James Grant: Gold joins the mainstream


By James Grant
Forbes magazine
June 18, 2007

Once upon a time gold was the sanctuary of nonconformists, visionaries, contrarians, idolators and cranks. And the gold price moved accordingly. If stocks went up, bullion went down, and vice versa. Which is to say, as the financial theoreticians say, that gold was an uncorrelated asset.

But the barbarous relic has moved ever closer to the investment mainstream. "Strength in commodity markets will be something we should see generally over the next 10 to 20 years," Russell Read, chief investment officer of the California Public Employees Retirement System, was quoted as saying by Bloomberg a few weeks ago. Read has lots of bullish company. In 21TK2 years the market cap of the gold bullion exchange-traded fund StreetTracks Gold Shares, trading at $66 a share, has ballooned to $10 billion from nothing at all. Goldbugs rub their eyes. They feel like the starving artist who awakes one morning to discover that his neighborhood has gone upscale.

Actually, the goldbugs stopped starving some time ago. Since February 2000 the gold price has risen by 130% compared with the S&P 500's 11% and the Nasdaq's minus 45%. Adversity, of course, is the bullion market's old, dear friend. Whether it was the 1987 crash or the Sept. 11 attacks, gold and stocks have tended to go their separate, uncorrelated ways.

If you sat close enough to the blackboard in business school, you may believe that uncorrelated returns are almost as good as just plain high returns. By diversifying into assets disconnected to stocks and bonds, theory has it, an investor can earn greater returns without assuming additional risk. Few assets have answered the call of disconnectedness better than gold. Between 1975 and April 2007 the correlation between weekly movements in gold and of the broad U.S. stock market was around zero.

But a funny thing happened last winter. One day the Shanghai stock market fell out of bed, and, in sympathy, so did other world stock markets--and so did the price of gold. It fell by $23 an ounce. In the 50 days leading up to the Feb. 27 break gold and stocks might as well have been ships in the night. But as the Dow Jones industrial average dropped by 416 points, equities and bullion set sail together. Their correlation rose to 0.6 and stayed there for the next 50 trading days. (At a reading of 1.0, gold and stocks would be in lockstep.)

It could be that this uncharacteristic joining of equities and bullion was a fluke that the safety-seeking gold buyer can safely ignore. But I doubt it. The stellar returns of the postmillennial metals markets have been lost on no one. Investors have chased them, and academics have rationalized them.

The trouble I see is that the opportunists increasingly outnumber the goldbugs. Goldbugs are quick to buy their precious metal and slow to sell it. Opportunists are quick to buy it and quick to sell it. Their principal monetary conviction is that all money is good--not a bad outlook in the abstract, but nothing to hold on to in a bear gold market. So when gold goes down, or when its correlation characteristics change, the opportunist can be expected to dump it as unceremoniously as he would a sack of flour.

It follows that gold could be in for a rough patch. Insofar as it trades like the stock market (at least, on the days when stocks fall), it will tend to lose its newfound adherents. Even its old, grizzled, eccentric fans may despair of it. Why own a defective insurance policy?

That is the near-term risk. But I continue to believe in a sizable long-term reward. Yes, gold has had a nice seven-year run. But the monetary phase of the bull market has hardly begun. How could it have? People, for the most part, still trust the currencies in their wallets and the central bankers who print them. The day gold stops trading as a decorative asset, and begins trading as an alternative to Bernanke & Co., is the day that the gold bull run, part II, begins.

The U.S. this year will emit some $850 billion into the world's payment stream. Most of this money will be absorbed not by profit-seeking individuals but rather by foreign central banks. The central banks of Russia, China and Brazil, for example, will acquire the dollars with currencies they print for the very purpose. This system of creating rubles, renminbi and reals with which to soak up redundant greenbacks might be characterized in many ways. But "bearish for gold over the intermediate to long run" is hardly one of them.


James Grant is the editor of Grant's Interest Rate Observer.

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