefits from it.
Eventually, however, the monetary inflation subsides as governments and
central banks begin quarreling over how to address the underlying deflation.
Some governments choose the austerity route, which is the surest way of letting
deflation run its course. Other governments (namely the United States) prefer
the stimulus route. But additional monetary stimulus only goes so far, as
we're finding out now. Despite the confusion these conflicting monetary
policies breed, gold continues to increase in value while the deflationary
cycle is still raging.
Along those
lines, ECB President Mario Draghi recently
announced the ECB would do "whatever it takes" to end the euro zone
debt crisis. That announcement coincided with the launching of a $650 billion
bailout fund in early October. But while the European Stability Mechanism, or
"bazooka," as it has been nicknamed, is meant to help struggling
European countries by extending loans or making bond purchases, its
implementation is a far cry from what has been promised. Since EU member
countries have been slow to provide start-up reserves, the fund will only
have about $100 billion by 2014, according to reports. As one source pointed
out, "That suggests that troubled countries like Spain may not get much
help in the meantime."