Some stuff about gold...
The Inflation-Adjusted Gold Price
In our 18th June report we included a chart showing the Dow/M3 ratio, that is, we included a chart showing the Dow Industrials Index adjusted for changes in the total supply of US dollars. This was a useful thing to do because a) it provided additional backup for our view that US equities are entrenched in a secular bear market, and b) it showed that long-term trends in the Dow/M3 ratio are similar to long-term trends in the Dow/gold ratio. This latter point is significant because it validates our opinion that the REAL (inflation-adjusted) long-term trend of any market can be seen by looking at the market's performance relative to gold.
So, we can look at a market's performance relative to gold if we want to see how it has performed in real terms over a very long time-span (10 years or more). But how can we see how gold, itself, has performed in real terms?
One way is by looking at gold's performance relative to other commodities or other investments; for example, by looking at the gold/GYX ratio (gold relative to an index of industrial metals) and/or the gold/Dow ratio. Another way is by looking at the gold/M3 ratio (the gold price adjusted for changes in the total supply of US dollars), because by doing so we see how gold has performed in inflation-adjusted terms using ACTUAL inflation (money supply growth) rather than the fictitious price indices that purportedly represent the effects of inflation. We have therefore included a chart of the gold/M3 ratio below.
Here are some brief observations/thoughts relating to the chart:
The gold price was fixed at $35/ounce from 1933 through to 1971 while the supply of money was in a steady upward trend. As a result, during this period the inflation-adjusted gold price was in a steady decline (when the gold price was fixed, every increase in the money supply caused gold's real price to fall). This meant that by the time the official link between gold and the US$ was severed (1971) the real gold price had a lot of catching-up to do; hence the sharp rise in gold/M3 during the first half of the 1970s.
When the 1970s came to an end gold had done a lot more than just catch-up to where it should have been based on money supply changes alone. To be specific, spiraling inflation fears, as opposed to actual inflation, caused gold's real price to overshoot its mark by a wide margin. This overshoot set the stage for the pendulum to swing back in the other direction; and swing back it did to the extent that by the time the new millennium rolled around the inflation-adjusted gold price was even lower than it had been at the beginning of the 1970s.
Since 2001 the real gold price has risen steadily, but the bull market has not been particularly impressive to date. Our thinking is that the really impressive phase of gold's bull market -- the phase where the sheer magnitude of the price rise forces everyone to sit up and take notice -- won't begin until the early years of the next decade. We do, though, expect to see significant additional gains over the remainder of this decade.
Many 'goldbugs' claim that gold's price is sure to rocket upward in the not-too-distant future because the fundamentals are extremely bullish. However, some of the fundamental factors regularly cited in bullish arguments for gold are almost totally irrelevant.
Chief among these irrelevancies is the so-called "supply deficit" -- the gap between the quantity of gold mined each year and the fabrication demand for gold. Advocates of the "supply deficit" theory claim that: 1) a move by the gold price to new highs is all but inevitable because the amount of gold extracted from the ground continues to fall short of fabrication demand; and 2) anything that adds to the deficit -- a reduction in South Africa's gold production or an increase in the amount of gold jewelry sold in China, for instance -- will significantly enhance the bullish case for gold. However, while there are reasons why the gold price could move to new highs over the coming year and will almost certainly move to new highs over the coming 5 years, the gap between mine supply and fabrication demand is not one of them.
The "supply deficit" argument for a higher gold price falls flat because it amounts to applying a traditional commodity-style analysis to an asset that's held primarily for investment/monetary purposes. When analysing nickel or oil or any commodity except gold it is appropriate to focus on how much is being produced relative to how much is being consumed in industrial/commercial processes, because most of what gets produced in a year gets consumed during that year. For example, the total amount of nickel in aboveground storage right now would satisfy the world's industrial demand for no more than a few weeks, meaning that tomorrow's demand will have to be satisfied by today's production and that changes in the quantity of newly-mined nickel will have a very strong influence on the market's supply/demand balance. With gold, however, the current aboveground supply would satisfy the world's industrial demand for more than 30 years. As a result, changes in mine supply and industrial demand have almost no effect on price. Changes in the INVESTMENT DEMAND for the EXISTING ABOVEGROUND GOLD STOCK are, instead, by far the most important determinants of the gold price. In fact, nothing else really matters.
The difference between gold and other commodities stems from gold's historical role as money and its current role, in the eyes of hundreds of millions of people, as a store of value.
Further to the above, when trying to figure out whether gold's fundamentals are bullish or bearish it is necessary to determine whether the store-of-value function provided by gold is becoming more or less sought-after. And to do this we need to look at things like interest rate spreads, inflation expectations, currency exchange rates, and gold's valuation relative to competing investments.
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