The Golden Game

Those serious precious metals investors will know that this isn’t a game – at least not in the long term.  As long as politicians and central banks keep printing money in their attempts to “solve” their economic problems, fiat currencies will continue to lose value and force prices for precious metals and other commodities upward.

However, the recent turn of events in Europe shows that the short term, erratic price movements can turn the most fearless investors into trembling game players, trading their long-term winners for short-term losers.  It’s worth a deeper look into this phenomenon, because the psychology in play here is one that will be predominant when the final crash eventually brings everything down.

If the crash comes via the sudden political transformation that abruptly halts the printing presses, thus forcing austerity by lack of currency supply, then everything, including precious metals, will crash (at least temporarily). In this case, cash will be temporarily enthroned – it will be hard to come by.  Prices will come down on everything and those that have cash will be able to sweep up some sweet deals.

This is what most investors were afraid of during the European crisis of September and October, 2011.  They were “keeping their powder dry” in case this scenario played out.

But eventually, the economy would need a strong, dependable currency again in order to sustain any growth. If the government simply started printing again, they’d only get more of the same problems. There would therefore need to be some kind of guarantee that would prevent the money supply from inflating at will – perhaps by backing the currency with precious metals.  In either case, holding precious metals for the long term is the best strategy.

Investment AllocationsBut how much should an investor allocate his/her investment portfolio to precious metals? The chart to the right suggests that a 33% allocation each, in cash, stocks and physical metal, will best serve to enable good deals to be snatched up when the market drops and still rake in gains during the the long-term bull market.  Keep in mind that owning a precious metals ETF is not the same as owning physical metal – an ETF would be part of the stocks allocation.

Using this type of approach, the investor must continually adjust the allocations as needed when the market fluctuates. Note that this allocation chart is for investable funds only and should not include cash that is needed for living expenses or any non-discretionary items.

How High Can Gold Go?


September 18, 2011

With gold in a 10-year bull run and the price relatively expensive, every investor must ask themselves if gold has reached its top. And with recent highs above $1,900/ounce followed by severe volativity and price plunges sometimes near $100/day, the question becomes more pertinent.

It’s interesting to recall back in January, 2010 at the Annual World Economic Forum in Davos, Switzerland, George Soros claimed “The ultimate asset bubble is gold.” At that time, the gold price was at $1,100/ounce, down from a high of $1,225/ounce a month prior.

Of course, at the time, the main-stream media only picked up on the “bubble” reference and did not take into account the context in which the reference was given. So, obviously most investors began to question their faith in the continuing rise of gold.

Soros’ reference was that asset bubbles form when interest rates are low. Easy money provided by the Fed’s policies drive people to use the money to buy all kinds of things. The more buyers there are in relation to sellers makes the prices of things rise. This is the simple logic behind all markets – supply and demand.

Gold is the “ultimate bubble” because it is the asset that serves as a barometer for the measurement of how well the central banking monetary policies are (or are not) working. In this sense, it is literally the bubble to end all bubbles. As the central banks around the world print ever more paper money without any substantial backing, gold’s price rise is sustained. Until this kind of policy is reversed, gold’s “bubble” will continue to grow.

So, back to the question, how high can we expect gold to rise? There are many different theories, some of which will be discussed below. But keep in mind that as long as gold is denominated in fiat paper money in order to establish a price, the relation with the true gold asset gradually loses its psychological connection as fiat becomes worthless and gold becomes the real money.


Using the
Consumer Price Index
to determine Gold’s Possibilities

Using the Bureau of Labor Statistics CPI inflation calculator, we can determine what something would cost in today’s dollars versus what it cost at some time in recent history (as far back as 1913, when the Fed was created).

Plugging in the average price of gold in 1913 ($18.92/oz), we get a price of $432.95/oz. That’s interesting! Is gold over-priced today at $1,800/oz? Or is there something special about gold or fishy with CPI statistics?

After President Franklin Delano Roosevelt confiscated Americans’ gold in 1933 in return for $20.67/oz, he immediately re-pegged the dollar at $35/ounce. Using the same numbers in this CPI calculator, we come up with only $25.61/oz for 1934, about $10 less than the President’s price peg. So, it is becoming evident that the CPI calculator is not historically keeping up with the price of gold.

Furthermore, after 1933 citizens were prohibited from owning gold bullion. So, there wasn’t a free market available to establish a real gold price. It wasn’t until 1975, after President Gerald Ford signed a bill legalizing private ownership, was gold put back into a free market.

In 1975, the average price of gold was $160.86. Using this CPI calculator, the price in 1975 should be only $102.82/oz, again under-stating the price of gold by about 38%.

From an historical perspective, then, it seems this CPI calculator cannot be used to determine the price of gold. In fact, the tool is geared to specific data points, like those of this table, which excludes any precious metal.

Further still, the CPI measurement methods themselves keep changing. The reason for the constant changes is because CPI attempts to sustain the strength of the dollar and reduce the claims agains unfunded liabilities like social security. If the government can show that inflation is not rising as much as it is, they don’t have to increase pay-outs to social security recipients. Of course, this ends up hurting those individuals dependent on their ss checks because they’re getting hit harder at the grocery stores and their income isn’t increasing enough to compensate.

The CPI calculation method, therefore, is more of a tool to prop up the value of the dollar rather than to accurately measure the price of a commodity such as gold.


Using the
Currency/Gold Ratio
to determine Gold’s Possibilities

As this Seeking Alpha article from April 25, 2011 explains, the Gold Standard Act of 1900 tied the value of a dollar to 1/20th of an ounce of gold. This meant that the U.S. treasury needed to keep one ounce of gold in their vaults for every $20 of currency in circulation. (Note: Precise value was $20.67.)

Back in the early years of the 20th century, if one were to divide the amount of U.S. dollars in circulation by the ounces of gold held in reserves, one would consistently arrive at a value close to $20. But as the century progressed, with economic depressions, wars and central bank interference, the value fluctuated both up and down. But as shown in the table in the article, the ratio has historically tended to be an accurate predictor of the higher prices that eventually came to pass.

As the article goes on to describe, the currency supply of the U.S. has been inflating at the average rate of 8.5%/year between 1913 and 1971, and an accelerated 11.5%/year since 1971. As of April, 2011, there was about $949 billion worth of currency floating around. This is the M0 money supply, which represents all the paper bills and coins in circulation. Note: it is reported by the government not as M0, but as the column headed “Currency(1)” in the Components of M1 table on this page.

Next, this M0 amount must be compared with the reserves of physical gold held by the U.S. Treasury. According to The World Gold Council via Wiki, the U.S. currently has 8,133.5 tonnes (approximately 261 million troy ounces) of gold in its reserves.

So, using the currency/gold ratio for April, 2011, we have $949 billion divided by 261 million ounces = $3,636/oz.


Using the
1980 Peak of $850/oz
to determine Gold’s Possibilities

In January of 1980, gold hit a record price of $850/oz. Granted, the peak of 1980 concluded with a huge price drop back down to the $300’s because of the responsible actions taken by the Chairman of the Federal Reserve, Paul Volcker – he raised interest rates as necessary to reduce the easy money available, thus taming inflation and bringing the gold price down. But we see no such effort by those in power today. They’re faced with a declining world economy, making it difficult to make the unpopular decision to raise rates. Indeed, our current chairman, Mr. Bernanke has told us to expect interest rates to remain near zero through mid 2013.

Today, with gold over $1,800, one can say that we’ve already surpassed the 1980 peak. But this would not take inflation into account.

Now, we’ve already dismissed the Bureau of Labor Statistics CPI calculator above as a valid tool for establishing the price of many assets because it showed a tendency to under-state inflation, hence under-state prices. However, using that calculator and the government’s own data for measuring inflation, we see that it correlates the 1980 peak of $850/oz with a price of $2,336.93/oz today. As of this writing, we have not yet achieved such a price, thus the peak of 1980 still holds in even the weakest inflation-adjusted terms.

But is there another source of inflation data which describes the inflation situation better than CPI. In fact, there is such information available, thanks to John Williams’ ShadowStats. Data from ShadowStats indicates that CPI inflation measurements have traditionally under-stated inflation significantly. “The problem lies in biased and often-manipulated government reporting.”

This site also has an inflation calculator, which compares inflation adjusted prices using both governmental CPI and ShadowStats measures. Unfortunately it’s subscriber protected. However, here’s a Bullion Vault article from January, 2011 that references ShadowStats data and indicates that gold would need to reach $5,467/oz in order to match the 1980 peak! And here’s an older “Flash Update” from Mr. Williams in November, 2007 stating that the “Peak Gold Price is $6,030/oz.”


Using the
Run-up to the 1980 Peak
to determine Gold’s Possibilities

Again, using this list of annual average gold prices it can be seen that in 1971 the price of gold was at a low of $40.62/oz. After 1971, the price began to surge to its peak in 1980. The average price for 1980 was $615/oz. That represents a 1,414% increase.

On this current bull-run that started in 2001 when the average price was $271.04, in order to achieve a similar 1,414% gain, the price would have to climb to $3,833/oz.

Using the actual bottom-to-top numbers ($37.39/oz in 1971 to $850/oz in 1980), the percentage gain was a whopping 2,173%. The absolute low of 2001 was $255.95/oz. A 2,173% increase from that low would be $5,563/oz.


Comparing the
U.S. Gold Reserves Versus U.S. Monetary Base
to determine Gold’s Possibilities

Here’s an interesting “chart-of-the-day” from Bloomberg. This method tries to establish a “fair value” for gold by mapping U.S. gold reserves against the M1 monetary base. The theory tries to map every dollar in existence – currency, checks, certificates & any other instrument exchangeable for currency such as traveler’s checks – to the amount of gold held in U.S. reserves that could possibly provide backing for the currency.

The interesting thing about this theory is not that the fair value for an ounce of gold last June was $10,000/oz, but that as a percentage of the monetary base, gold is sitting at historic lows – 18%. Even during the $850/oz peak of 1980, the U.S. had such a relatively small M1 monetary base that if everyone who had any form of an exchangeable dollar instrument suddenly demanded an ounce of gold for it, the U.S. would be able to cover it – no problem! At that time, as a percentage of the U.S. monetary base, U.S. gold reserves amounted to 120%. But now, due to the ever-increasing monetary inflation, the U.S. would be completely drained of its gold and still have 82% of its dollars outstanding with absolutley no backing!

If you didn’t get that last paragraph…. it’s an eye-opener, so go back and try again!

Precious Metals Crash

The precious metals investor has to ask, “Why?” All the fundamentals that made gold and silver rise to the highs they saw in August are still in place. How can it all be erased in 3 days?

First of all, looking at a multi-year chart of gold performance, one can immediately see that the price rise was ascending at a much accelerated pace since July. Here’s the GLD chart which exemplifies this pattern.

Two year GLD chartThere were good reasons for gold to take off like it did – as political and economic problems persisted in Europe, the middle east and the U.S., things were looking bad. And nothing’s changed. In fact, much has gotten worse! For example, the Swiss have effectively pegged their currency to the Euro, which means there isn’t any true safe haven currency to flee to anymore. In the face of all that, why the sudden plunge in precious metals?

The “leap” in the slope shown in the graph above is more speculation of future prices, rather than an indication of current prices. And the markets love to take advantage of speculators on both the long and short sides when they can make money from it. And that’s exactly what’s happened here.

There isn’t a bubble in precious metals. Gold and Silver will continue to rise until the governments of the world stop their incessant spending programs and central banks stop accommodating them by printing paper money at will.

There are two levels of investing going on here:

  1. Speculators on the long term trend of gold and silver due to the fundamentals;
  2. Traders taking advantage of short-term, irregular trends in the market.

Keep your cool & stay the course. Watch the trends for good times to buy back into the market (like RIGHT NOW!!!!)