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A bet on gold is a bet against the equity bull market

Marc Faber, publisher of the Gloom, Boom & Doom Report, reiterated his bullish view on gold this morning and under usual circumstances the phrase "Marc Faber is bullish on gold" is about as useful as "water is wet." Mr. Faber's perennial bullishness on bullion, however, has been accompanied by sizable precious metals investment by two of the biggest and most successful names in investing, multibillionaire hedge fund managers Stanley Druckenmiller and George Soros.

The answer to the question "Is it time to buy gold?" can be answered with a focus on bullion's primary function in the financial world. The "anti-dollar" gold rises as the U.S. dollar – still the world's reserve currency – sinks as inflation or monetary expansion devalues the greenback's spending power.

The first chart below shows the price of gold versus the Federal Reserve's inflation-adjusted, trade-weighted dollar index (data to April 30, the last available figures for the index). The negative correlation is there – gold and the dollar have moved in the opposite directions in the long term – but there are frequent periods where the gold price has a mind of its own. In other instances, large moves in one of the lines on the chart are met with much smaller changes in the other.

The sloppiness of the relationship between gold and the greenback implies that investors as sophisticated as Mr. Soros and Mr. Druckenmiller are unlikely to make big bullion bets based solely on their forecast for the U.S. dollar.

Mr. Druckenmiller's comments at the most recent Ira Sohn Conference in May suggest that his sizable gold position results from a process of elimination – he doesn't like the outlook for anything else, neither global equities or bonds.

"[H]igher valuations, three more years of unproductive corporate behaviour, limits to further easing and excessive borrowing from the future suggest that the bull market is exhausting itself," he said, according to Bloomberg. Mr. Druckenmiller also characterized the "experiment" of negative interest rates in Europe and Japan as "absurd."

Mr. Soros has not publicly explained the full reasons for his large gold position. The fact that his fund sold 37 per cent of its U.S. equity holdings suggests Mr. Soros, like Mr. Druckenmiller, thinks the bull market in U.S. equities has run its course.

Mr. Soros is also concerned about global market instability. In an April speech in New York, he equated the current situation in China with the U.S. economy in 2007. In the wake of the British referendum, Mr. Soros wrote a column for Project Syndicate with an ominous prediction: "Now the catastrophic scenario that many feared has materialized, making the disintegration of the EU practically irreversible."

Mr. Soros's geopolitical anxieties imply he is banking on the insurance value of gold – a haven for investors in times of severe volatility.

The second chart, with a correlation leaps and bounds tighter than gold versus the U.S. dollar, presents a summary of the argument for gold investment in the current market environment. It is, in short: Expect a U.S. and global economic slowdown as the effectiveness of monetary stimulus declines.

The chart marks the performance of bullion against the yield on the five-year Treasury inflation-protected securities (TIPS). The latter can be viewed as the inflation-adjusted dividend yield on the five-year Treasury bond. Further, this yield is interpreted as the market's mid-term view on U.S. inflation and economic growth – as the grey line falls, economic optimism is declining with it.

This will come as a surprise to investors who view gold as a hedge against inflation, but bullion has been rising as growth and expectations fall. In effect, gold prices are rising as deflationary fears rise.

Mr. Druckenmiller's and Mr. Soros' bets on gold, combined with their public "U.S. bull market is over" sentiments, are most likely a reflection of their belief that credit-driven equity and bond market gains are now over, and that an economic and profit recession may be in store. This would involve five-year real yields falling further, and gold rising to new heights. Investors confident in declining global economic and profit expectations can be comfortable following along and adding gold to their investment portfolios.

Follow Scott Barlow on Twitter @SBarlow_ROB.

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