Below is an extract from a commentary originally
posted at www.speculative-investor.com on
23rd June 2005.
In our 14th March commentary, under the heading "High-Confidence
Views", we wrote the following.
"The 12-month forecasts we can make with the greatest
amount of confidence are, in no particular order:
a) The US$ will rise relative to the other major fiat currencies
b) Gold will rise relative to oil and the industrial metals
c) There will be a pronounced shift away from risk"
We then went on to explain the reasoning behind each of these
At this stage there is evidence that the first of the above
forecasts is on the right track, although it's way too early
to tick it off as being complete because our expectation is
for a lot more dollar strength over the coming year and because
the bulk of the recent rally in the dollar has been relative
to the euro (our forecast is for a large rise in the US$ relative
to ALL major fiat currencies, not just the ones in Europe).
The third of the above forecasts got off to a good start because
there was a definite shift away from risk during March and
April, but market participants appear to have become emboldened
again over the past 6 weeks. Therefore, it's also still early
days as far as this high-confidence view is concerned.
But what we want to focus on today is the second of the above
12-month forecasts; in particular, our expectation that gold
will rise relative to oil. The short-term price action is
clearly yet to provide any support to this longer-term outlook,
but we are no less confident in this view than we are in either
of the other two. In fact, all three forecasts are inter-related
since rising US interest rates combined with a contraction
in global liquidity will likely result in a higher US$, a
shift away from riskier investments, and, later on, strength
in gold relative to almost everything -- oil included -- as
central banks begin to fight the liquidity contraction.
As intimated in the above paragraph, significant strength
in gold relative to cyclical commodities such as oil isn't
likely to occur until after there are enough obvious economic/financial
problems in the world for the markets to begin anticipating
the next round of central-bank-sponsored inflation. As things
currently stand, however, the financial markets appear to
be anticipating a fairly benign outcome encompassing a modest
slowing of growth in the US
and Europe (certainly not a recession), no major tightening
of credit conditions, and Asia continuing to power ahead. Hence the rebound in growth-oriented
investments that has occurred since the beginning of May.
Needless to say, we aren't anticipating such a benign outcome.
Specifically, we expect that a) recessions will occur in the
the largest countries of Europe during 2006, b) it will become
considerably more difficult to obtain credit, and c) there
will be a pronounced slowdown in Asia's economic growth over the coming year.
In addition to our expectation that the economic backdrop
is going to become progressively more bullish for gold and
less bullish for oil (and other cyclical commodities), there
are valuation- and sentiment-related reasons to anticipate
substantial out-performance by gold over the coming 12-18
months. From a relative valuation perspective, for instance,
the below chart shows that the gold/oil ratio is currently
testing the 20-year low reached in September of 2000. In fact,
over the past 35 years the only time the gold/oil ratio has
been lower than it is right now was during the second half
of 1976 -- just prior to the start of a phenomenally bullish
3-year period for gold.
From a sentiment perspective, there appears
to be almost universal bullishness towards oil at this time.
Whenever the Wall
St financial houses issue their price forecasts for oil they
almost always under-estimate, but we get the impression that
most investors stopped listening to these self-serving forecasts
long ago. In particular, the bullish case for oil is very
widely understood and gets repeated ad nauseam in the mainstream
press. However, hardly anyone understands the bullish case
for gold. Even many of those who describe themselves as gold
bulls cite spurious reasons for their bullishness, such as
"there's a big deficit between fabrication demand and
new mine supply" and "the gold price has been artificially
suppressed for so long that it's bound to rocket higher regardless
of what happens in other markets" and "gold is a
great hedge against deflation".
Under the current monetary system gold bull markets are all
about confidence in central banks, in paper currencies, and
in financial assets (stocks and bonds). When confidence is
in a long-term downward trend then gold will be in a bull
market and when confidence is in a long-term upward trend
gold will be in a bear market. End of story. The challenge
is that it's often not easy to anticipate the confidence trend,
or even to identify it while it is still in its early stages.
The point is, when a bullish story is very widely known it
is reasonable to assume that it is mostly factored into current
market prices. Also, a widespread appreciation of the bullish
case tends to only occur during the latter stages of a bull
market. On the other hand, if only a relatively small number
of people understand the fundamental forces that are driving
the price higher then it is generally safe to assume that
the bull market is in its infancy.
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