Gold’s Relationship With Real Estate

When I think of gold today, and I try to convince myself to be a bull, I feel a sense of greed more so than the feeling that I’ve arrived at a logical conclusion. Everywhere I look prices are dropping, yet gold hovers roughly 20% below its all time high. At the same time, the dollar is about 15% off of its lows and oil is about 45% off of its highs… don’t get me started on housing. Yet for some reason I have this itch to buy gold. I feel like a soon to be loser would’ve felt at the height of the tech bubble - I just don’t want to miss out while other people make money. Take a look at the following chart.

Here are some of my observations when looking at this chart.

1) You may be thinking that it makes sense that gold is off 20% on a 15% rise in the dollar. Gold reflects the dollar’s value right? As we can see from the chart, a 200%+ increase in the value of gold resulted from about a 30% depreciation in the value of the dollar. If this relationship was set in stone, the value of gold would’ve risen from about $300 to $390 and then pulled back a little from the recent dollar appreciation. There was obviously more to this gold bull market right?

2) Gold and Real Estate have historically been the two ways to store real value as they are as real assets as you get. So what happens when the value of one real asset is artificially manipulated? We all know by now what caused the bubble in real estate, but, at the height of the bubble it was unknown to the market that it was a bubble on the verge of bursting. At that time, the real value of a house was perceived to be its nominal value. If a house is the core asset of your average family and a reflection of their wealth, does it not make sense that the asset that tracks real values (gold) would rise as well?

The correlation is amazing as you can see in the chart above. What I have noticed is that gold lagged the DJ Real Estate Index and then starting in 2006 responded with more volatile movements until the sharp pullback in real estate price over the past 12 months at which point real estate volatility moved higher. What gold is missing is a sharp pull down of magnificent proportions to properly reflect real value.

3) Real estate has pulled back almost to the point that it truly reflects dollar debasement over the past 9 years. It has now turned to a supply and demand issue. I often argue that much like CPI, gold is inherently flawed as an inflation tracker as most of its movement is based on supply and demand, not the value of the dollar. Now we are seeing the opposite happen. While gold demand has dropped this year in terms of quantity (not in $ terms), it has not dropped nearly as much as housing demand has. In addition, housing supply is as high as it’s ever been, while gold supply is struggling to keep up even with the lower demand because of various mining related issues. So these prices have diverged and ‘real’ value is anyone’s guess.

What I can confidently say is that gold prices cannot go up indefinitely if housing prices continue to fall. On the contrary. I think we will still see a further drop in housing prices as unemployment rises and recession pressures are felt. Consumer prices are going down and consumers are moving to deflation expectations. Yet gold traders are still very bullish. A classic signal of a bubble.

Addressing a Dollar Crisis

You may be surprised to hear that I am actually a big dollar bear and I wouldn’t be surprised if the dollar has a major crisis in the next several years. It may even be the tipping point from recession to depression. If you are American I would suggest at minimum diversifying your cash position as this recent flight to ‘quality’ has pushed the dollar artificially high.

However, as I pointed out above, there is significant basis risk in playing a weakening dollar through gold. Now I may be a little early in calling a gold bubble, but the answer lies in liquidity. Let’s assume that we do reach a point where there is a stampede out of the dollar. The first place individuals will look is gold, although the smart money will be moving into all currencies and other non-dollar assets. This demand for everything non-USD will have varying demand impacts depending on liquidity. For example, a stampede into Swiss Franc and Japanese Yen will not cause those assets to move nearly as much as gold because they are far more abundant (Liquid). A sudden explosion of demand, although very beneficial to those currencies, will not move them nearly as much as it will move gold. Take a look at a chart comparing Yen and Gold over the same time period as the chart above.

The question is, is this still going to happen, or has this been happening while the dollar lost 30% of its value over the past 8 years. Are we in the middle of a bubble, or just the first leg that’s going to lead to an even larger bubble? Remember this is your money we are talking about here, your life savings, don’t just jump in because you don’t want to be the only idiot who didn’t like when you bought stocks in the tech boom. Remain diversified as always, even in your cash positions, but don’t move all your assets into gold for its perceived safety. You will find far more safety today in the Japanese Yen and less volatility.

Many people try to short in a bubble and get killed as the bubble continues to grow. I will be sitting this one out. If the divergence between real estate and gold prices continues to increase, there may be a trade to bet on the ratio returning to normal levels.

As you can see from both this chart and the first one, the ratio was relatively calm in 2006, but starting in the summer of 2007, gold prices rallied as housing prices collapsed and a huge divergence resulted.

Where is real value? I don’t know. I don’t believe that anyone does right now. If the U.S sees a similar stagflation environment as Japan saw, deflation may persist with rates as low as 0%. WSJ reported that the ‘Smart Money‘, or the largest hedge fund managers are sitting on the sidelines. There is a lot of uncertainty in the market that could support gold in the short term. However, in order to see a significantly higher move in gold right now, we would likely have to see a very strong upward move in equities and a rebound in housing. If that doesn’t happen, persistent deflation may be the name of the game and at some point gold would have to drop to reflect that.

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