The Gold Bull Market – Shortened Edition
The seasonally strong period for the gold price is now upon us and, at the time of writing (26th Sept 2009), the price has recently sustained a move just above the psychological $1,000 an ounce level. After a record breaking eight-year bull market, which has seen the gold price quadruple from a 20-year bear market low of $255 in mid 2001, gold’s financial attributes are now widely appreciated. The question many are asking is - can the gold price sustain this move above the $1,000 an ounce level and make further upward progress ?
Gold Price Above the Long Term Inflation Trend
As the accompanying charts highlights, the dollar gold price is currently well ahead of the price that can be justified by the long term inflation trend in the US. The chart is a semi-log scale which is effective at displaying the proportional rise in the gold price over time. Had the gold price simply tracked US inflation since 1935, it would currently be trading at just under $600 an ounce. Our calculations are based on a starting price of $35 an ounce for gold in 1934, when the dollar at that time was devalued from $21 to $35 an ounce as the US attempted to escape from depression in the mid 1930s. The $35 price seems a logical starting point, although we have to acknowledge that different starting points produce different (and mostly lower) inflation-adjusted gold prices.
Premium Reflects Global Debt & Inflationary Concerns
The current premium over the theoretical inflation-adjusted price most likely reflects deep seated concerns by investors regarding the financial risks of consistent global trade imbalances, the level of debt build up in the global economy and the possible inflationary consequences if it all gets out of hand, which could result in a dollar crisis.
Is the Premium Justified ?
As we discuss in more detail later in the article, the near term demand and supply outlook appears to be overwhelmingly in favour of higher gold prices. But for the ‘buy & hold’ investor, the question must be – does the current gold price premium over the long term inflation trend already sufficiently factor in the inflationary risks or do these risks justify higher gold prices still?
Gold’s Physical Attributes are Remarkable
First, however, it is worth examining gold’s physical attributes as they are remarkable and are an integral part of the metal’s monetary or financial attractions.
Gold is the heaviest metal (highest density), it is virtually indestructible and its melting point is 1064 degrees Celsius. It is the most stretchable pure metal known to man - a single gram can be crafted into a sheet one metre squared, which is so thin that the sun can shine through. It does not oxidise (rust) in air or water, it has no taste in its purest form and it is an excellent conductor of electricity. Its physical beauty has seen it used as jewellery for thousands of years. In addition, its robustness and dependability has seen it in increasing demand in many new complex industrial applications where price is less of a consideration.
In terms of its geological rarity, gold bearing rock is very rare and even when it is discovered an average tonne of gold ore yields only 6 grams of gold. That is six parts to a million. Its durability, rarity and divisibility make it valuable and tradable and allow significant wealth to be stored or transported with relative ease. It is easy to understand, therefore, how gold has been an accepted form of money for thousands of years.
Three Gold Bull Markets in the Past century
The Depressionary 1930s
The first major bull market in gold in the past 100 years occurred during the deflationary depression of the 1930s. Then, governments globally severed the existing gold-currency exchange rate allowing the money supply to be rapidly increased in several currencies (economies). These attempts largely worked to kick start economic activity and helped end the depression.
With a significant increase in the supply of other currencies in circulation in the mid 1930s against a relatively fixed supply of gold, the result was a higher gold price relative to those paper currencies. In US dollars, the gold price increased from $21 to $35 an ounce in the mid 1930s. It was officially fixed at that price until 1971 although the free market price started to edge up from 1967 onwards.
The Inflationary 1970s
The next major bull market in gold started in the late 1960s, when the US was spending heavily to fund the Vietnam War in particular, and extended to early 1980. The financial resources required to fund the war led to a significant increase in supply of US dollars at that time. In this period, unlike the 1930s, rampant inflation was the result.
From1967 to early 1980, the price of gold rose from $35 an ounce to over $800 an ounce at the peak. That peak in the gold price was not seen again for 28 years (2008). Undoubtedly, the markets had over-reacted and pushed the price of gold too far at that stage in anticipation of double-digit inflation for years to come. Worse still for the gold price was that inflation peaked shortly thereafter and gold’s correction became a severe one and over an extended period of time as disinflation through the 1980s and 1990s became the norm. As the accompanying table above highlights, by 1980 the price of gold had risen substantially ahead of the long term inflationary trend.
Then the 21-year Long Bear Market
But, as the chart also shows, just as the market over bought gold on the way up, so too it over sold it on the way down. The 21-year long bear market that lasted from 1980 to 2001 saw gold trading significantly below the long term inflationary trend by the mid 1990s. Sentiment was further dented when central banks globally started selling off some of their long held gold reserves. Of course, we now know that Central Banks acted unwisely in dumping a portion of their gold reserves at that time. The Bank of England in particular must take the distinction for having sold a significant portion of its gold reserves at the bottom of the market in 1999 when the gold price first hit the low of $255 an ounce.
But there is nothing like outstanding values to call the bottom of a bear market. Outstanding values eventually bring the buyers back in and the gold market was no different.
Enter the Global Trade Imbalances of the 2000s
The recent bull market, which officially started in May 2001, has seen the gold price rise from $255 to over $1,000 an ounce currently. This current gold bull market has been driven by global trade imbalances, which have led to on-going competitive currency devaluations across the globe. This resulted in lower interest rates globally than would otherwise have been the case and which, in turn, led to excessive asset price inflation first in stock markets and then in property and perhaps also in corporate earnings. In the pursuit of escalating asset prices, debt levels rose strongly also. The out turn, as we now know, was the destabilisation of the global financial system and a collapse in financial and property markets.
The response to the global credit crunch has seen governments inject significant liquidity into the financial system. If this liquidity is not withdrawn at some stage, then it will mean too much money chasing too few assets and eventually inflation will take off. This is what the market sees and gold, as usual, provides the ultimate hedge against this eventuality.
Although all three gold bull markets of the last century appear to have different causes, the common theme was a substantial increase in the supply of money in circulation that was not matched by an equal increase in the amount of goods and services traded.
The Near Term Demand & Supply Outlook is Favourable
On the supply side, the principle areas of gold supply is mine production, recycled jewellery and industrial gold and central bank selling of gold reserves. In all, the annual gold supply is declining and it is difficult to envisage what factors could lead to an increase in supplies in the near term.
Mine production provides the biggest source of annual gold supply. But existing production supplies obviously have a finite life and exploration activity for new mines has become an increasingly difficult task even with the advances in technology. A fall out of the global credit crisis of 2008 for the gold market has been the impact on project funding where even deposits are ready for commercial production have been held up. The bottom line is that gold production from mines globally has fallen marginally over the decade.
The higher gold price has increased the supply of recycled gold and there appears to be little reason why recycled gold should not continue to provide an increase in supplies for several years yet.
But the supply from central bank selling is declining rapidly. Indeed, a fall out from the global credit crisis in 2007-08 is that central banks are now even more aware of gold’s attractions as a financial reserve. In times of crisis, liquidity is of paramount importance. In contrast to government bonds, Gold is no one else’s liability and the global gold market is highly liquid. It is logical, and almost certain, that central banks will return as net buyers of Gold.
On the demand side, the annual demand for gold has been rising and the trend looks sustainable. The largest source of annual gold demand is from jewellery and industrial usage. With the global economic downturn, demand from this area has fallen significantly in the past few years. But, equally, a recovery in the global economy should lead to a recovery in industrial and jewellery demand.
As we discussed on the supply side of the argument, while central banks have been net suppliers of gold in several years since the mid 1990s, it is highly likely that they will swing back into being net buyers of gold as they have been over the decades.
The last significant source of gold demand is from the investment community. And, in the past several years, investment demand has more than plugged the gap left by the central banks and the downturn in industrial and jewellery usage.
Investment Demand is the Major Swing Factor
As outlined at the start of the article, investment demand is being driven by the on-going risks inherent in global trade imbalances, which reflect competitive currency devaluations globally.
This trend resulted in interest rates globally being lower than they should have been during the late 1990s and early to mid 2000s. The resultant cheap money globally undoubtedly assisted in causing asset price inflation (in property in particular) and excessive borrowing in the chase to participate in rising asset prices.
On the banking side of things, artificially low interest rates (and government bond yields) encouraged banks globally to try and improve the income they could earn from assets on their balance sheets by buying higher yielding but riskier assets and to take on and give out more debt than they should have. The subsequent realisation that system wide leverage had become excessive against a backdrop of falling asset values caused a stampede for liquidity and an aversion of risk – in essence, everyone wanted their money back at the same time due to a sudden loss of confidence. The result was the global credit crisis.
The response from governments and central banks was swift but the resultant escalating levels of government debt, ballooning budget deficits and central bank quantitative easing (money printing) has left investors with serious reservations concerning an outbreak of inflation.
Lingering deflationary threats serve only to make the argument more compelling. And that is the nub of the current gold bull market. A bonus is that the current cost of holding gold after inflation has rarely been lower.
A Definite Trading Opportunity
In summary, the demand/supply outlook appears overwhelmingly in favour of higher gold prices in the short term and the decisive break above the $1,000 level in September 2009 is likely, in my view, to be sustained. And the move above the $1,000 level has occurred without any signs of bubble-like activity by investors. There has been no parabolic rise which typically signals the end of irrational bull markets in any asset class. At the very least, a trading opportunity is surely beckoning.
But Not So Clear Cut For the Investor
For the ‘buy & hold’ investor, however, the case for gold is less clear cut. As the earlier chart highlights clearly, the gold price is already well ahead of the long term inflationary trend. If global trade balances continue to correct, if government debt is seen to become more manageable and if central banks are successful in withdrawing the excess liquidity out of the financial system then the financial threat from excessive debt levels and the likely inflationary consequences will 
recede. In that scenario, the gold price may well revert back to its long term inflationary trend. But what odds would you put on this goldilocks scenario? If you deem the odds of a successful outcome to the global economic problem to be low, then gold provides the ultimate hedge.
Detractors argue that gold produces no income. But such arguments fail to point out, or understand, that gold does not need to as it has no liability (debt) against it. Said another way, gold does not produce wealth. Rather, it protects wealth. Hence, it should not be compared to assets such as shares or property, which are also decent hedges against inflation. Rather, gold is the ultimate alternative currency to paper money.
You can access the extended edition of our article on the Gold Bull market HERE
Rory Gillen
The InvestR Centre
26th Sept 2009