Spring 2007
This edition...

• Our Outlook for Gold

Follow the Yellow Brick Road

Back in 2001, we first alerted readers to start looking seriously at gold, as we were convinced that a new bull market was emerging.  Since that time, gold prices have nearly tripled.  The gold spot market (i.e. cash market) price rose to $730/ounce in May 2006, retracing more than 78 percent of its 21-year bear market decline.   We've observed in recent years that the month of May has been associated with either key highs or lows in gold, and following last May's highs, prices corrected more than 25 percent, before recovering and then lapsing into a trading range.  Whether or not the "May cycle" repeats itself, we think the price consolidation should have another low remaining as we exit April.  Even so, our longer-term view remains that gold entered a secular bull market, for the various reasons described below.  

To give some historical perspective, while the US dollar remains the benchmark for gold pricing, the relationship between gold and the USD was forever decoupled in the early 1970s.  From 1971 onward, both derived their pricing in the open market, and so when we talk about bull markets and bear markets in gold, we're really talking about trends that date back 36 years.  

The chart above is a plot from 1971 through March 2007 of gold prices (in black) and gold prices adjusted by the CPI (in red) to look at their constant dollar (i.e. inflation-adjusted) value.  One of the more striking things the data reveals is that despite gold spot prices coming close to retracing their 1980 peak last year, on a constant dollar basis, prices are nowhere near an equivalent retracement.  In fact, gold would be undervalued by as much as three-times its "fully valued" level of $850/ounce in 1980, suggesting prices could easily exceed $850 over time.  By contrast, the Dow Jones Industrials are some 8% below their January 2000 peak in constant dollar terms, versus the more than 10% above the January 2000 high achieved in the cash index with its recent break to 13,000.  On that basis, stock prices are trading above the rate of inflation, unlike gold, which is still trading below.

A rise in gold prices is generally associated with inflation, though under certain conditions, they may even rise in a deflationary trend (we'll look those conditions in a moment).  The chart above is a plot from 1971 through March 2007 of gold prices, and an index of the US dollar, both inflation-adjusted by the CPI to look at their constant dollar value.  (For purposes of this study, we use our proprietary Unweighted Major Currency Average.  You can read more about our UMCA here.)  This allows us to compare the buying power of gold versus the USD, and as the chart suggests, the dollar has experienced the greater loss over time.  The more downward pressure on the USD, the better gold prices have performed.  The reverse has also tended to be true.  But even so, and other than two periods during the 1980s and 1990s that saw some appreciation in USD value, the dollar has essentially remained in a downtrend.  Per our unweighted average, it has also resumed the bear market decline that had paused in December 2004.

When talk about a downtrend in the dollar, what we're really talking about is loss of buying power.   Although there hasn't been a gold standard among the major world economies for several decades, the relationship between gold and foreign exchange rates is nevertheless significant for the simple fact that both gold and currencies are synonyms for the same thing - money.  Consequently, the value of money isn't only measured in terms of how much of it you have, but also in what it can buy you in your home currency.  In the US, the severing of gold as the standard of value for the dollar really begins with the administration of President Franklin Roosevelt, who outlawed personal ownership of gold.  Those who owned gold for the purpose of transactions were required to redeem it for cash, or face criminal penalties.  This action was part of a larger strategy to combat the deflationary spiral of the Great Depression, and institute a system of "fiat money" to flood the economy with liquidity.  Fiat money (as in "money by decree") takes two forms.  Either the central bank just prints up a bunch currency, or it creates liquidity by encouraging borrowing and lending though the manipulation of interest rates.  Both methods are designed to get people to spend in the interest of spurring economic growth.  For the Fed, the extension of credit has been the strategy most used, and its most direct impact has been on the buying power of the USD.   According to the Fed's own statistics, the monetary aggregate M2 has swollen by over 1,000% since 1971, injecting historically unprecedented levels of liquidity into the US monetary system.  And it just keeps getting bigger each year.  The low cost of borrowing that helped fuel the real estate boom of the past few years, along with the U.S. economy's debt-financed economic growth, have added more than $2.2 trillion to the money supply since just 2001.  By comparison, for the entire decade of the 1990s, the money supply grew by $1.7 trillion.  

The dramatic historical decline in USD buying power is directly attributable to the expansion of the money supply.  Buying power decreases to the extent that the money supply increases, which is why it costs more money to buy things.  In other words, it creates inflation.  The dollar still remains the benchmark against which changes in foreign exchange rates are measured, and inflation is usually given a boost when the dollar is falling in value against its major cohorts, like the Euro.  The effect is a double whammy, between a fiat money policy that systematically creates inflation, and the natural bull and bear market cycles that occur when currencies are freely traded.  When we read that "the Fed is fighting inflation," what this means in reality is that it's trying to prevent the system from having more inflation, something it's never been successful at.  Perhaps closer to the truth, it's fighting a process that its own policies have helped to engender.

This creates an environment in which gold prices can flourish.  Once gold was unshackled from its government mandated $35/ounce pricing after 1971, the combination of mounting inflation and free-market trading started to see prices rise.  In 1975, President Gerald Ford removed the prohibition against personal gold ownership, and gold prices soared, hitting an intraday day spot high of $850/ounce in January 1980.  Per our unweighted dollar index, the USD achieved a key low in valuation in June 1980, and appreciated steadily until 1985.  Over that same 5-year period, gold launched into a bear market, and fell over 60%.  A rise in USD value does bring a certain amount of disinflation with it (to the extent that the growth in the money supply slows) which can have an impact on gold pricing.   But it isn't necessarily the case at all times, as we'll see below.  

To our observations, one of the keys to gold's continued rise is its underlying trading trend.  All freely traded markets go through their bull and bear phases.  In the case of gold, the latter lasted for 21 years, a number which itself has some cyclical significance with respect to time.  As we noted above, inflation does have a relationship with rising gold prices, although technically, we've had some degree of inflation with us for decades.  One would presume that the most adverse condition for a rise in gold prices would be an outright deflation, i.e., a massive increase in currency value and buying power that results in an overall drop in producer and consumer prices.  The issue, however, seems to come down to whether or not gold is in a bull market when the deflation occurs.  In the deflationary depression of the early 1930s, silver prices fell, as did the prices for most commodities.  Because the price of gold was controlled at the time, there's no historical example to compare with.  Presumably, if it too had fallen into a bear market, then its price would have fallen as well.  However, there is one contemporary example of a deflationary economy that allows to see how gold could perform under a deflation if the underlying trend is bullish.

Japan fell into a deflationary spiral in the early 1990s, a situation from which it has not fully recovered.  The chart above shows gold prices denominated in Japanese Yen (yellow line), and Yen spot prices in black.  To the right of the red line above, which captures Japan's deflationary period, gold prices both fell and rose.  For the first half of that deflationary period from 1991 to 2001, gold still had ten years remaining in its bear market, and so naturally, the price continued to fall until the bear market concluded.  In 2001, however, its new bull market started to emerge, and despite the deflationary conditions in Japan, gold prices rose steadily.  The years 2001-2004 are also significant here, in that they represent an exceptionally bearish period for the US dollar, and one in which USD value against the Yen fell by a substantial 25 percent.  Although gold prices initially rose in a somewhat flat fashion (as is often the case in an emerging bull market) the point is that prices rose, despite deflationary conditions that would otherwise have been adverse to it.

It's doubtful that after just five years - against 21 years of a persistent bear market - that gold's bull market would have concluded in May 2006, price corrections notwithstanding.  On the contrary, we think the gold bull will stick around for a while, and we continue to regard price consolidations as opportunities to be timed for the right entry.

To all our readers, my best wishes.
Tony Carrión
May 2, 2007