Gold, like most assets, experiences secular bull and secular bear markets. Of course, during these long term trends gold experiences a lot of volatility. Emotional investors, often referred to as 'weak longs' tend to second guess their decision to own gold at the first sign of a decline. Yesterday's 5% decline has many investors wondering if the great gold bull market that began in the early 2000s is over.
Investors with conviction may maintain their belief in the gold bull market. After all, money printing continues, budget deficits are bloated, economies are in massive debt, banks are walking zombies, consumers are defeated and catastrophic systemic risks remain. While these risks are somewhat measurable the measurements are highly subjective and require many assumptions. You can find very smart people to take both the bull and bear sides of the debate for all these issues.
In my quest to find an objective determinate to help me identify the end of the secular bull market, I created the chart below. The shaded areas represent bull markets in gold. The line represents the real interest rate, as measured by one-year US Treasury yields minus one-year change in food prices.
(Why food instead of CPI? CPI, the mainstream method for measuring inflation, is flawed. First of all, the methodology used to calculate CPI has been manipulated over time. Second, the CPI basket weights assumes all consumers make the same purchases in the same proportions. Food, on the other hand, is a less manipulated proxy for inflation that affects us all. There may be better alternatives, but this is what I went with. Besides, although the numbers will be different, the general pattern of real interest rates over time should remain fairly similar regardless of whether one uses CPI, food, energy prices or various other measures.)
When looking at the chart you'll notice that gold bull markets are paired with volatile and low-to-negative real interest rates. Gold bear markets, on the other hand, occur when real interest rates are relatively stable and consistently positive. In fact, the end of the last secular bold bull market was triggered when real interest rates rose so high as to break the backs of the gold bulls.
Why does gold perform well when real interest rates are low/negative and volatile? Simply put, real interest rates represent the post-inflation returns bond investors receive on their holdings. Low real rates mean lower after-inflation returns on bonds, resulting in less of an opportunity cost for switching into other asset classes. Moreover, volatile real rates imply that market/economic forces are causing uncertainty in the Treasury market. During these periods, investors who want to preserve capital but aren't willing to accept low/negative real returns are more likely to invest in gold.
Looking at the graph below (click to enlarge image), if real interest rates truly are a measure of a gold market's strength, it doesn't look like the current secular bull market has met its end.