The Markets: The Myth Of The Gold Bubble By Gareth Milliams

April 23, 2009

SPDR Gold (GLD) is the most successful ETF in history. Back in 2004, it opened with 260,000 troy ounces of gold. It now has 35,000,000 ounces of which 16,000,000 have been added in the last year alone.

I get told so often that gold is in a bubble, but how can that be? There is presently no correlation between gold purchase and return. This is partly because there is no perceived gold shortage - yet. It is also because certain other economic factors dictate gold value, such as dollar strength and inflation.

Inflation is at a comparative low. In fact at the moment we are currently experiencing a slight deflation of -0.38% (click on the chart below). The dollar is also relatively strong and therefore hedging against dollar weakness is not required. Yet despite this, gold still holds its value. Last year, as the markets crashed and banks failed, GLD even garnered an 8% profit.

courtesy of www.dshort.com

So what will defeat deflation? Unfortunately, it is rabid government spending that will create the inflation that will reflate the global economy. After the Great Depression, Roosevelt regretted that he hadn't spent more on infrastructure projects. Luckily (?) World War 2 came along, which (at the time) led to the greatest government spending initiative in history and deflation disappeared only to return in the late 1940's. Click on the chart above and you'll see that on the clearly marked 1940 line that there is a tiny spike in inflation (lendlease?) followed by a massive surge at the beginning of 1942.

A more modern example close to home is the deflation experienced in Japan during the 1990's. Despite a global boom, Japan's economy stayed in the doldrums because of a lack of internal investment and the government's inability to confront zombie banks that weren't lending and were in fact, bankrupt.

My point is this: Whilst spending for the sake of it goes against the grain, deflation is the greatest enemy of growth. To reflate we need to inflate and that means massive spending programmes from central governments. Click the chart below to see a shocking graphic of how the Adjusted Money Base (AMB) of the United States has increased.


All of this spending means that there will be a huge reduction in the comparative demand for US dollars. Excessive supply of any asset only weakens its value. The problem is, is that the US dollar is the lifeblood of the international finance and trading system and this level of printing will cause a massive weakness in dollar value and therefore a systemic increase in the cost of commodities such as gold and oil.

That is where gold comes into its own as a flight to quality and as a simple hedge against persistent dollar weakness. At some point there may be a mass hysteria for this finite metal pushing the price up toward record inflation adjusted highs.

So for my portfolio clients, I heartily endorse GLD and for monthly investors, the resource funds from JP Morgan, Black Rock, Martin Currie and Investec.

Inflation is coming, that is certain. We must prepare to benefit from it.