Monday, January 7, 2013

Is the price of gold about to take a dive?

In my childhood in the 1970s, the price of gold rose along with inflation. Investors wary of the falling value of the U.S. dollar were buying gold as a hedge, it was said.

In 1970, gold sold for $38.90 for one ounce. By 1974, the spot price had risen to $183.77. After a few down years from 1975-77, gold climbed up to $208.10 in 1978. A year later, the price more than doubled to $459 an ounce. It peaked in 1980 at $594.90.

With inflation whipped in the 1980s, gold took a fall. In 1990, an ounce cost $386.20, 64.9 percent as much as a decade earlier. In 2000, gold was down to $272.65. It had lost 54.17% of its value of 20 years earlier.

Since 2000, we have had very little inflation.

So if the price of gold is a function of inflation, where buyers turn to it as a hedge, there would have been no reason to think that from 2000-12 the price of gold would have skyrocketed to unprecedented levels, given what we know about consumer prices over the last dozen years.

Yet gold has taken off. Its price per ounce increased by a whopping 610.3 percent from 2000-12. Here are the closing prices since 2000:

  • 2001 $276.50
  • 2002 $342.75
  • 2003 $417.25
  • 2004 $435.60
  • 2005 $513.00
  • 2006 $635.70
  • 2007 $836.50
  • 2008 $869.75
  • 2009 $1,087.50
  • 2010 $1,420.25
  • 2011 $1,531.00
  • 2012 $1,664.00

 To my eye, that looks like a classic bubble. There is no relation whatsoever to the rate of inflation. It seems like there is a serious risk now in holding gold, and that it is possible that in 2013 or shortly thereafter the price of gold could drop by 60 or 70 even 80 percent.

It's also possible there is a rational explanation for its current price. For example, gold may have gone up over six times in value in the last dozen years because the total money supply, a large share of which is held by foreign central banks, has gone up that much.

That, however, was not the case when gold prices were falling for 20 years. This chart shows a negative relationship between gold prices and money supply from 1980 to 2000:

Since 2000, our total money supply has increased rapidly--it's up 250 percent. But gold, as noted above, is up 610 percent over the same period. So if gold is not in some kind of a bubble, now, I don't know what the explanation is for its current price levels.

Writing for, Michael Gayed says today that gold prices may be ripe for a fall.

While stocks ended 2012 and started the new year off with a bang, gold has been notably absent from investor euphoria as of late, as risk-taking favors equities over metals in the near-term.  There is no doubt that gold has been a phenomenal performer over the last decade, but it might be time to entertain the idea that the environment might get more challenging for gold as a leader relative to stocks.

Mr. Gayed writes that the supply of corporate equities is falling, as companies use cheap debt to buy back their own stocks, and that means that stocks look more attractive than gold, where the supply of the precious metal is steady.
As interest rates have plummeted, corporate debt has become incredibly cheap to issue. If you're the head of a company, you have an embedded incentive to issue cheap debt and buy back company shares, shrinking the supply of shares outstanding to push up your stock price under dwindling investor demand and helping to prop up your earnings per share.
One of the reasons many invest in gold is because supply is set and can not be expanded. Against the backdrop of stock supply, which is shrinking, however, that particular reason for holding gold becomes an even stronger reason to own equities as a result of the share-buyback trend. Because investments must compete for dollars, this could explain why money has preferred stocks to gold under risk-on/reflationary periods.

The problem with Mr. Gayed's theory is that the supply of stocks was not rising rapidly from 2000-12. Yet it was during that period which gold went up 610 percent. Also, while I don't have a chart to prove it, I suspect there is no long-term historical relationship between periods when corporations were buying back their own equities and gold prices falling.

If I had to place a bet on gold, I would bet that over the next five years it is going to decline by at least half its present price, unless there is a serious global crisis in between. It seems to me that gold was driven up by irrational exuberance, probably triggered by the terrorist attacks early in the 21st Century, and sooner or later investors will realize that holding gold is a bad asset.

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