Gold Is Toppy, Buy More?
By Staff News & Analysis - March 10, 2010

Forget gold and focus on its producers … In December, I was told that China had appointed an agent in London to buy up every ounce of gold they could find. It was too incredible to believe. When speculation gets this hard to swallow it's a certain sign that a market is hitting a top. Today's news suggests it was another fantasy from the legion of gold bugs. The man in charge of China's $2.4 trillion of foreign-exchange reserves said that the yellow metal is unlikely to be a 'primary investment' as it diversifies. So the argument beloved of gold bugs that China will move to severely reduce the dollar as its reserve currency in favour of gold has been shot down. But that doesn't mean you should not have exposure to the yellow metal – quite the contrary. Gold is a key part of any portfolio. For now, it's not a good idea to buy into the metal directly, but instead to invest in gold companies that look set for strong production growth in the next few years. – UK Telegraph

Dominant Social Theme: Gold is bad, but gold producers are good, especially Barrick.

Free-Market Analysis: The logic of this article is a bit puzzling to us. The author, Garry White, describes himself this way: "As editor of the Questor column, I'm the Telegraph's share tipster, as well as its mining correspondent. I believe stock market investing is easy – all you have to do is look at trends in the world around you [and then] employ common sense. I'm particularly interested in commodities and the effect population growth will have on demand for life's basics such as food and water over time."

We're not sure in the article excerpted above, that White is entirely taking his own advice. Obviously knowledgeable, he seems to have left us with a logic gap. First, he writes that China buying up gold aggressively was a "fantasy from the legion of gold bugs." He also writers that "when speculation gets this hard to swallow, it's a certain sign that a market is hitting a top." Then he writes it's not a good idea to buy the metal directly but instead to invest in gold companies that look set for "strong production growth."

This seems to us, as we stated above, to be a tad illogical. There are reasons to buy mining shares and, yes, gold and silver will be toppy at some point. But we are not sure the article fully defines the theoretical underpinnings of the gold (and silver's) cyclical parabola. White has, however, inspired us (once again) to take a stab at it.

From our perspective, the market itself is not complex, nor is the arc it follows, though the time line can be short or long. In fact, the timing is always uncertain. Gold and silver break out in a big way only when central-banking generated fiat money has so distorted the larger economy that there is a gigantic blow-off and subsequent collapse.

Once a generalized collapse has started to take place, the value of paper money shrinks and gold and silver seem to gain in value, perhaps a good deal. The worse the economy gets, the more value accrues to gold and silver. As the business cycle turns, the powers that be flood the market with fiat money once more to salvage the system. Sooner or later in these scenarios there is almost inevitably a good deal of price inflation as a staggering amount of money has been printed to stabilize the lynchpin players of the fiat system. This happened in the 1970s and is happening in the 2000s.

But we have not, in our estimation, entered an inflationary period yet. The cyclical collapse of the 2000s is considerably longer than the collapse of the 1970s. It may take up to 15 years or more to work itself out and may, in fact, involve the failure of fiat currency as we know it and a new financial structure. Whether it does or not, the chances are that price inflation will eventually become onerous. And it is this price inflation that will send gold and silver – and its producers – soaring. (The alternative being a prolonged deflationary depression.)

Until we get to a point where price inflation is evident, we suggest that a gold and silver mania is NOT taking place. Inflation in the 1970s drove gold and silver to higher highs. But where is price inflation today? In a real price-inflation, gold and silver would likely move hard and fast. And once they did so, people, unable to buy the physical anymore, would begin to buy paper in earnest, especially mining stocks, and even junior mining stocks. The purchases would be driven by economic realities not by "promising fundamentals." Also, the money would flow to the best promoted mining stocks, regardless of promise. That's just how life is.

After Thoughts

The mechanism we are suggesting is a bit different than the one presented in the Telegraph article. But we have done our best to present it realistically, as we understand it. Since we have not seen evidence of severe price inflation yet (and sooner or later we believe we probably will) we think physical gold and silver are probably not toppy. A rumor about Chinese gold buying does not a blow-off make. First comes price-inflation, then higher gold and silver prices and finally the purchase of paper assets by those (investors) who can no longer afford the physical metal. When you, dear reader, see these various factors being realized, you may be able to orient yourself as to the market's historical position and act accordingly.