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First of all, I am not a gold bug and like Dennis Gartman, am not very comfortable when everyone becomes bullish on gold. Many analysts and journalists do all sorts of historical analysis for gold prices, looking back at the Q1 1980 high of $800 + (nominal price) and using this number in all sorts of statistical comparison. But what one has to be extremely careful about is the fact that this price was an extreme movement which didn't last for too long at that time. Gold moved above $700 and stayed there for just a couple of weeks before dropping into the $300-500 range (nominal) for most of the '80s.

Here is some research I did to explore what caused Gold prices to rise (and subsequently) fall so dramatically in the first 3 months of 1980. It's important to know the history, to figure out if a similar situation could manifest sometime in the future and how to trade such an opportunity.

--- Gold's dramatic rise and fall in 1980 ---

1. Conclusion: CPI and inflation fears set the general trend for gold prices (though they are not always correlated). But a dramatic spike and fall in gold prices were caused due to a combination of extreme geo-political events (Russian invasion of Afghanistan in Dec 1979, Iran hostage crisis) and strong and unconventional policy actions and market events (the Fed under Volcker increased fed funds rate from 13% to 20% for a short period in Q1 1980, and Hunt’s brothers silver market cornering failed due to their inability to meet a margin call during falling silver prices in Mar 1980, exacerbating the fall in precious metals). It is an interesting mix of these events which resulted in the roller coaster gold prices in 1980.

Inflation Adjustment: Inflation is measured by CPI and government has altered this measure since 1980 and some conspiracy theorists believe that this was done to understate inflation all along. Even if we use the traditional measure of inflation CPI, current gold’s price adjusted for inflation is much lower than its 1980 price. It's incorrect to compare it to the Jan 1980 peak which spiked due to geo-political tensions but nonetheless, gold’s inflation adjusted 1980 peak price was $2189 and the 1980 average price was $1732 (all prices in Sept 2009 dollars).

2. Rise of gold prices in Jan 1980:

Gold prices rose dramatically in late December 1979 and Jan 1980 due to two reasons:

2.1 Geopolitical reasons:

a. Soviet invasion of Afghanistan: On Dec 23rd 1979, Soviet military units occupied Kabul, the capital of Afghanistan and by December 28th, the Soviet Union seized control of Afghanistan and Babrak Karmal replaced overthrown and executed President Hafizullah Amin.

(Link here)

b.Iran hostage crisis: The Iran hostage crisis was a diplomatic crisis between Iran and the United States where 53 Americans were held hostage for 444 days from November 4, 1979 to January 20, 1981.

(Link here)

2.2 Inflation fears: Inflation in the US had been on a rise in the late 1970s and had risen to an all time high of ~ 13 +% by Dec 1979. Gold prices had been rising with inflation as measured by CPI (y-o-y) though the rise in inflation wasn’t the primary reason for the gold price spike in Jan 1980.

3. Fall of gold prices from Jan 1980 onwards:

Gold price fierce correction from Jan-Mar 1980 and downtrend from then onwards were caused by:

3.1 Interest rake hikes by Paul Volcker to subdue inflation and resultant CPIs downtrend from Mar 1980 onwards: Paul Volcker increased interest rate from ~13% to 20% around Q1 1980. The federal funds rate, which had averaged 11.2% in 1979, was raised by Volcker to a peak of 20% in June 1981. The prime rate rose to 21.5% in '81 as well. These dramatic interest rate hikes led to the gradual decline of CPI from a peak of ~14.8% in Mar 1980. By June 1983, CPI was ~2.6%.

(Link here)

3.2 Silver Thursday and added selling pressure on precious metals: On March 27th 1980, the Hunt brothers couldn’t pay a $100 mn margin call on their positions and the panic spread to the futures market in general, fearing that there would be systemic impact by their default. To save the situation, a consortium of US banks (under supervision of Paul Volcker) provided a $1.1 billion line of credit to the brothers, which allowed them to survive the ordeal.

Links:

http://en.wikipedia.org/wiki/Silver_Thursday

http://en.wikipedia.org/wiki/Nelson_Bunker_Hunt

http://www.gold-eagle.com/editorials_05/dyson012805.html

3.3 American response to the Soviet invasion of Afghanistan: President Carter had addressed the nation about the Soviet-Afghan situation by Jan 1980. The US had teamed up with the UK and China in covertly supporting the Afghan rebels and the shock element of the Russian occupation of Afghanistan started dissipating. The US had stepped up Operation Cyclone, which was the code name for the United States Central Intelligence Agency program to arm the Afghan mujahideen during the Soviet war in Afghanistan, 1979 to 1989.

Links:

http://en.wikipedia.org/wiki/Soviet_Invasion_of_Afghanistan

http://en.wikipedia.org/wiki/Operation_Cyclone

Figure 1: Gold prices 75-88

Figure 2: Silver prices 75-88

Figure 3: Fed funds rate 1975-88

Figure 4: : CPI (y-o-y) 1979-2009

4. References I used:

Gold price in 1980:

http://www.usagold.com/reference/prices/1980.html

Gold price adjusted for inflation by two methods:

http://www.goldprice.org/james-turk/2008/01/real-gold-price.html

Inflation adjusted gold price:

http://www.inflationdata.com/inflation/images/charts/Gold/Gold_inflation_chart.htm

Interesting article making the case that gold is a “crisis hedge”, not an “inflation hedge”:

http://www.inflationdata.com/inflation/Inflation_Rate/Gold_Inflation.asp

A look at the gold prices in Jan 1980:

http://seekingalpha.com/article/53145-gold-oil-prices-a-look-back-at-january-1980

Hunt brothers and silver market cornering:

http://en.wikipedia.org/wiki/Nelson_Bunker_Hunt

Silver Thursday:

http://en.wikipedia.org/wiki/Silver_Thursday

News links:

Dec 79: http://www.spiritus-temporis.com/december-1979/

Jan 80: http://eightiesclub.tripod.com/id95.htm

Jan 81: http://eightiesclub.tripod.com/id96.htm

Disclosure: None

Source: Gold's Dramatic Rise and Fall in 1980s - Why It's Important