Decoupling the gold price
July 8, 2005
After the bomb attacks in London the gold price rallied
from $423.76 (where it closed the previous day) to $428.90. But
by the end of day the gold price closed at $422.58, giving up the
entire gain, and lower than the day before.
Albeit brief, it was a bull market in gold. Like all
bull markets it was caused by capital flows that pushed the gold
price beyond its natural trading range and like all bull markets
the price retracted back to its natural trading range again. Gold’s
1.2% deviation from its trading range was small enough to correct
in less than a day.
In contrast, the bull market that coincided with uncertainty
regarding the European Union and the euro caused the gold price
to rise more than 5% above its trading range and those gains have
not completely been eliminated yet. Gold was around $420 at the
end of May and rose to $440 before the end of June. However, during
the same time the US dollar rose almost 4%, on average, against
the G10 currencies not included in the euro. Without any distortions
to the gold price from capital flows reacting to European developments,
the gold price should have fallen from $420 to $403. It now stands
at $423.
Clearly the gold price is in the process of giving
up the gains it made in response to the euro mini-crisis and barring
anything else that elicits an emotional reaction from investors,
it will either continue to fall towards $403, or the dollar will
fall.
Gold is money and just like any other form of money
it loses value due to inflation. Annual mine production of gold
is inflation of the above ground supply of gold. Almost all of the
gold that has ever been mined is still around in one form or another,
predominantly as jewelry, coins and bars. Think of this as the supply
of gold just like we talk about money supply when we talk about
fiat currencies. Because gold cannot be created at will and because
gold mining is for the most part a marginal business, the supply
of gold does not increase very rapidly. From 1900 to 2004 the average
annual increase in gold supply was only 1.73%. Gold lost, on average,
1.73% of its value each year for the past 105 years.
So why is the gold price higher now than it was a
hundred years ago? Because we measure the gold price in terms of
fiat currencies, like US dollars, and fiat currencies lose value
much faster than gold.
The price of gold in any currency changes as a function
of the difference in the currency’s inflation rate and the
inflation rate of gold. Because (I suspect all) fiat currencies
have higher rates of inflation than gold, the gold price continues
to rise against all currencies over time. It means that fiat currencies
lose their value faster than gold loses its value. But that is not
the same as a bull market in gold. This increase in the gold price
is a fundamental increase in relative value. A bull market occurs
when capital flows push the gold price higher than it should be
and that is why bull markets are followed by bear markets.
There is another factor that we must consider when
we talk about the gold price. Because almost all currencies today
have floating exchange rates, the gold price in any currency is
also a function of that currency’s strength against other
currencies.
The gold price can only decouple from exchange rates
during bull markets or bear markets, and even then exchange rates
will still exert some influence over the gold price. But remember
that bear markets follow bull markets and bull markets follow bear
markets; prices always return to their intrinsic value. It happens
in the stock market, in the real estate market, in commodity markets,
in currency markets and in the gold market.
As an example, capital flows pushed the gold price
four times higher than it should have been between 1979 and 1980
and it took four years for the gold price to fall back to its natural
trading range again.
The longer the bull market, and the more the price
deviates from where it should be, the longer it will take to normalize.
The bottom line is that a bull market in gold is an unnatural state
caused by capital flows that are usually an emotional (and often
irrational) response to current events.
We are currently in a mini bear market in gold as
the price corrects after it was pushed up in response to capital
flows reacting to uncertainty in Europe. The downward trend in gold
will most likely continue until the dollar starts falling again,
or until we see another emotional reaction from investors. But the
gold price will not sustain higher levels (in US dollars) without
a decline in the US dollar exchange rate.
Paul van Eeden
Paul van Eeden works primarily to find investments for his
own portfolio and shares his investment ideas with subscribers to his weekly
investment publication. For more information please visit his website (www.paulvaneeden.com)
or contact his publisher at (800) 528-0559 or (602) 252-4477.
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