Historically, in bull markets for gold silver usually outperforms its yellow cousin by a wide margin. Yet, even though gold prices have quadrupled since the early part of this decade, silver, while far outperforming the S&P has not kept up. This suggests that gold's gains in this decade are just a warm-up act and that the real bull market in precious metals lies ahead of us. Another way of saying this is that if you think the past decade has been turbulent you haven’t seen anything yet.
As we have pointed out before, new investors in precious metals are few and far between. When the real bull market in gold begins, the current trickle of new investors will turn into a flood, and by the time gold peaks (probably a decade or more from now), everyone and his brother-in-law will be talking about little else but hot gold stocks.
Some observers have suggested to us that a correlation exists between gold prices and the stock market, so that prospective weakness in stocks might hold down gold. We would point out that gold prices now are within one percent of their all-time high, whereas the S&P is sitting more than 30% below its all-time high. That's not the definition of a correlation. Nonetheless, while the future for gold prices looks especially sunny, we must admit that a correction in stock prices could produce a brief correction in gold – but not for the reasons our critics suggest. The situation is far more complex...
Right now, the Federal Reserve governors are caught between a rock and a hard place (exactly where we predicted, several years ago, they would wind up). On the one hand, investors have recently seen some positive news headlines. The Dow briefly regained the 10,000 mark, and the economy grew at a 3.5% yearly rate during the last quarter, for instance.
Good news like this creates a real headache for academically minded economists such as Ben Bernanke. For how can he justify keeping interest rates at rock-bottom, doing everything he can to stimulate economic growth, if the economy is not on death's door? If everyone believes the economy is recovering, Bernanke will be pressured to confirm this by raising rates.
Truth is, Chairman Bernanke would probably welcome a correction in the stock market. As a scholar of the Great Depression, he knows too well that in 1937, when the Fed prematurely began tightening credit, it resulted in a second wave of the Depression. Unemployment climbed, while growth tanked. A correction in stock prices now would give Bernanke the excuse he needs to keep interest rates low until the economy is well and truly healed. Better to let inflation rise than risk throwing more Americans out of work and risk societal upheaval.
Of course, that view may not be shared by his fellow governors. Most people on the Fed policy setting committee are bankers by training. To a banker, inflation is a far worse evil than deflation. In a deflationary environment, most of the assets bankers own and deal in do very well. Bonds (especially high quality bonds), cash, and even stocks did better in the Great Depression than they did in the inflation wave of the 1970s. Inflation, on the other hand, destroys the value of bonds, cash, and stocks.
Yet, if deflation is tolerable for bankers and investors, it brings with it a host of other ills. Deflation causes unemployment to rise and the economy to shrink, which in turn damages society as a whole. High unemployment can lead to higher crime rates, drug use, homelessness, prostitution, and other ills. A shrinking economy can reduce the government's tax revenues and its ability to tackle social problems. It can lead to a society that is less safe and less pleasant for everyone. Keep in mind in Germany it was not the hyperinflation of the 1920s but rather the depression in the 1930s, and the accompanying social discontent, led to the rise of Hitler and fascism.
We're pretty sure Bernanke wants to avoid a depression at all costs. So the last thing he needs is to see the Dow soaring past five digits or the release of more cheery statistics. Yet to tighten credit even slightly in the face of today's near-10% unemployment could lead to catastrophe.
Not only that, raising interest rates could further discourage banks from lending. One article in the news last weekend was the story that Citigroup is hoarding hundreds of billions of dollars in cash - not enough to cover their bad assets, but still a sizable hoard. This is one sign that bank lending remains nonexistent today, and without lending there can be no sustained growth.
So now the question is what will happen at the Fed meeting on Wednesday.
Admittedly, we don't find it easy to second-guess the Fed. But this time, we have a few thoughts. For instance, we think it would be highly unlikely for Bernanke to raise interest rates. On the other hand, he is likely to suggest that rates will not stay this low forever. He will probably threaten to raise rates if growth appears to be truly turning positive.
The point of such comments would be to let the market correct (on fears of higher interest rates) while keeping rates low to prevent an all-out crash. Such a correction would give him an excuse to continue with quantitative easing until the danger of more deflation has ended.
We were happy to note similar sentiments expressed this weekend at a high-level meeting in Shanghai. The highly intelligent and financially astute attendees included George Soros, Nobel prizewinning economist Joseph Stiglitz, and Chinese Commerce Minister Chen Deming. All of these men argued that the world economy is far from being out of trouble today.
Chen made the most significant statement, saying that, while continued economic stimulus does risk inflation, it is a risk worth taking. For withdrawing stimulus now could be very damaging to the global economy.
We think Chen gets it. Deflation could potentially destroy society, including Chinese society. Inflation, though a problem, would be easier to cope with.
So, for now, we expect the Fed to oppose further gains in the Dow so it can maintain an inflationary bias.
One critical point is that once inflation does start to rise, we expect to see silver prices soar even faster than gold.
In the future, you may hear a lot more from us about the interrelationships between various commodities, but for now continue to hold our resource plays, zero coupon bonds, and stocks with significant exposure to BRACC nations.
