Irrational exuberance in the gold market
March 05, 2004
Investors who bought gold in late 1979 or early 1980
lost fortunes. Understanding what happened then will hopefully make
sure we don’t lose ours when irrationality strikes again,
which it will.
Irrational expectations of the gold price in 1979
and 1980 were rooted in the early 1970s, specifically the Arab-Israeli
war of 1973. This was the catalyst, albeit perhaps only one of many,
that escalated tension between the United States and the Middle
East for the remainder of the ’70s.
Shortly after the war, Arab members of OPEC took control
of the organization and raised the oil price from $3.00 a barrel
in October 1973 to $11.65 in January 1974, a 288% increase in just
four months. Furthermore, the United States and the Netherlands
were completely cut off from OPEC oil because of their close ties
to Israel.
The scarcity of oil and the increase in the oil price
hurt the US economy and, in conjunction with double-digit dollar
inflation (M3 increased by an average of 13% from 1971 to 1974),
caused a significant increase in consumer prices. The US Consumer
Price Index (CPI) jumped 11% in 1973 and 9.1% in 1974.
Yet throughout this time the gold price remained
faithfully close to its theoretical value (see chart below and last
week’s column). From 1973 to 1975 the average gold price remained
within 16% of its theoretical value – not an unreasonable
amount of volatility for any market.
But annual dollar inflation (change in M3) continued
unabated, rising from a low of 8% in 1975 to 12% in 1977. M3 essentially
tripled from 1970 to 1980, an average increase of more than 10%
per year.
On the backdrop of rampant dollar inflation, a shortage
of oil and tension with the Arab nations in the Middle East, the
gold price over-reacted in 1979 when fifty-two Americans were taken
hostage at the Embassy in Tehran.
The gold price rapidly shot up from an average of
under $200 an ounce in 1978 to over $300 in 1979 and more than $600
in 1980. It peaked in January 1980, briefly exceeding $800 an ounce.
At the time there was a strong feeling among gold
investors that the gold price would continue its upward drive. A
thousand dollars an ounce was believed to be within reach. But the
average gold price in 1980 was more than two and a half times its
theoretical value. Now if the gold price had no correlation to the
calculated theoretical value it may well have continued onwards
to a thousand dollars an ounce. On the other hand, if the gold price
is correlated to the theoretical value, we should see the gold price
always trend towards it, which is exactly what happened.
By 1984 the gold price had declined to within 7% of
its theoretical value. From 1984 to 1988 the average difference
between the actual gold price and the theoretical gold price remained
only 7%.
This is remarkable in several ways. Recall from previous
columns that the theoretical gold price is calculated by starting
only with gold being $20.67 in 1933, the last year of the gold standard,
and accounting for dollar inflation and gold production since then.
It has absolutely nothing to do with the actual gold price in its
derivation. Yet in 1988, fifty-six years later, the actual gold
price differs by only 3% from this calculated theoretical value.
It could be a coincidence, but if you look at the
chart above, you will see that with the exception of the impact
the Iranian hostage crisis had on the gold price during 1979 and
1980, there is a remarkable correlation between the actual gold
price and the theoretical gold price.
If we exclude the impact of the Iranian hostage crisis
on the gold price, by averaging the increase in the actual gold
price from 1978 to 1984 (as shown on the chart by the dotted line)
then the gold price differs on average by less than 15% from its
theoretical value for the entire period from 1971 to 1988. And if
we exclude the years 1971 to 1973, since the gold price was adjusting
to its fair value after being artificially constrained for thirty
eight years, the deviation of the actual gold price from its theoretical
value is less than 9%.
Had this calculation been done in 1979 and 1980 it
would have been immediately evident that the gold market had become
irrational with respect to the value of gold. Yes, there were psychological
reasons for believing things could get worse in the economy, and
on the political front, but that is gambling. Investors typically
pay attention to boring things like value.
Observing the relationship between value and price
has enabled many of the greatest investors, like Warren Buffet for
example, to amass fortunes. It has most certainly helped yours truly
in the past and, I suspect, it will continue to be of benefit in
the future. If we cannot get a handle on the value of our investments,
then price loses all meaning.
The gold price can now be adequately explained from
the time that Nixon closed the gold window in 1971 right up to 1988.
Although our analysis doesn’t stop there, we’ll continue
next week.
In the meantime, for anyone that’s interested,
I was recently interviewed on Resource World Radio. You can listen
to the interview in Show Fifteen at www.resourceworldradio.com.
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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