Why gold shines brightly.

Author:Hummel, John
Position:Financial analysis

An asset-allocation strategy with a current emphasis on gold produced strong returns of 11.33 percent in the third quarter and 16.95 percent for the year to date. Such allocation is based on the analysis that gold will continue to outperform both stocks and bonds for the foreseeable future.

The financial market events of the third quarter are forcing central-bank policy makers into uncharted waters. The central-bank policy of the past decade created the environment that allowed unprecedented housing and credit market speculation to develop.

Recent history

The credit bubble was first apparent in late 1996. Federal Reserve Chairman Alan Greenspan identified "irrational exuberance" in the stock market, but the central bank did not rein in speculation through a tighter monetary policy. Greenspan later denied the ability to identify a financial bubble and further stated that it was not the bank's responsibility to stop it. However, if a financial bubble formed and later burst, Greenspan stated, the central bank would respond if the bubble negatively impacted the economy.

Following the bursting of the Internet bubble in 2000, the Fed responded with a powerful series of credit-easing moves from early 2001 through 2002. As a result, short-term interest rates dropped from approximately 6 percent to 1 percent. Rates were taken this low as a high level of fear developed that a deflationary spiral might occur from debt liquidation. However, the easing tactics were so successful that it led to the recent speculative bubble in both the housing and credit markets.

2001 revisited

The financial markets and the economy are now in a similar position to 2001. Instead of a dotcom stock market collapse, the recent credit-market seizure and collapse of housing threaten the economy. Strains typically appear first in the financial markets and only later in the transaction economy.

In an attempt to avoid sending too aggressive a signal to the financial markets, the Federal Reserve's first response to the credit crisis was fairly limited. Not until an extremely weak monthly employment report in September did the Fed respond more aggressively. The result has been a calming of the credit markets, a rebound in stocks, a very weak dollar, and a strong rally in gold and other commodity prices.

The dilemma facing both policy makers and investors is whether recent Federal Reserve credit-easing moves are sufficient to maintain continued economic growth or whether a recession...

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