Huge government debts mean you should hang on to gold
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Associate Editor
David Stevenson Jan 14, 2010
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Investors seem to have incredibly short memories.
"Seldom have markets returned so swiftly to the scene of the crime. A range of investments linked to hopes of global growth all crashed together in 2008", says John Authers in the FT.
"Now [investors] are rushing back into the same places. The repetition of behaviour that so recently inflicted so much pain is hard to explain".
The consensus is that governments and central banks pulled us back from the brink in 2008. And now it's onwards and ever upwards for asset markets.
But markets are becoming increasingly vulnerable. And while we can't be sure of what will trigger another slide, the higher they rise, the more severe the correction will be. And when it comes, governments will be in no fit state to bail the economy out again. Here are five reasons to be on your guard…
1. Stock markets are expensive
First, stock markets are expensive. The Shiller p/e is the valuation of the US stock market based on a ten-year moving average of earnings. Basically this strips out short-term profit wobbles, and gives a good idea of how cheap or expensive a market is in historical terms.
Right now, the US market has rallied so sharply that the Shiller p/e is on 21 times. That compares to a historical average of around 15 or so. Sure, it's been even higher in the past. It hit a peak of 40-plus in the daft 'dotcom' boom of 2000, and 33 in 1929. But these were huge exceptions – and we all know what happened next. The fact remains that 21 is very near the upper end of the Shiller's normal long-term historic range - going back to 1870.
In other words, US shares, which still drive the rest of the world's stock markets, are right back into bubble territory. And if we should have learned anything from the past ten years of vanishing returns, it's that people who buy things when they're expensive, tend to lose money in the long run.
2. There are signs of complacency
Second, take a look at the VIX – otherwise known as Wall Street's fear gauge. This measures the cost of insuring against sudden market movements. If traders are paying less for insurance, it means they're less fearful for the future. That's the case right now. The VIX is at its lowest level since May 2008. But such complacency is a bad sign, not a good sign - after the May low, the S&P 500 index halved in value over the next nine months.
3. The supply of bears is running out
Third, there's the American Association of Individual Investors retail sentiment index. This currently shows near-record lows in bearishness, says James Phillipps at Citywire. When the supply of bears runs out, it suggests that almost everyone has got back into the market. That means no buyers left, which is bad news for shares.
4. The bond issue glut
Fourth, there's the recent bond issue glut. Companies have been rushing to take advantage of lower loan costs while they can. It's nice for the borrowers. But it's not good news at all for bond investors, for whom "it's hard to argue there's any value at all", says Euan McNeil at Aegon Asset Management.
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If more companies are competing for the money that's out there, then they have to offer potential lenders better terms. So bond prices will fall (pushing up yields). That also puts pressure on shares. Why pay for a share (which is riskier, after all) if you can get a bond that offers an attractive alternative?
5. The real economy is too weak to support forecasts
Fifth, the real economy is too weak to support investors' optimistic forecasts for future growth. Private individuals are de-leveraging – paying off debts. That's likely to take a while, and in the meantime will make it harder for economies to expand. As Albert Edwards of Société Générale pointed out this week, the real bedrock of economies is the smaller company sector. Here, despite recent stock market moves, "optimism has barely recovered".
This all suggests to us that markets will have a very tough time making progress in 2010. That's why we're sticking with defensive stocks.
Hang on to gold
As for the longer run, we'd also be hanging on to gold. The yellow metal may well suffer along with most other asset classes in any correction. But its bull market has a long way to run yet. Why?
Because of inflation, is the short answer. In the absence of growth from the private sector, the public sector is trying to pick up the slack by spending stacks of money it doesn't have. But in the long run, that'll only make things worse. Edwards' colleague Dylan Grice reckons that if you include all the claims on 'developed world' governments, such as pensions and healthcare, then true state deficits are many times higher than the published figures. These millstones are so heavy, says Grice, that they logically mean just one thing. Most of these governments are insolvent. And the only way out is through some form of default.
That can happen in one of two ways. Either governments globally don't repay the money they've borrowed. Or - a more likely alternative - they stoke up lots of inflation, maybe between 10-20% a year, so that they can repay their debts out of massively devalued currency.
Why inflation is likely
If you don't think that will eventually happen, look at yesterday's UK debt auction. The Treasury managed to unload £2.25bn of government bonds, or gilts. It was happy to pay an interest rate of more than 4.3% until - wait for it - December 7th 2049.
In other words, the keepers of Britain's public purse are taking a big 40-year bet. They're gambling that the UK will grow in 'nominal' terms - i.e. in actual money - at least as fast as this interest rate. Because only then will the government be able to raise enough extra tax each year to fund the annual cost of this gilt.
If Britain's economic growth rate, and so the extra tax-take, falls short of what's needed, our government's easiest option is simply to engineer inflation higher. So it'll just keep printing more money until eventually it manages to push prices up.
Grice agrees with us, that when that happens, gold will be just about the best way to protect your money. You can find out more about how to buy gold here: Investing in gold.
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David Stevenson
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