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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