With the recent drop of 15% in the gold price one might reasonably ask if this is the bubble bursting. To be honest I, too, was stunned for a few days staring at the falling price of gold on my computer screen. This just didn’t make sense. The fundamentals and prior gold history were written all over the wall. So after a few agonizing days of internal turmoil my goal was to clear up my mind and put down in writing one by one all the reasons for which I still consider gold a safe asset preservation tool.
First, I told myself to stop being emotional. After all I am convinced that many folks who were vested in PM’s allowed their emotions to act by selling their gold. Panic is defined as a sudden feeling of fear or worry that makes one unable to think in a clear or calm manner. That’s what I mean, panic takes over not allowing one to rationalize his act of selling. Not long ago I read a little book called A Gift to my Children in which one of my favorite financial commentators, Jim Rogers, shares his investment wisdom with his readers. What I learned from him was: to act unlike the majority (in other words, get rid of the crowd mentality), to not allow emotions cloud my judgment, and to learn from past mistakes. Apparently someone out there knows how to apply these mental techniques. He thinks taking in gold in lieu of dollars may not be a bad idea. He is a successful investor who decided to fire the dollar and take gold bullion for the lease deposit on one of his exclusive properties. His name is Donald Trump and the full story is here.
I’ll put gold into its proper perspective. Gold is not an investment. It is money. Investments are wealth-producing assets, they generate cash-flow. Gold is just a sterile asset with no cash flow. Gold, as evidenced by Donald Trump’s business affairs, is money, despite the fact that it’s not officially embraced by governments and central banks (yet, they started to load up on it heavily.) So owning gold doesn’t mean I’m investing in it but that I’m saving it. It’s about liquidity and when I’m thinking whether gold is for me, it deserves to be evaluated against the dollar and the other currencies of the world. My idea is to save enough gold while the dollar and the rest of the fiat currency continue to drop. This allows me to preserve the integrity of my assets. At some point in the future the time will come when I’ll want to spend that gold to buy undervalued assets that generate wealth through the next boom/bust cycle.
To make a sound decision – whether to stay invested in gold and other precious metals – it is necessary to dive into fundamentals and to review economic history since the birth of the Federal Reserve System. So, here we go. The one fundamental factor driving the price of gold is real interest rates. What economic writers refer to (on “real interest rate”) is the interest rate adjusted for inflation. Currently it stands at negative -3.79% and it’s calculated by subtracting the 12 months rate of change in the CPI-U (Consumer Price Index) from the 3 months T-Bill yield. When the real interest rate falls at or below zero it should look very good for gold. Conversely, when it goes above zero it starts to threaten gold’s position and that is because gold does not pay interest. The higher the real interest rate the more likely the drop in the price of gold.
One of the best examples occurred during the 1970′s after the dollar’s removal from the gold standard. It is no coincidence the government started a policy of excessive spending. The accommodating Fed increased the money supply thus causing interest rates to drop and commodity prices to rise (food, energy, precious metals). A decade of negative real interest rates encouraged the gold bubble until 1980 when Paul Volcker took charge of the Fed and got the interest rates high enough to kill the runaway inflation. And with that the gold bubble burst.
What we experience today is the result of a government (and people) not willing to live within its means. We also have Mr. Bernanke in charge of the Fed, who unlike Volcker continues to expand the money supply. So then, it’s logical to think that for as long as these events continue gold’s rise against the dollar looks very likely.
One other factor I keep an eye on is the Dow Gold Ratio. I like to often check how many ounces of gold it takes to buy the Dow Jones Industrial average. This is a useful guide that tells me when stocks are cheap and when they’re overvalued and conversely, when gold is undervalued or overvalued. I like to use the chart (below listed) from sharelynx.com since it’s easy to get the big picture of the extremes during the past century.
Beside the fact that the boom/bust cycles have intensified after the formation of the Federal Reserve in 1913, notice how the ratio gets really low at the end of the last century’s two major crises. A ratio of 2 towards the end of the 1930’s depression and a low of almost 1 at the end of the inflationary 1970’s. Currently is at 6.8 and this figure changes daily due to market volatility. So history tells me the time to sell may be when the ratio gets down to those low levels. I am also paying attention to the most recent Dow Jones peak on the chart and can’t help thinking such high level would probably translate into an equally corresponding low which means the Dow Gold ratio could fall below 1 at the end of the current economic crisis.
A while back (before I found these awesome charts from sharelynx.com) I was curious to get an idea at what percentage of price increase (against the dollar) did the gold bubble burst back in 1980. Based on my own calculations I came up with a 2,200% increase. Then I wanted to calculate at what percentage it increased so far since the current bubble started around 1999. Based on the average starting price of $250 and today’s price of about $1,623 the percentage of increase stands at 549%. Again if history means anything – beside understanding the severity of the current national debt and weakness of the dollar – I am inclined to say that we’re not close to that time to sell. And since I found the chart for my explanation I am including it below. It comes with a bonus since it provides all the bubbles’ percentage increases for the past 50 years.
Another reliable indicator is the Fear Index, developed by James Turk in the mid-1980s. It measures gold’s relative value against money. The Fear Index is the percentage of the stock of gold in a country’s central bank divided by the quantity of that country’s money supply. It rises when fears arise about the safety and stability of a country’s monetary and banking system, and it falls when confidence is restored. James Turk is one of the most respected individuals in the world of precious metals, I trust his knowledge and judgment more than the combined talking heads in Washington DC. His latest calculations show the August Index rose to 3.36%, the highest level since the months immediately following the October 1987 stock market crash. For more details read the full story. You’ll also be able to see the chart with the Fear Index levels of the 1930′s Great Depression and the 1970′s inflationary decade. Considering the recent drop of roughly 15% in the gold’s spot price I am almost certain that the Fear Index would have now dropped below 3%. This recent drop in the index should now be associated with a decrease in global investors’ fears. More reasons to hang on to gold and buy some more.
Finally the way a government manages its budget is a great indicator of gold’s price movement. Talk about the plans to reduce the deficit are of minor importance. Action is what matters the most. When the too big to fail institutions will stop being subsidized by the government, when the military troops are being brought back home, when the social security and other government ponzi schemes collapse (due to their insolvency), in other words when welfare and warfare budgets experience serious cuts, that may be the time to sell gold. So far I see nothing to indicate any of these but the opposite.
A smart man once said ” Expect the best, plan for the worst, and prepare to be surprised.” And boy, did I get surprised? Reminding myself of Denis Waitley’s words of wisdom I have to always keep in mind the surprise factor. This time my thoughts take me to the idea that one day – possibly in our lifetime – gold may return as a world wide accepted currency. Looking back in the past I learned there was no fiat currency that lasted indefinitely. Then why should the dollar, the euro, or any other fiat of today be different? History always has a way of repeating itself, it just comes in different flavors. If the world’s influential governments and their corresponding central banks have a change of heart, or if – or I should say when – the fiat currencies collapse (lead by the dollar), the surprise may come in form of not even having to sell the gold. This would be a nice surprise. But a monetary reform would be a bitter one on us. Governments known for their debasement of currencies resort to such tricks. When time comes, whether the surprise is good or not, I still believe that simply by applying the method of asset class elimination gold may be one of the best assets to own .