Market Review: Every Cloud Has a Gold Lining

Uncertainty shrouds the situation on the Gulf Coast. So many questions have been raised in the last few weeks that have no clear-cut answers. Did the federal government act too late? Is the state government at fault? Or does the blame lie squarely on the shoulders of American societal standards as a whole? Who knows? Who will ever know?

There is one absolute certainty in this mess – the U.S. economy will take a beating in the wake of Hurricane Katrina. Consumer confidence is at an all-time low, energy prices are skyrocketing, and global inflation concerns are pushing down Treasury bonds.

However, there is one winner in all of this – gold.

This week, gold rose in New York and London, hitting a 17-year high as investors bought the yellow metal as a hedge against financial assets that could be eroded by inflation.

"People look at gold these days as part of the protection for the inflation that they see coming into the economy," said Stuart Flerlage, managing principle at Patronus Capital in New York. "Consumers are starting to see it hit their wallets."

The 48 percent jump in oil prices has caused manufacturers to pass those high costs onto consumers. DuPont Co., the third biggest chemical maker in the United States, said on September 12 that it will have to raise prices on 35,000 products.

Government spending on the clean-up of Katrina, which has been predicted to cost around $200 billion, will certainly add to inflationary pressures that already been fueled by record-high energy prices.

"The Bush administration’s response to the hurricane stoked investors’ anxiety about the government’s ability to fight the deficit," said our own Addison Wiggin, in a interview.

"Never has a reserve currency faced fighting such a huge debt and spending problem,” Wiggin continued. "Gold is trading as a counterweight to fiat currency and that’s why we’ve seen this steady climb recently.”

Gold is definitely the "asset to own," as Brian Garvey, senior currency strategist for State Street Corp., put it. The metal has outperformed the world’s eight major currencies since Katrina hit on August 29.

Many investors are viewing their gold holdings as insurance policies from the inflation that is showing up in prices all of retail market. If the precious metal breaks last December’s high, it will be the longest bull market since it was freely floated in 1968.

This is the good news that we at The Daily Reckoning, and goldbugs everywhere, have been waiting for.

Kate Incontrera
The Daily Reckoning

P.S. Gold isn’t the only asset to own right now. We know of one worth $137,000 that you can get at a 98% discount – but only for the next two weeks. Click on the link below to find out about the only asset that will never be affected by stock prices, bond prices or currency fluctuations…and allows you to make money, save money and help your entire family grow

— Daily Reckoning Book Of The Week —

The Importance of Living
by Lin Yutang

In Friday’s edition, Bill wrote about the often overlooked redeeming qualities for ‘doing nothing’ in times of crisis – in other words, letting the bad times run its course.

Another proponent of inactivity is Chinese philosopher Lin Yutang. He is known as the philosopher of leisure and "letting go." His most famous quote usually angers Americans:

"The busy man is never wise, and the wise man is never busy."

THIS WEEK in THE DAILY RECKONING: Will the Fed pause in their rate hike at next week’s meeting? John Mauldin explores the possibilities in Thursday’s essay…

The Importance of Doing Nothing  09/16/05
by Bill Bonner

"Few things are as damnable as inaction. In politics, it is cause for recrimination… In finance, it is cause for regrets. In war, it is cause for firing squads."

To Pause, or Not to Pause?    09/15/05
by John Mauldin

"There are more and more calls for the Fed to pause in September. Clearly the markets are expecting them to do so, and this has given a boost to the stock market."

The Fed’s Wild Imagination    09/14/05
by Kurt Richebächer

"’Global savings glut.’ You’ve heard members of the Federal Reserve refer to that term lately, but do you know what it really means? Luckily, the Good Doctor is here to explain…"

The Commodities Conundrum   09/13/05
by Puru Saxena

"Stocks, bonds, property and commodities have all benefited from the abundance of cheap credit. But will this asset-boom continue forever – or will the party come to an abrupt end? Puru Saxena explores…"

Gold, How Undervalued Art Thou    09/12/05
by The Mogambo Guru

"The next time somebody taunts you for being a gold bug, you can tell them that the International Monetary Fund (IMF) believes in gold. Read on…"

FLOTSAM AND JETSAM: There are many different ways to determine the value of gold…you could measure it against a currency, or even the world’s population. Paul van Eeden explains which assessment is most accurate…

by Paul van Eeden

I recently received a comment from a reader claiming that monetary inflation only occurs when the supply of money exceeds the increase in real gross national product. That is incorrect. Inflation occurs when the supply of money increases. Price increases occur when the rate of inflation exceeds the rate of increase in real gross national product. An increase in prices is not the same as inflation; it is the result of monetary inflation.

Another comment was that gold is removed from supply when it is fabricated into jewelry. It all depends on how you look at jewelry. Many of us view jewelry purely as items of adornment. But during times of trouble, jewelry quickly becomes a source of currency and in some countries jewelry is widely accepted as a store of wealth. In my opinion gold jewelry is no different than coins or bars of gold. It has a higher manufactured component to it that could become a loss to the owner, but it will always have at least its intrinsic weight-value of gold (less smelting costs).

If we view gold as money, then the supply of gold consists of all the gold that has ever been mined, since practically all of it is still with us in one form or another, mostly as bars, coins and jewelry. Annual mine production of gold increases the supply of gold (the total of all the gold previously mined) and can therefore be thought of as inflation of the gold supply. The inflation rate of gold is annual mine production as a percentage of all the gold previously mined.

Since 1900, the supply of gold has increased, due to mining, by an average annual compound rate of 1.73%. As the supply of money increases, the value of each unit of that money decreases. The value of each ounce of gold has therefore decreased by an average of 1.73% per year since 1900 in absolute terms, not relative to anything else.

By comparison, the U.S. money supply (as measured by M3) has been increasing by an average compound rate of 7.8% since 1959. While gold devalues at the rate of 1.73% per year, the dollar devalues more rapidly. The value of gold in U.S. dollars has therefore increased at an average rate of 6.07% since 1959. Note that I did not say "the price of gold" in the previous sentence. We all know that gold was under-priced at $35 an ounce in 1959. According to work I have done, I estimate that the gold price should have been about $51.22 an ounce in 1959 and, if you assume that that is more or less correct, you can calculate what the gold price should be today. Compounding $51.22 at 6.07% for 46 years results in a current value for gold of $770 an ounce.

The gold price today would be about $770 an ounce were it not for the surge in the U.S. dollar exchange rate during the 1990s. The fact that gold is not trading at around $770 an ounce today is due solely to the strength in the dollar; it has nothing to do with market manipulation or a conspiracy against gold. In due course, I believe that the U.S. dollar will decline sufficiently for the gold price to reach its fair value again, but that will be nothing other than a bear market in the dollar. In the long run, the percentage increase in the price of gold in U.S. dollars is equal to the difference between the inflation rate of gold and the inflation rate of the dollar. The same is true for the price of gold in any other currency. In the short-term, however, the gold price can deviate from its fair value due to exchange rate volatility and capital flows.

Exchange rates cannot be ignored. The moment you define the gold price in terms of a currency, any currency, you have linked it to the exchange rate of that currency. To talk about the price of gold is meaningless: we have to specify in which currency we are pricing gold. Consequently, the price of gold in U.S. dollars is subject to changes in the U.S. dollar exchange rate, the price of gold in euros is subject to the euro exchange rate and the price of gold in yen is subject to the yen exchange rate.

We can also attempt to value gold in other terms. We could measure gold against a basket of goods and services. Or we could measure gold against the world’s population.

Gold’s value relative to goods and services is a not a useful indicator. The value of gold will decrease against goods and services that become scarcer with time and increase with respect to goods and services that become more abundant. This is again a relative game, so we have to consider the relative changes in the goods and services. Not to mention the difficulty of trying to come up with goods or services that are uniform and constant over time.

According to the United Nations the global population in 1950 was 2,519,470,000 and it is 6,464,750,000 now. That is an average annual compound increase of 1.73% and by coincidence the same rate as gold inflation – I didn’t make this up. Because the increase in population is the same as the increase in the supply of gold, the value of gold remains constant relative to people.

Because the inflation rate of gold and the increase in population are similar we should find that the value of gold remains constant relative to labor. The biggest problem (other than a lack of data) is that labor costs change dramatically depending on the skills, experience and level of education of the labor force. While it may be difficult to come up with an international labor cost index against which to measure gold the mere fact that population growth and gold inflation occur at similar rates would suggest that gold should retain its value relative to labor, and labor is perhaps the most basic measure of value.

Comparing gold’s inflation rate to changes in a country’s gross domestic product could give us an idea of how gold’s value changes in relation to goods and services in that particular country. But there are so many uncertainties when it comes to gross domestic product, such as the deflator that is used and, in the case of the United States, hedonic adjustments, that I do not think we will find it to be a reliable measure of gold’s value.

Regardless of what we use to gauge the value of gold, we should keep in mind that gold is simply a store of wealth, an independent form of money that cannot be created at will, and therefore, retains its value better than anything else.


Paul vanEeden
for The Daily Reckoning