Why gold shines brightly

Tooling & Production, Nov 2007 by Hummel, John

An asset-allocation strategy with a current emphasis on gold produced strong returns of 11.33 percent in the third quarter and 16.95 percent for the year to date. Such allocation is based on the analysis that gold will continue to outperform both stocks and bonds for the foreseeable future.

The financial market events of the third quarter are forcing central-bank policy makers into uncharted waters. The central-bank policy of the past decade created the environment that allowed unprecedented housing and credit market speculation to develop.

Recent history

The credit bubble was first apparent in late 1996. Federal Reserve Chairman Alan Greenspan identified "irrational exuberance" in the stock market, but the central bank did not rein in speculation through a tighter monetary policy. Greenspan later denied the ability to identify a financial bubble and further stated that it was not the bank's responsibility to stop it. However, if a financial bubble formed and later burst, Greenspan stated, the central bank would respond if the bubble negatively impacted the economy.

Following the bursting of the Internet bubble in 2000, the Fed responded with a powerful series of credit-easing moves from early 2001 through 2002. As a result, shortterm interest rates dropped from approximately 6 percent to 1 percent. Rates were taken this low as a high level of fear developed that a deflationary spiral might occur from debt liquidation. However, the easing tactics were so successful that it led to the recent speculative bubble in both the housing and credit markets.

2001 revisited

The financial markets and the economy are now in a similar position to 2001. Instead of a dotcom stock market collapse, the recent credit-market seizure and collapse of housing threaten the economy. Strains typically appear first in the financial markets and only later in the transaction economy.

In an attempt to avoid sending too aggressive a signal to the financial markets, the Federal Reserve's first response to the credit crisis was fairly limited. Not until an extremely weak monthly employment report in September did the Fed respond more aggressively. The result has been a calming of the credit markets, a rebound in stocks, a very weak dollar, and a strong rally in gold and other commodity prices.

The dilemma facing both policy makers and investors is whether recent Federal Reserve credit-easing moves are sufficient to maintain continued economic growth or whether a recession is in our future. Can an economy highly adependent on equity extractions from rising home values keep growing, if this element is missing? Can business investment or export growth pick up the slack left by a weak housing sector?

This is unlikely - but the jury is still out.

What we face

If the economy does weaken further, additional Federal Reserve easing will put further downward pressure on the dollar and substantially increase inflationary pressures. This creates policy challenges for foreign central banks. Do foreign central banks allow their currencies to continue appreciating and in the process make their exports less price competitive or do they ease their monetary policies and allow their inflation rates to increase? In the 1970s, inflation became a global problem as the dollar weakened and other central banks eased credit conditions. A repeat of this phenomenon may be unfolding once again.

Given the political environment in this country and the highly leveraged state of the economy, the Federal Reserve will choose economic growth over a stable dollar and will also accept a higher inflation rate if that is necessary to maintain economic growth. The alternative of a recession with the threat of spiraling deflation, due to accelerating debt liquidations, would not be tolerated in today's political environment.

To a certain degree, we are in an unknown financial wilderness. But the odds are increasing that we face continued dollar weakness, higher inflation, and a steepening yield curve, as long-term interest rates increase, even as the Federal Reserve pushes short-term rates lower. If such a scenario unfolds, both domestic and foreign investors may lose their appetite for long-term bonds and possibly stocks as price-earnings ratios come under pressure from rising long-term interest rates. It is for these reasons that I remain suspect of the financial-market returns and expect gold to continue providing superior returns.

John R. Hummel is president and a founder of AIS Futures Management LLC and AIS Capital Management LLC, a registered investment advisor. Hummel has 40 years of investment experience managing equity, fixed income, and futures portfolios. The AIS group of companies manages four investment strategies combining macro economic fundamental research with proprietary quantitative strategies developed by Hummel and his co-founding partner, Brad Stern. Hummel s papers and published articles can be found at the website: www.aisgroup.com. His e-mail is jhummel@ais.com.