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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