The Price of Gold

GOLD CRITICS OFTEN SAY THAT THE SHINY YELLOW METAL has few industrial uses, compared with, say, silver or copper. That happens to be what we call a half truth. It’s also beside the point. It is usually lamented by bears refusing to accept the market’s valuation of gold.

The whole truth is that gold has very few industrial uses at current prices. Gold is worth about 55 times silver and more than 3,000 times copper per unit of comparable weight. If it were as cheap as copper, we would have wired our houses with it, as well as the Internet; if it were even cheaper, you’d probably be sitting on it in the bathroom, as that Commie Lenin advocated.

We don’t use gold in more common applications because of its finer qualities: Relative scarcity, our vanity, to name just a few. And the bulk of gold’s value is still monetary, a fact that its enemies are loath to admit. Consequently, changes in the price of gold tend to reflect mainly changing monetary factors.

Gold bugs can’t ignore the market’s judgment, either. They must acknowledge that the monetary demand for gold had in fact ebbed during the 1980s and 1990s in favor of the dollar standard — a standard launched by default in the early 1970s.

The waning view of gold as money helps explain why gold didn’t keep up with the Consumer Price Index (CPI) through the ‘80s and ‘90s, despite the three-fold increase in narrow money (M1) and the five-fold increase in broad money (MZM). The bears claim this poor record shows just how bad an inflation hedge it is. But their time horizon is both short and selective.

I’ll give the bears credit for identifying the drop in the monetary demand for gold as the reason it lagged the CPI in the ‘80s and ‘90s. But they are hopelessly naïve if they believe that the 35-year-old dollar standard is an evolution in the monetary system, as if it were progress. Gold served as the market’s solution for money for thousands of years.

The government forced the dollar onto the U.S. producer by legal tender and other laws. It forced the dollar onto trading partners by extortion. These partners were already drowning in dollars no longer backed by gold. They had to choose between letting the whole system fall apart and using the new “dollar standard” to their advantage. America had the largest and most developed consumer market in the world at that time, and they all wanted in.

Fast-forward to today: After a couple of decades of experimenting with this system, it is no longer working to anyone’s satisfaction. In order to maintain their trade advantage, America’s trading partners have to inflate at an ever faster pace (than the Fed) and soak up increasing quantities of dollars. This scheme always was untenable, but now it’s falling apart. There’s even talk of the need for a new global reserve currency.

So far, the media spotlight has been on the euro as contender, but the media will see that is untenable too. Gold is really the only alternative to the dollar. But that’s a lesson the gold bull market has yet to teach. Let me know when you can use the euro on the streets of Bombay or in a Wal-Mart in California as easily as you can use the U.S. dollar, or at least when the price of gold stops outperforming the euro. Then I might consider taking it seriously. Meanwhile, we’re likely heading back to where this story left off in 1980.

Playing with Numbers

Before I delve into a rudimentary analysis and probably futile attempt to value gold, let me admit that I don’t know how high it is going to go. No one really does. We’re all just guessing. A bull market in gold basically means that gold’s monetary allure is on the rise. That is, market participants are beginning to prefer it again — either as a hedge against inflation (investment), a measure of monetary value, a means of international settlement, a monetary reference point, or even as a genuine medium. These reasons all constitute what I mean by “monetary demand.”

Of course, no such thing as a bull or bear market in gold would exist if gold were already money, because the total demand for money does not fluctuate very much. On the other hand, the total demand for a particular kind of money may. The bull market in gold is a byproduct of the decline of the dollar standard. Not surprisingly, it is outperforming the CPI again.

If the CPI were an accurate measure of changes in the value of money, and the monetary demand for gold were constant, the CPI-adjusted gold price might represent some notion of fair value for gold prices. But the CPI is anything but a reliable measure of change in money values. Chances are it understates this problem.

Is a Gold Correction Coming?

I have been forecasting “Gold: $2,000-2,650” for many years now. My early forecasts, back in 1999 and 2000, called for a straight-up move to $2,000 per ounce. That forecast overestimated the willingness of investors to grasp the gold story and underestimated their addiction to the prevailing monetary policy, and I scrapped it in 2001 in favor of a more drawn-out affair.

I adopted the view that this bull market would last 10-15 years and include two-three sequences.

We are now on year seven of the current advance — the first primary sequence. There is little doubt in my mind that the dollar standard is on its way out and that the monetary demand for gold will return to the levels of the late ‘70s. But the exact prognosis is anyone’s guess.

As a trader, I can tell you that nothing goes straight up. The market tends to change the rules just when most people have become accustomed to a particular set. Hence, every bull market contains surprisingly violent corrections. These corrections convince many latecomers that the bull market has ended.

None of the corrections we’ve seen in gold during the past seven years qualify as this type of correction. The rise in gold prices to this point has been steady and sustainable. For much of its rise, gold has been in a stealth bull market. But the gold price advance is no longer stealth. It’s not as spectacular as oil’s advance or some of the base metals’ advance in 2006, yet. But the chart says it wants to go parabolic.

That’s the good news. The bad news is that such moves bring in weak hands, which set the stage for a big correction. Remember this whether you want to trade the trends or buy and hold.

Ed Bugos
February 6, 2008