Sunday, 22 December 2013

The Reflation Trade

2013 has been a year of consolidation for hard assets. Silver is down over 50% and Gold has backtracked from around $1,800 to $1,200 an ounce. The stock markets have been at near record valuations with general optimism on all the TV financial network channels. The momentum is definitely with the stock market, however the saying "be greedy when others are fearful and fearful when others are greedy" would apply aptly to both stocks and precious metals at the moment. Prices are always subjective and get distorted over time. When Gold hit record highs many said it was at the peak of its bubble rationalising on the headline price, however you need to account for price inflation over a 30 year time period. If you account for this then of course Gold was not at a record level. Also if an asset is in a bull market and fundamentals are still in play then generally the price target of the asset moves, allow me to explain. If Gold is now around $1,200 at a time when Governments are in the midst of a money printing bonanza, the price target moves further. Inflation is still here and it will only get worse which moves the end Gold price higher. Inflation will catch up for one simple reason - Interest Rates.

Talk of Interest Rates rising are just that - talk. They will only raise these to real levels when it is too late. Debt is so high that even if they went up only a few percentage points - which would still be at historically low levels - the Government and public would have to default on large parts of debt. This in turn means private banks go bankrupt requiring bailouts to stop mass financial collapse. Its a debt bubble and one the Central Banks can not stop that is now in play. They will keep rates too low for too long; this is the move Central Bankers took.

A better price metric for Gold is the Dow to Gold Ratio over the past hundred years. As the above chart shows, stocks and commodities (in this case Gold) have been counter-cyclical. This is the price metric I use to assess what value both asset classes really have. The general idea is that an once of Gold should have the same value as the Dow stock market index. Currently that ratio is high, near 15. The stock market in around the year 2000 represented a low for gold with the Dow trading around 40 times more than Gold. Since then Gold has gained back some of that ground, but over the past year has re-traced some of this.

If I didn't own Gold I would be using this as a good price indicator. Gold may go down some more - I don't know, I don't trade as there's better things I like to do with my time (markets are too efficient anyway!). Like many I invest in Value and Fundamentals with a buy and hold mentality. So if we check the fundamentals, have Governments solved their debt problem? Have trade deficits corrected? Have Interest Rates returned to real levels? Then check the value which is the Dow to Gold Ratio, explained from a historical perspective. Both Value and the Fundamentals from my view are in a good state for precious metals.

Mini cycles always occur in long term bull and bear markets, the bull and bear traps as they are known. Prices rise, people get interested, buy, then demand dries up, with professional traders liquidating from the market. Prices fall, people get less interested and stop looking. Then the next stealth phase occurs. Investors notice the value, buy back in with prices slowly rising again. At some point the parabolic stage is when everyone starts jumping into the asset. It goes on longer than expected and its at that time to bail. The recent pullback is just like the one in the mid seventies for Gold or the 1987 Stock market crash - the fundamentals were still there but it just corrects along the way, setting up the next stealth bull phase.

Gold stocks also look very undervalued, again beaten down with no one paying them any attention. I also believe Gold will go to much higher levels from its present level, a target of $5,000 to $15,000 per ounce within the next ten years. In my opinion this is actually a conservative price as the Dow currently stands at 16,000 (of course in 10 years $10,000 may not have the same real worth as $10,000 now). Silver has even more potential, but with more volatility.

If you haven't got any of your assets in precious metals now may be the time to reconsider that position. Why? Because no one else is paying them any attention. The reflation trade in the stock markets can't go on forever.