As gold prices continued their long slump, investors grew more confident in the stock market. But constant asset purchases from central banks around the world virtually guarantee an economic collapse. The People’s Bank of China recently made a decision that will have serious repercussions on the commodity markets, especially on gold.
The precious metal has fallen nearly 12% in the last year to $1,145.90 on July 15, 2015. Meanwhile, firms like Facebook and Apple saw their shares appreciate by 36% while investors abandoned commodities. To put it in perspective, you could have made more than 17% by just putting your money in an index fund that tracked the NASDAQ Composite.
Why are metals selling for so much less than their value? There are plenty of rumors about manipulation; that someone is sitting on the price of gold to artificially depress its value. But the answer may lie in the Federal Reserve.
Since the Great Recession, America’s central bank has engaged in a voracious stimulus program to bolster the economy. The bank’s balance sheet quadrupled over the last several years as the Fed bought low quality financial instruments in a bid to stabilize asset prices. However, quantitative easing didn’t end once they had pulled the market out of freefall—it continues to this day.
That being said, here’s the only reason you need to invest in gold right now.
In June 2015, China’s stock market began a record-setting decline that would result in the Shanghai Composite Index losing nearly a third of its value. A key piece of regulation was responsible for the crash.
A year earlier, Chinese regulators started letting investors borrow money to invest. The shift led a 150% stock market rally between 2014 and 2015, a run fueled largely by credit. Government officials grew worried about excessive leverage in the marketplace and reversed the policy on June 12, 2015. This is what happened a few days later:
Chart courtesy of StockCharts.com
In addition to flip flopping on the “margin trading” policy, China had to borrow a tactic from the Federal Reserve. The country’s central bank began pouring money into its finance sector—money that came fresh from the printing press. (Source: The Wall Street Journal, July 5, 2015.)
Unfortunately, we don’t know how much quantitative easing China is undertaking because they aren’t compelled to disclose those figures. The country also does not disclose how much gold its central bank is holding, but estimates put it well above the 1,024 tons reported to the International Monetary Fund (IMF). (Source: MarketWatch, April 27, 2015.)
What worries me is not that China’s attempt to rein in leverage caused their stock market bubble to burst. It’s that they re-inflated the bubble as soon as it became a scary situation, which means the next crash will be even bigger.
The Lender of First Resort
China’s spectacular growth was one of the reassuring signs after the financial crash. It was comforting to think that actual growth, not just financial gain, was happening somewhere on the planet.
Now China is emulating the American model of financial excess. Its investors are getting greedy and trying to pump up their positions with credit. The goal is to magnify your returns, but it can work the other way too.
If you bet $1.00 and lose $1.00, you have nothing. If you bet that same dollar but leverage it at 2-1, you’ll end up owing $1.00. That may be a risk worth taking in some cases, but when it becomes the only thing driving the market, things get scary. Remember 2008?
The problem with stimulus that runs on new money and credit is that it’s very tough to unwind. For instance, the Fed technically ended its bond buying program last year, but continues to take on residential mortgage-backed securities.
Interest rates have also been kept artificially low to encourage borrowing. The economy and the stock market are riding high on a wave of money printing by the Fed. It’s as simple as that. Now that China has adopted that strategy too, global growth is running on nothing but debt and quantitative easing.
Don’t get confused by the false optimism, because optimism can’t last forever. When this bubble finally breaks, investors who bought gold now will make a fortune.