Gold Bugs Just Might Be onto Something…Finally!

“The Financial World According to Inya” Column,
by Inya Ivkovic, MA

Since early March through mid-October, the S&P 500 Index has gained over 60%. Thriving in the same often hostile economic environment, gold is hitting record highs, too. Now, if you owned an exchange-traded fund (ETF) where the underlying entity is a recognized index such as S&P 500 SPDR or if you owned gold, which of the two would you keep in your portfolio?

Allow me to digress a little. It is not easy to be a gold bug. There is no respect in it, being constantly compared with and often even equated to conspiracy theorists, bad news bears, survivalists and nutcases of all species and brands. Even more so, gold bugs are often accused of waiting for the Great Hyperinflation that never comes.

On the other hand, what I cannot understand for the life of me is how anyone can ignore the centuries of a relationship between gold and financial crises. And I particularly cannot understand how anyone can ignore gold in the aftermath of the credit bubble, the explosion of which has left leverage the size of a proverbial Moby Dick. The only question now is whether Moby Dick is inflationary or deflationary, and the price of gold just might offer an answer.

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Let me first define leverage. It is a simple concept that has existed throughout the history of finance — debt secured by assets. This simple structure has also been a historic explanation for far too many bubbles, created as the rationale that it is okay for debt to grow far beyond the available asset coverage has gained considerable traction.

Recently, the real estate bubble swelled beyond anyone’s wildest dreams, because consumers genuinely believed their future earnings power and their exaggerated net worth would only grow. Admittedly, some of those expectations were so grossly exaggerated that many now believe they were flirting with fraud. When the credit-card addicts have finally spent the last maxed-out dollar and when the last rocket scientist has signed on the dotted line of a negative-amortizing mortgage (when principal payment is less than interest charge, thus increasing the outstanding loan amount), the credit bubble burst and the rest is for the history books.

Despite the mirage of recovery in the form of Cash for Clunkers programs and phantom inventory restocking, we have plunged deep into a deflationary trend. Consumers are no longer interested in borrowing and, until the last garage and yard sale is done and the last bid is closed on eBay, no one will be rushing the doors of lenders asking for cash.

Consumers have finally figured out the Federal Reserve’s prisoner’s dilemma, a concept in game theory that shows why two people might not choose to work together even if it is in both their best interests to do so. They have finally realized that their net worth was a Fata Morgana, an illusion created by inflated home prices, and not a result of personal income growth. Americans have also finally taken off their blinders and seen that manufacturing and service jobs have left the domestic labor market and moved to significantly cheaper overseas markets. Unfortunately, the only way the Fed knows how to deal with American consumers’ rude awakening is to pump more and more money into the financial systems, hoping to jumpstart the economy to its original growth rates, which were surreal to begin with.

The Treasury’s power to print enormous sums of money is quite formidable and it may avert severe deflation. However, this will not stop the U.S. dollar from leaving American soil and it will not narrow the trade gap. This troublesome dynamics will reverse its course only when the U.S. economy starts yielding more jobs and when personal incomes start rising again. The only problem is that no one can tell for sure when the reversal will finally happen.

This is where we, the gold bugs, may offer some insight. At this point, this is not just about betting on inflation and relying on conventional wisdom. In all honesty — and not many gold bugs out there would ever admit it — gold was not exactly the most predictable among inflation hedges out there. However, what no one can deny is that gold has been more often than not a viable safe haven against deep currency depreciations.

On these PROFIT CONFIDENTIAL pages, I have talked extensively about deflation and inflation. But I don’t think I have really called for hyperinflation before. And it is the third possibility serious investors should consider, particularly in the current environment of the quickly depreciating U.S. dollar.

Currency, just like any other financial instrument, is really an obligation covered by certain assets. Only in this case, the underlying asset is the U.S. economy. Furthermore, currency is also more than susceptible to bubbles. When a government fears its currency jumping off the cliff, it often succumbs to irrational behavior, such as making individual purchases of gold illegal or choosing to increase taxes.

Judging by the dollar’s recent performance, the U.S. economy is worth considerably less than the implied value of its debt. How much less? I don’t think anyone really knows, which is precisely why gold bugs like all of us here at Lombardi Financial are buying gold, gold stocks, gold ETFs, you name it. And we are not selling any of our gold holdings either. As a colleague of mine has said, “We should keep piling it on. You never know when the government will make gold a controlled commodity again or even prohibit transactions in it.