A New Gold Index
January 16, 2004

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The gold price took a dive yesterday on concern that the dollar may strengthen against the euro. This kind of volatility is going to become the norm, not the exception, so it’s best to get used to it. As the dollar declines, countercyclical rallies in the dollar are going to become more pronounced, causing severe, though temporary, declines in the dollar-gold price. These are, to use a cliché, buying opportunities.

Since the price of gold is intricately linked to currency exchange rates, how can we, without relying on any one currency, get a better sense of what the price of gold is really doing in a global sense?

I have talked in the past about the gross domestic product (GDP) weighted index that I use to look at the gold price and individual currencies from a global perspective. For lack of imagination I call this index the PVE Index.

The PVE Index consists of thirty-six currencies: the US dollar and the currencies of thirty-five of the United States’ largest trading partners. I started with the United States’ fifty largest trading partners but had to eliminate fifteen due to lack of data. Going forward I hope to expand the index as I source more data.

Each currency in the index is weighted by the GDP of its issuing country. This is done so that small countries with volatile currencies do not have an undue impact on the overall index. A GDP weighting also allows countries to impact the index in relation to each country’s contribution to the global economy. Therefore countries such as the United States and Japan, or economic blocks with a single currency such as the euro have a significant influence while at the same time the collective effect of smaller countries and their currencies is not ignored.

When used to measure gold, we get the PVE Gold Index. Similarly, when used for a currency, such as the dollar for example, we get the PVE Dollar Index. Regardless of which currency, or commodity we plug into the PVE Index, what we get is the average, worldwide trading pattern for that currency or commodity.

The chart below shows the PVE Gold Index and the price of gold in US dollars for comparison. Remember that the US dollar-gold price is one of the thirty-six components of the PVE Gold Index.

There are several interesting features on this chart. The most obvious is that the average, worldwide gold price did not experience anywhere near the same decline as did the US dollar-gold price. Because the United States represents 28.34% of the PVE Gold Index, the effect of the US dollar can be clearly seen from 1996 to the end of 1997; but while the US dollar gold price declined by almost forty percent, the average gold price in the world (including the dollar-gold price) declined only about twenty percent.

This, of course, implies that the gold price in most currencies did not decline at all during the period from 1996 to 1998, which begs the question: was there really such a terrible bear market in gold during those two years? The bear market in gold is generally regarded as lasting until 2001, when the US dollar-gold price started to recover. In this chart you can clearly see that the price of gold around the world started recovering three years earlier, in 1998, and has been increasing since then at an average compounded rate of just under eleven percent per year.

Because we can clearly see that the average gold price in the world was increasing from 1998 onwards I find it hard to believe there has been any conspiracy to depress the gold price. If there was one, it certainly wasn’t very effective. There is also very little evidence that central bank sales, or producer hedging, were negatively effecting the gold price in any significant way.

The most prominent features of the average gold price chart since 1998 are the announcement of the Bank of England auctions that caused the gold price to decline in early 1999 and the Washington Agreement (under which many European Central Banks agreed to limit their gold sales) that was signed in late 1999. Notice that when those two events occurred, the average gold price in the world was steadily rising. It was only declining in US dollars and a few other currencies.

At the time though, the gold industry was obsessed with central bank gold sales and the impact that producer hedging was having on the gold price. The fact that the Washington Agreement actually got signed is an indication that hardly anyone in the world was cognizant of what the gold price was really doing. The US dollar-gold price and the strength in the dollar were misleading.

Because we have both the US dollar gold price and the average gold price in the chart we can see several interesting features of the dollar during the nineties. Notice that the dollar-gold price and the average gold price coincide from 1990 until around the third-quarter of 1992. At that point the dollar-gold price starts to deviate from the average and it has not yet recovered. In next week’s column we will look at the reason for this deviation and what it might foretell about the future price of gold and the value of the US dollar.

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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