Cowboy Confessional

Being a contrarian is entertaining, especially when you are right.

A few weeks back I decided to short gold (betting the price of gold would plummet) much to the astonishment of mavens who see the rapidly rising price of yellow metal as an unstoppable upward event, just like the housing boom, the dot-com era, “peak” oil, Florida real-estate and other Icarus investments.  With gold recently charging past $1,400 per measly ounce (well above its commercial manufacturing value) they thought my selling short  was insane.

Wax wings sounded like a good idea at the time too.

At the peak of the dot-com bubble, my Uncle Bob sold everything.  This seemed a mistake, despite tech companies continuing to have share prices so far above earnings that P/E ratio calculators broke under the numerical strain.  Uncle Bob merely said “Whenever I see a lot of people doing a stupid thing, its time to get the hell out of there.”

This advice applies to investing, riots or San Francisco orgies.

What triggered my initial decision were reports that small investors were suddenly buying gold in droves.  Legendary are the errors of small investors who are always late to the feeding trough.  So when like lemmings they swarm toward one investment or another, it was a sign that all the possible profit in a bubble has been procured by others, and it was time to sell.

But more importantly is that the price of gold is speculative on the economy in which it is based, namely the U.S. dollar.  In anticipation of inflation brought about by a decade of war, bank bail-outs and Obama “stimulus” spending, many turned to gold as a hedge.  Not a bad strategy, but at some point the price catches up to the reality and surpasses even projections.  We have hit that juncture on multiple points.  Keeping in mind that U.S. debt is the primary factor behind inflation:

click either chart for a larger version

• The price of gold relative to the U.S. debt level is at the closest point in the last decade.
• Gold prices compared to U.S. debt as a percent of GDP are even closer.
• There has yet to be any inflation because the new debt was partially created to prevent deflation (to avoid going into negative economic growth and thus bring us back to about zero).
• Republicans taking hold of the House – which creates the Federal budget and hence the Federal debt – has a better chance of halting new debt more than the alternative.
• The debt commission, which is already preparing the public for the pain of budget cuts, may actually cause some spending freezes if not outright cuts.

So at the instant where gold prices seem to have caught up with debt and small investors swarming, the worry about ever expanding debt is going away.  The timing is made sweeter still with other nations economically imploding (Ireland is near doomed and other PIGS are on the butcher block) or hitting the breaks (China likely to face steep inflation on top of their housing bubble).  All this bodes well for the dollar, the U.S. economy and thus not for the price of gold.

All of which explains the drop in gold prices today.

It may be too early to tell if gold has reached the bubble breaking point, but I’ve sold short and will enjoy the long road down to normal, or about $450.

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This entry was posted by Guy Smith on Friday, November 12th, 2010 at 3:18 pm and is filed under Economics. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.