Nothing Shines Like Gold

The S&P 500 is making new bear market lows today. The Dow Jones Industrials did that last week. There's only one risky investment doing well: gold.

A week ago gold traded above $1,000 per ounce, coming within spitting distance of the all-time highs made last March. It's pulled back now to about $940. But still — what other investment other than riskless government bonds can you point to that's so near all-time highs?

Amazingly, just a month ago, gold and the S&P 500 were trading at about the same price — gold at $854, the S&P 500 at 840. From there, stocks have fallen 10% to near their bear-market lows of last November, while gold has risen as much as 16%. That's a divergence of more than 25%, in just a single month.

Readers of this column know that I've been touting gold for quite a while. I think the bull case for gold still holds, and I would be a buyer of any pullback. I think it's highly likely that gold will be at new all-time highs within the next several months.

If that happens, it will be great for my portfolio. But you have to be careful what you wish for. The force driving gold is the prospect of inflation. So if gold breaks new all-time highs, the bad news is that it will be a scary signal of inflation to come.

It's a mistake to think of gold as a barometer of global wealth. Sure, when people get rich they like to buy more gold jewelry. But global wealth is collapsing now, and yet gold is near all-time highs. So there must be another explanation.

It's also a mistake to think of gold as a panic asset — something that people hoard because they think the world is going to come to an end, and gold will be the only thing left of any value at all. In the all-out financial panic that started last September and climaxed at the stock market bottom in November, the price of gold collapsed, too. It fell almost as much as stocks. The real panic asset is cash, not gold. When things get scary enough, people will sell their gold to get it. So now with stocks back to the same levels as last November's lows, there must be another explanation for why gold is near all-time highs.

As Sherlock Holmes said, when you rule out the impossible, whatever's left — however improbable — must be the solution. Thus: inflation.

I admit that seems improbable. Yet it is the answer.

I say it seems improbable because all the other evidence all around us is pointing to deflation, not inflation. That is, falling prices, not rising prices.

The simplest evidence of that is the Consumer Price Index. It's been showing deflation more intense than that experienced in the middle of the Great Depression. You have to go all the way back to 1921, the great deflation that followed the end of World War I, to find the equivalent.

Yet still, gold is signaling inflation. I think the reason why is that the gold market understands that Federal Reserve Chairman Ben Bernanke will do everything he can to keep deflation from worsening or persisting. Bernanke knows that in times like ours, when households and institutions are struggling with dangerous debt burdens, deflation is the worst thing that could possibly happen.

The reason why was first explained in a 1933 paper by the famed economist Irving Fisher, in an attempt to understand why the Depression was so severe. Fisher noted that when investors hold assets financed by debt — whether its banks holding toxic securities, or individuals holding expensive homes — deflation destroys in two ways at the same time. First, in a deflation the prices of assets fall — so the value of your portfolio, or of your home, collapses. At the same time, your debt burden gets worse, because you are committed to make loan payments in dollars which are becoming increasingly valuable in deflation-adjusted terms.