Does It Make Sense to Hold Gold if the Dollar Does Not Collapse?

By Przemyslaw Radomski, CFA  DEC 12, 2012 12:12 PM

Yes, if you consider that we are in a bull market and there are no clear indications that it will end any time soon.

 


Today, my firm follows up on our essay on gold and the dollar collapse from December 4, 2012. In that essay, we speculated what could happen with gold if the US defaulted on its debt in real terms. Today, we describe possible scenarios in the opposite case where the greenback is not destroyed in spite of excessive debt.
 
The “imminent” collapse of the dollar has been spoken for years now. Since 2008 this talk has been fueled largely by consecutive rounds of quantitative easing (QE). With QEs at $2.25 trillion and counting, the number of borrowed dollars is hitting new highs and it’s no wonder that the ability of the US to sustain such programs in the future is being questioned.
 
As we discussed in the above-mentioned essay, it is possible for the US to default on its obligations. Not default in the technical sense of the word, but in a more intuitive sense. Let’s explain that. All the US obligations (bonds, Treasury bills etc.) are denominated in dollars. So, the US government is to repay its debt in a pre-specified amount of dollars (currently $16.37 trillion). If you consider the fact that the authorities have the sole right to print dollars, it becomes obvious that, at the end of the day, they can simply print money to cover any debt outstanding. This is unlikely, and would have disastrous consequences for the economy, but it’s possible. In such a scenario all the debt would be paid off, but the money the creditors would get would be worth near to nothing. This is what we call a default in real terms. Precious metals investors are holding on to gold as a hedge against such a possibility.
 
The common misconception, already pointed out, is that the collapse of the dollar is “imminent,” “sure,” or “certain.” It’s not. Just as nobody knows what will happen in the future, nobody can say that the dollar will collapse for sure. And, even if somebody is convinced that the dollar is heading for the gutter, there’s absolutely no certainty when this will happen.
 
Even though the number of borrowed dollars has never been higher, current debt levels in relation to GDP are not at their historical highs. As of 2011, the US debt to GDP ratio stood at 98.1%. The chart below shows that, in terms of debt, the U.S. economy has already been here.
 

 
In 1946, one year after the end of World War II, the debt to GDP ratio stood at 121.3%, its highest historical level so far. Obviously, the economic conditions after WWII were quite different than the conditions we have today, but the point is that in the past the US economy was able to recover from enormous debt levels. It is still possible that it will recover from all the debt the QEs have been amassing.
 
The implosion of the dollar and the global currency system is not imminent. Can anyone – with 100% certainty – rule out the case in which the countries around the world agree to inflate all currencies gradually until the debts are mostly erased? Or – again with 100% certainty – can anyone say that nobody will come up with a solution that would not lead to US dollar’s destruction? If the widely discussed collapse of the dollar never materializes, in spite of the current debt levels, can it still be a good idea to hold on to gold? It can, particularly if you consider that we are in a bull market and there are no clear indications that it will end any time soon. What's more, we haven’t seen a pronounced phase of exponential growth in prices, nor have we experienced the craze of the third stage of the bull market when everybody and their brother would jump at the opportunity to buy precious metals. We provide some comparisons in the chart below.
 

 
The yellow line represents the price of a troy ounce of gold between 1980 and 2012. The solid red line is the price of gold during the 1980 top ($850) corrected for the official US inflation numbers and the dashed red line is the same price corrected for inflation numbers as they would have been calculated prior to a change in the methodology of inflation calculation (accidentally, this change coincides with the 1980 top). In other words, the solid red line shows you how expensive gold would have to be to buy you the same things it bought in 1980 if you followed official data. The dashed line shows you how expensive gold would have to be if you took into account unofficial data.
 
As of the end of November 2012, according to official US Bureau of Labor Statistics, gold would have had to trade at $2,527.24 to match the 1980 top. It traded at $1,719.00, which could imply that if the top were to be seen in the nearest future (very unlikely), gold could shoot up by 47.0%.
 
Taking a look at the unofficial data, gold would have to appreciate to $9,548.34 to be able to buy you the same amount of goods it did in 1980. Compared to the price of $$1,719.00 (end of November 2012), this would mean an appreciation of 455.5% (!). The target of $10,000 without the collapse of the dollar seems far-fetched, but even if the unofficial numbers exaggerate the inflation, and the latter has been so far somewhere between the official and unofficial numbers, this would mean a possible price for gold beyond $2,500.
 
If the bull market continues throughout the next years and plays out similarly as the previous one without the collapse of the dollar, we see the gold-going-to-$2,500 scenario as a worst case one and the gold-going-to-$10,000 as a possibility. $2,500 might be a worst-case scenario because:
In short, if the 1980 top is anything to go by, then even if there’s no dollar collapse ahead of us, it still may be a good idea to be invested in precious metals.
 
Thank you for reading. Have a great and profitable week!

For the full version of this essay and more, visit Sunshine Profits' website.

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