Why Be Bearish On Gold?

How Do Gold Prices Generally Work?

With a peak price of around $1,900 an ounce in September, 2011, gold prices have been on the rise almost every year since 2006. But why has gold continued to rise? Why do we see workers on street corners flipping their signs to buy our gold jewelry?

In general, gold moves in the opposite direction of the dollar; this is because gold, similar to oil contracts, is denominated in USD. So while the value of the dollar decreases, the price of gold generally increases; a relationship shown in Graphs 1 & 2. Although the graphs are not well-aligned, both demonstrate that, over the years, relative to the Euro, the USD has decreased in value, while gold prices have sky rocketed.

Price Per Ounce of Gold Since 2000 (Graph 1)

 

Price EUR/USD Since 2000 (Graph 2)

The example of the USD decreasing in value against the Euro is just an example of how the value of the dollar can affect gold prices. But why has the value of the USD decreased in value relative to the Euro?  

 QE1 & QE2 - The Increase in Money Supply Decreases Value of Currency

We can partly attribute the decreases in the value of the dollar versus other currencies over the past few years to QE1 & QE2, the buying of Treasuries from the Fed, which increased our money supply, and has been keeping our interest rates artificially low. This monetary control was "Helicopter Ben's" attempt to spur growth and keep us out of a full-blown depression, and so far it has seems to have worked.

However, the increase in money supply is a primary cause of currency devaluation; whenever you see a country increase its money supply, you can assume that the value of its currency will decrease in value - the same amount of goods, but more money, means things will cost more (inflation). The decrease in value is also caused by less demand for our currency; a simple supply/demand graph can explain the relationship. Basically, since rates are so low, investors look elsewhere to place their money for a higher return.

Also contributing to the low value of the dollar is the fact we run large trade deficits with the EU, which means we have more dollars to exchange for Euros than the Europeans have Euros to exchange for dollars. 

Overall, the devaluation of the dollar makes gold more expensive because gold is denominated in dollars.

Gold: Inflation Hedge and Fear

There are a few, but major, traditional concerns that leads investors fleeing to buy gold: inflation and fear. If investors believe there will be high inflation (sometimes caused by the devaluation of currency or high demand for goods), they will feel the need to buy gold. Ironically, if you look back at which asset classes have outperformed inflation over 18 year periods, gold has not been a good hedge against inflation. In fact, equities almost always outperform inflation. Those who make the claim that gold is a good inflation hedge have never looked at the data.

Fear is another reason investors buy gold. With many EU countries potentially defaulting, and with the US budget/deficit issue becoming more politically complicated, gold may seem appealing to those who fear a global default. Although gold has no real value, other than being used in jewelry and in a few other industrial applications, investors still flock to it in times of crisis.

Why I'm Short Gold

The fear of European default, the US deficit issues, QE1 & QE2 increasing the money supply, and the fears of inflation in the US, have all helped to prop up the price of gold. Still, I believe that gold is overvalued and that it will fall in value over the coming months. Why?

The first reason is that trade deficit gaps with Europe have been slowly closing, leading to a small relative increase in the value of the dollar to the Euro. Furthermore, as the European sovereign debt crisis continues to worsen, there may be a flight to quality out of European denominated securities and into securities such as Treasuries, which are considered among the safest assets in the world, backed by the US government. This flight to quality, because of the fear of default, would require Europeans to exchange their Euros for dollars, further increasing the value of the dollar.

Another reason why I believe gold will decline in value is that there has been no significant inflation in the US or Europe, mainly because there has been a slowdown in economic activity. I believe the European sovereign debt crisis will also slow down the Asian markets, eliminating the fear of inflation there as well. Moreover, the QE2 ended in June, and the Fed has signaled that there won't be more quantitative easing, plus the US economy has been signaling signs of slow recovery.

Finally, I believe that those who invested in gold years ago will now dump gold to take their gains before the end of the year. While there seems to be no real reason to buy gold at its current elevated price, I think that there will be a large sell-off because investors will want to dump gold as the dollar increases in value, the trade gaps narrows, and as Europe leans towards a potential recession.

Follow this link to an article that came out this morning on CNBC:
http://finance.yahoo.com/news/gold-sheds-cant-lose-status-165243054.html

The European Sovereign Debt Crisis Continues ------ Market News Dec. 14, 2012

Europe's Sovereign Debt Crisis - Controlling Global Markets

Although US markets are down about 3% this week, European markets have been hurting much more, taking all markets on a wild roller coaster ride. Let's focus on a major market mover over the past months, the sovereign European debt crisis, and the policies that are being implemented to try to fix it.

Angela Merkel, Germany's chancellor and central banker, and French President, Nicolas Sarkozy, lobbied for euro zone members to open their budgets in order to deter the crisis. But what exactly does that mean? It means that they want countries to sign an intergovernmental treaty "to make it easier to force governments to balance their budgets and trigger automatic sanctions if they don't" (Latham).

They want to control how much countries are spending, borrowing, etc. so that this kind of debt crisis doesn't happen again. But this runs into two problems. First, who will be the European authority implementing strict budget oversight (will they really be able to say to a sovereign country, you can't spend more money?)? And, how will this treaty help the current European sovereign debt crisis in the short-run?

Simply, the leaders don't know who will be responsible for oversight, and the treaty does not solve the current crisis. In my opinion, this integration of oversight in budgets will only pose a greater political threat in the future, as the countries become too integrated. The countries that agree to the treaty will have to submit their budgets for central review and then may be asked to limit the deficits they can run. Last Friday, 23 countries said they were in favor of the treaty, while one straight out said no: Britain.

A Little History on European Monetary Union

I think Britain knows best, being one of the countries to stay out of the European Monetary Union (they are still on the Pound), they have avoided the structural problems of sharing a common currency with other EMU nations. While some of the goals of the euro in 1991 were to create lower transaction costs, to lower financial risks for independent countries, and to increase international cooperation (rather than wars), the EMU caused unforeseen consequences for its members such as the inability of one EU member, Greece, to repay what it has spent. In the past, countries such as Greece whose governments overspent, would be able to devalue their currency to pay back their debts more easily. Yet by giving up its own currency to join the euro, Greece gave up the power to increase its money supply since power over the euro is granted to the ECB.

While many money managers believe that there may be a partial break-up of the euro zone, I believe that it will stay together. First, there is so much "red tape"; there are many legal ramifications from members trying to leave that breaking up would be extremely complicated; in fact, it is illegal for a member to leave the zone. Secondly, it would be very difficult in terms of feasibility for  these countries to revert back to their old currencies. Third, countries leaving the euro zone could cause a global economic crisis much worse than the debt crisis we are experiencing now.

Furthermore, all of the countries have benefited greatly by sharing the same currency, especially Germany, the economic powerhouse of Europe. Instead, I believe reforms and new policies, similar to the open budget treaty, will be the next steps to be taken after the crisis.

Although the proposed treaty lifted European markets for a day, on hopes that this new treaty will spark an opening of credit to debtor nations, lowering the cost of borrowing (helping to spur growth), the market has been slumping as no short term solutions from EU leaders arise.

Additionally, with no help from the European Central Bank (ECB), stating that it will not buy up bonds to lower yields for the PIIGS (Portugal, Ireland, Italy, Germany, and Spain -- the countries with the largest debt problems), the costs for European countries to borrow has risen dramatically.

US Looks Better As Europe Looks Worse

While the economy in the US is looking better (especially during the holidays with the markets propped up on retail sales and dropping unemployment, although a closer look reveals this is because workers are leaving the workforce, not because of more job creation), Europe has shown no real solutions. The recent EU summit failed in resolving the euro zone's debt problems and Germany is urging now that the ECB not interact in the market to try and put off the debt problems by artificially bringing down the yields of PIIGS.

Opinion: Long US Large Cap Stocks and USD --> Short Europe

Because of the issues above, I believe that in the next few months there will be a large decline in European markets, and recommend being short the PIIGS, and even larger countries such as Germany. The S&P downgrade watch on the EU will especially play a major role, as it pushes the EU countries to get their acts together. I believe that the Euro will fall relative to the USD, as there is a flight to quality (safety), and that US markets will prove to be more attractive. Because we are so connected to the EU through international trade (although not too much) and debt, I recommend buying stable US stocks in the next few months, rather than speculative stocks, just in case Europe does go into a free-fall, bringing the rest of the world with it. As the Euro declines, market participants will search to invest in non-Euro denominated securities, and I believe this search will find its way to large cap US companies.