Why Gold Is Underpriced

The pervasiveness of the previous year’s downturn in asset categories led many analysts to decry the wisdom of any asset investment, resulting in anxious sell-offs of precious metal …

The pervasiveness of the previous year’s downturn in asset categories led many analysts to decry the wisdom of any asset investment, resulting in anxious sell-offs of precious metal and mining shares.  These same experts attribute gains in gold as a market aberration while practically dismissing the dollar’s decline, consequently creating a golden opportunity for investment in gold, commodities and foreign assets at bargain prices. For more on this, see the following article from Money Morning.

There can be little doubt that 2008 was a nightmare for investors of all outlooks. In the midst of the carnage, it seemed to make little difference whether your portfolio rested on the bedrock of sound economic principles or if it was based on nothing but hot air.

However, as I pointed out at the time, the mad scramble of last fall was perhaps the largest head fake in market history. In a bizarre outcome, investors holding gold, commodities, foreign currencies, and foreign equities suffered the biggest short-term losses. Yet, the rally of recent months in those markets likely indicates that last year’s violent downward move was simply a correction in ongoing long-term bull markets.

But with the wounds so fresh, investors remain extremely cautious. The fear has created a proverbial “wall of worry” that is difficult for these markets to scale.

When all asset classes fell simultaneously in 2008 (with the exception of U.S. Treasuries), most market strategists jumped to the erroneous conclusion that all asset classes were equally vulnerable and equally flawed. I was virtually alone in insisting that the sell-offs in commodities, foreign stocks and foreign currencies were not justified by the unfolding financial crisis in the United States.

Recent market action confirms my thinking. Sharp sell-offs in stocks over the past month – including the near-200-point drop in the Dow Jones Industrial Average on Sept. 1 – produced only a slight rise in the dollar and virtually no decline in the price of gold.

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However, many traders likely played the markets like we were still in 2008. They bought dollars, and sold precious metals and mining shares, in anticipation that both foreign currencies and gold would follow the equity markets lower.

When these patterns did not emerge, shorts likely looked to cover their trades. The dollar quickly surrendered its small gains and within a few days made new lows for the year, while gold and silver prices surged, sending mining shares to their highest levels of the year.

Since most investors simply take their cue from whatever image is fading in the rear-view mirror, many expect that if the current ‘green shoots’ wither, the resulting 2009 sell-off will look like the one we had in 2008.

Nervous investors – rightly concerned about the U.S. economy – are hesitant to exchange their dollars for gold or foreign stocks for fear of a repeat of 2008. Therefore, the dollar will need to fall a lot further and gold and silver prices rise much higher before such investors regain the confidence of their prior convictions.

This unwarranted “ear premium” built into the dollar will likely work to the advantage of those still trying to get rid of their remaining dollar holdings. It is comical to watch so-called experts on CNBC trying to rationalize gold’s gain. With their nearly universally held conviction that there is no inflation anywhere in sight, and that economic recovery is already under way, they must seek out alternative explanations for gold’s strength.

As a result, they conclude that gold’s rise must simply be a fluke and that it bears little significance for the U.S. economy or financial markets. Of course, since gold is a leading indicator of inflation, by the time inflation is evident in lagging indicators like the consumer price index (CPI), it will be much too late for these confused investors to do anything to protect their wealth.

I also find it laughable that most market pundits attribute the fall in the value of the dollar to an increasing appetite for risk. The theory is that as investors become more confident in growth, they are willing to assume more risk, so they sell the dollar and buy other currencies.

However, this explanation has it backwards. The dollar is the risky currency, and investors who are dumping dollars are in search of safer havens. These are the same pundits who first assured us that the economy was sound – just before it collapsed – and who subsequently proclaimed that the dollar would rise as the United States led the global recovery.

Instead, the dollar has resumed its decline, and the United States lags the global recovery. In fact, the endless stimulus and bailouts enacted by Congress and the Obama administration ensure that our economy will not recover anytime soon.

In the meantime, stock market bulls will continue to use the renewed strength in stocks to discredit the bears. They will likely accuse us of missing out on the rally in stocks. While such allegations may apply to a few misguided bears that are cowering in the perceived safety of U.S. dollars – or worse, U.S. Treasuries – the smart bears are not missing out on anything, as they enjoy much stronger rallies in foreign stocks, mining stocks, precious metals, and commodities in general.

As investors, we are indeed fortunate that so many others are so clueless regarding both the dollar and the U.S economy. As a result, assets such as gold, commodities, and foreign equities will continue to be under-priced. Though the ride will likely be bumpy, I believe the final destination will more than compensate for any discomfort.

This article has been republished from Money Morning. You can also view this article at
Money Morning, an investment news and analysis site.

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