Before I start, I don’t think that many other assets hold their long term value like gold does.  An ounce of gold bought a high quality suit in 1900, and it still does today.  At the same time, paper money loses its buying power due to inflation.  However this doesn’t mean that gold is a short term safe haven against stock market losses.  Read more to find out why I think this.

The current market turmoil has high volatility in share prices, reflecting uncertainty.  If gold was a true short term safe haven, we would currently see much higher gold prices, instead they have slipped.  

This was also the case in 1987.  Gold prices briefly rallied after the crash, then collapsed.  I was working in a bank branch at the time, and customer put their money into gold accounts, and promptly withdrew it when the price decreased.

Most of the price action in the most recent gold rally is more of a response to underlying inflation, caused by stealthy inflation of the money supply (which lead to an asset price boom).  We didn’t see much headline inflation because the cost of some goods decreased as they were produced in China and oil prices were stable.  The previous gold price rally was in the early 1980s when there were similar concerns about inflation and oil prices.

So I believe that gold prices are inflation driven rather than uncertainty driven.  Gold is a hedge against inflation in uncertain times (inflation tends to be quite long term) rather than short term protection against volatility.  This is why I am fairly bullish on gold in the long term.  

In the long term, oil prices will increase as oil becomes more scarce, despite consumption dropping.  However, I believe the largest impact will come from a government that spends heavily.  It is in the interest of the US government to continue to expand the money supply rather than raise taxes, or cut government spending (this includes money for bailouts).  This continues to be inflationary.  Making more money increases prices.

In the short term, don’t expect volatility to support the gold price.  In the long term, look for inflation concerns to drive gold prices.  You also need to remember that gold prices can go down for years at a time.  I remember when I worked in a bank treasury, someone developed a gold product – the most profitable way over a period of years was to simply go short!

Tags: bailout, gold, inflation, safe haven

This entry was posted on Monday, October 20th, 2008 at 1:14 pm and is filed under Commodities. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.