The typical analysis out of Wall Street tends to downplay gold and precious metals while being at the very least conservative about prospects of future price inflation. After all, according to official government numbers price inflation is under control and is no threat. However, this has never sit well with most people who have to deal with rising gas prices and rising food prices. What I intend to show is that using historically consistent data, we are in for the largest inflationary episode that this country has seen for at least the past 30 years and that the fundamentals of gold are almost exactly the same as they were at the beginning of the 2000-2008 bull run.
Before getting into my correlation analysis, I first would like to describe the source material that I used for inflation. Historical prices for oil, gold, wheat, corn, coffee, beef, sugar, rubber, and iron were acquired from Index Mundi to generate what I consider to be a more accurate picture of price inflation.
Source: IndexMundi Commodities. The previously listed commodities were sourced to produce average inflation across a broad selection of goods.
This chart, shown in log scale, shows relatively tame inflation throughout the 1980s and 1990s, with a brief spike in the 90s that was quickly corrected. In general, price inflation was negligible through these decades. Starting in the early 2000s, though, inflation began to steadily rise, and there was a brief dip from the 2008 market crash that was quickly surpassed until we reached our current plateau with relatively steady prices.
After this I decided to look at the relationship between the Adjusted Monetary Base and this alternative measure of inflation. The results are striking.
This chart is showing in black the ratio of monetary base to broad basket inflation. What this shows is that as this ratio peaks (that is, as the base soars far higher than current price inflation), price inflation begins to climb. As the ratio approaches a valley, price deflation sets in. A definite corrective relationship is apparent. A few things stick out from this chart. First, the growth of the monetary base relative to price inflation in the early 2000s was enormous. Second, at the dawn of the 2008 crash, this base/inflation relationship was not far away from historical norms. Thirdly, the monetary base was engorged at this crash, but it has never stopped growing since then such that as of this writing since 1984 we have never seen such a large disparity between the base and price inflation. Thus, we are on the precipice of the greatest inflationary episode that this country has seen in the past 30 years.
So now the issue becomes how do we relate this information to gold. Using the broad basket inflation and the average real (BBI adjusted) gold price between 1984 and 2014, I have established the historic price of gold and expected nominal price based, and also determined the expected nominal price of gold based on the adjusted monetary base. The first chart shows these and the actual nominal gold price between 1984 and 2008.
Source: IndexMundi Historical Gold Price
The first thing to notice is how well the BBI expected gold price tracks the actual gold price. The other thing to notice is that between 2000 and 2008, the nominal gold price and BBI expected gold price were approaching the Base expected gold price. However, in 2008 the crash set in and we saw a massive inflation in the monetary base, setting off another wide discrepancy between nominal gold price and base expected gold price that has only been exacerbated since then.
Around 2000, the nominal and BBI expected gold price sat about 4x lower than the Base expected gold price. That set off the great gold bull run of the 2000s. Today, this relationship is at about the same value. The nominal and BBI expected gold price currently sit about 4x lower than the Base expected gold price.
Moves to Make
The most obvious move to make is to get exposure to gold and other precious metals. You can never go wrong buying bullion, though you may want other options to increase your leverage. I personally prefer royalty companies such as Royal Gold (NYSE:RGLD) and Franco-Nevada (NYSE:FNV). Alternatively, for a riskier play you may try gold miners themselves, though I would caution you to go for a basket of these companies rather than investing all in one. Two prominent junior miners (who as a group are set for a huge recovery) are Eldorado Gold (NYSE:EGO) and First Majestic Silver Corporation (NYSE:AG).
I am less convinced about buying any gold ETFs, but these are also an option if you want broad exposure to the market for a low price.
The fundamentals of gold saw a serious change during the bull run. What was a great investment in the early part of the 2000s became possibly a bubble around 2008. However, when the Fed decided to begin quantitative easing and the monetary base exploded, it set off what is again a historic buying opportunity for gold. Do not be detracted by wavering gold prices in the past year. Gold is set to take off, as is inflation, so take advantage.
Disclosure: The author is long AG, EGO, PVG, RGLD. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.