For instance, one atypical event--no weather references here--in the commodities futures markets has garnered our attention recently. On Dec. 2, for the first time ever--yes, ever--the gold market went into backwardation. For the uninitiated, backwardation is an event where the price for more distant future delivery of a good is priced lower than near-term delivery. Gold spot prices--or the price you could fetch at this given instant--have always traded at a discount to the near-month futures contract. This is far from true with other commodities, such as industrial metals like copper and consumable goods like oil, where slightest hint of a temporary supply disruption can flip the futures curve shape in an instant.
Much of gold's persistent contango--the event when spot prices trail futures prices--has to do with its inertness. Gold is rarely consumed and is typically held merely as a store of value. The above-ground stocks of gold, presumably available for disinvestment at all time, are about 60 times greater than its annual production of about 2,500 metric tons. Unlike any other commodity, most of the gold that has been mined throughout the ages is still out there somewhere. At an estimated 150,000 metric tons, this above-ground stock of gold with most visible portions in private hands or tucked away in central bank vaults dwarfs the annual production.
So how do we interpret this unique backwardation event? Frankly, the simple answer is that physical demand is being met only by higher prices as those that possess physical gold appear to be more reluctant to part with their hoard today than they may be in the future. Although this does not imply that the gold market will be in permanent backwardation as carrying costs (interest rates) realign to historical norms, we still wonder why it is that gold is now dearer in the face of what could turn out to be, according to many, a major deflationary environment ahead.
Historically, gold has assumed the role of an inflationary hedge. Accordingly, gold bugs have been telling us that the strength of gold prices recently reflects the enormous sums of money that are being printed to bail out the failing financial institutions. The inflationary implication of such fiat sums of money is clear-cut to gold bugs based on what economist Milton Friedman taught us; inflation is a monetary phenomenon. Some use charts showing how the supply of money, having gone through the roof lately, is the precursor to runaway inflation ahead. However, the flaw with that rationale may be its ignorance of the velocity of money, which has decelerated dramatically as well--a natural outcome of deleveraging. That's why it could be suggested that the deployment of monetary tools including reducing cost of money through the Fed window to prevent deflation is akin to pushing on a string. If the velocity of money is decelerating, we would expect nominal economic growth to remain anemic no matter which accommodative path the federal government utilizes--either printing much more money or dropping its overnight interbank interest rate to zero.
The case for gold in an inflationary environment was proved over several recessions experienced since the 1970s. But when we examine the last major deflationary recession, we have to go all the way back to the 1930s. Although gold was fixed for a long time at $20.67 per ounce, in 1934 a massive devaluation of the U.S. dollar coincided with gold's fixed price jumping to $35 per ounce. During this period of entrenched deflation, and in spite of the fixed price of metal, gold proxies saw dramatic price increases--New York Stock Exchange listed shares of Homestake Mining Company shares rose from about $4 to $500 from 1929 to 1935. The company operated for some 120 years until its flagship Homestake mine in Lead, S.D., ran out of economic reserves a few years ago and the company ceased to exist.
We are not suggesting that the stock prices of all gold companies are poised to soar at this point, but they are not likely to struggle, either. What we are arguing is that in either mode of general pricing instability--inflation or deflation--gold is making a strong case as a disaster hedge. Even those that sit in the "deflation today, inflation tomorrow" camp can look to establish their gold position today rather than trying to time the market. Look no further than comments by Ben Bernanke regarding how an effective cure for deflation is policy-dictated inflation:
"Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934. The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt's devaluation."
So how can you put all this theory into action? We think that one of the easiest ways for individual investors to get on the gilded bandwagon is through ETFs.
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