July 5, 2011, 12:01 a.m. EDT
Gil Morales on Gold/Debt Crisis
By Gil Morales and Chris Kacher
PLAYA DEL REY, Calif. (MarketWatch) — Given all the possible permutations of the continuing debt dilemmas in both the United States and Europe, finding a way to profit from the potential effect they’ll have on the markets is a complex challenge. Indeed, the current global landscape is fraught with so many cross-currents that calculating potential causalities is becoming less of a science and much more of an art.
In the U.S., failure to raise the debt ceiling will end the country’s ability to continue its “Ponzi scheme” of issuing ever more Treasury debt to cover principal and interest payments on existing debt.
The debt situation also leaves the dollar in a growing state of uncertainty. If Congress is forced to make serious cuts in the Obama administration’s proposed budget, it should strengthen the U.S. currency — but further legislative inaction and the very real specter of a U.S. debt default could just as easily provoke a run on the dollar.
In Europe, things are even worse.
The European Monetary Union (EMU) has threatened to cut off Greece if that country does not enact and implement austerity measures. However, given the exposure the major European banks have to Greek debt, it’s doubtful the EMU can actually afford to carry through on its threat.
On the other hand, what’s the effect if the EMU doesn’t cut off Greece, continuing to prop up an essentially insolvent nation with what is little more than a money-printing bailout? Does this set the precedent for a broadening wave of “Euro-QE” — one that could expand to Italy, Ireland and Spain as those other “PIIGs” begin to suffocate in their own mud pits of debt?
The answers to all those questions are still educated guesses, but one thing is certain: The rapid expansion of debt denominated in any particular currency eventually leads to the devaluation of that currency, be it the U.S. dollar, the euro or a player to be named later. Certainly, over the short term, bounces and rallies can occur but in our view the long-term trajectory of such currencies will always be to the downside.
After all, those who have studied their economics know that no government in the recorded history of humankind has ever succeeded in overcoming an astronomical debt burden by debasing its own currency and allowing inflationary forces to run their debilitating course. Yet, this seems the exact tactic the economic regimes in the United States and Europe are currently resorting to.
So what should investors look to do as the world’s “Endless Summer” of debt progresses?
Given our view that the U.S. and Europe will continue to inflate their way out of these debt crises, printing money and debasing their currencies, we tend to favor precious metals — but we wouldn’t look to buy just yet.
That’s because recent economic numbers indicate the potential for a continued sell-off in stocks through the summer — a sell-off that could spark margin calls and raise liquidity issues among large investors who also hold positions in precious metals and commodities. That, in turn, would prompt a sell-off in gold as well.
This is similar to what occurred in the financial crisis of 2008 — and Chart 1, a four-year weekly chart of the SPDR Gold Trust Shares /quotes/zigman/41663/quotes/nls/gld GLD -0.11% , clearly shows how gold plunged during that market break. The yellow metal’s initial move came in March 2008, when the financial crisis first began to weigh on the markets in earnest. That marked the first wave of what became a classic three-wave downside move, culminating with a sharp break lower that mimicked the drop in stocks in the last quarter of 2008.
However, gold bottomed well before the stock market, and by early 2009 was pushing toward new highs, as again shown in Chart 1. A clean break out later in 2009 set the stage for a rally that carried gold above the $1,000-an-ounce level, followed by a roughly 50% upside move from there.
A further stock-led sell-off in gold this summer – sustained by any potential expansion of the European or U.S. debt crisis – could easily set the stage for a similar metals rebound in the months ahead, with the intervening bottom presenting investors with a strong buy opportunity.
The trick is in gauging where ultimate support will be found. Initially, we would look at the 40-week moving average, equivalent to a 200-day moving average on a daily chart, as a potential support level for the yellow metal. Right now, that puts near-term support at $1,450 an ounce — but this projection must be watched carefully.
In 2008, gold backed all the way down to the $700 level, right on top of a prior consolidation area. A similar 30% pullback this time around would take gold down to the $1,000 level – the top of the major consolidation zone from which gold broke out in late 2009.
We don’t actually expect that big a pullback in 2011 – if only because the expanded printing of Euros, coupled with the expanded printing of dollars, should revive gold’s appeal as an alternate “currency” of choice at much higher price levels.
The bottom line is that investors should recognize the inherent long-term weakness of the major fiat currencies, and begin diversifying at least some percentage of their funds into hard assets, closely watching where major support levels develop for gold in order to identify the prime entry points.
Only by doing that can we hope to successfully weather this “Endless Summer” of debt.
Gil Morales and Chris Kacher are both Managing Directors of MoKa Investors, LLC, and co-authors of the book, “Trade Like An O’Neil Disciple: How We Made 18,000% in the Stock Market” (Wiley, 2010). Neither holds the SPDR Gold Trust Shares.
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