Gold: A letter to a friend

A friend, a fan of libertarian Republican presidential candidate and noted gold bug Dr. Ron Paul, recently asked me whether the price of gold had collapsed. I gave him a brief answer, and then wrote him a note expanding on it.

Gold peaked Aug. 23 at $1,917.90, and declined to $1,704.50 by Aug. 25. the price has since then recovered to $1,867.40.

So, the decline was 11% at its maximum, and the net loss as of today is 2.6%. In other words, no big deal. Gold and other commodities fluctuate in that range all the time. To do it so quickly is a bit unusual, but the loss is the same whether happens in two days or two weeks.

Going forward, I think it's useful to contrast gold with stocks.

Stocks rise because people are optimistic and hopeful. They think companies are going to be more profitable in the future, and so they bid up the price of shares.

Gold rises because people are pessimistic and afraid. They fear that the value of their official currency  will decline, which we call inflation.

So, the question any smart gold trader must ask is, to what extent do I expect inflation, going forward?

The bond market is pricing in only 1.8% annual inflation for the next five years. That's pretty low. The Federal Reserve clearly doesn't expect inflation, because they've committed to zero interest rates through the middle of 2013. The experience in Japan after its economic collapse in the 1980s is that a nation's economy can stay inflation-free for decades despite a lot of government spending and stimulus.

So, if the currency inflates despite all expectations, then gold will continue its rise. If the currency deflates, then gold will decline further, since deflation means all the $20 bills you have hidden under your mattress are in fact becoming more valuable with the passage of time.

That's the long answer. For my own trading, at this point I'm neutral gold. A price rise above [price channel level] $1,917.90 would be bullish under my system; a decline below [price channel level] $1,478.30 would be bearish.

For many people, the idea that the price of gold might decline seems a bit shocking. After all, compared to $20 bills or the digital bits that represent money in the bank or brokerage, gold seems like solid, substantial wealth.

Dr. Ron Paul, during his time in Congress, has certainly helped spread that idea with his assertion that gold is "real money" as compared to Federal Reserve notes. I think his definition of gold is flawed. 

There is only one thing in this world that I'm legally obligated to pay money for, and that is taxes. Everything else that I need I can obtain through barter. So "real money", in my book, is whatever I'm obligated to use for paying taxes. And that, in the United States today, is Federal Reserve notes, or fiat money.

I see gold as being a commodity that moves opposite to the value of fiat money, and that can make it very useful at times as a store of value. But since I can't use gold to pay my taxes, it is no more real money than are bottles of whiskey or Christmas hams.

Best,

Tim