The graph above demonstrates the inflation-adjusted gold price movement in 1264-2011. The initial year for calculations is 1264, since the RPI (Retail Price Index) data, provided by MeasuringWorth.com, are available only from 1264 onward. The ascending trend channel (parallel green lines on the graph) probably starts, at least from the year 1208, when the first "Great Bullion Famine" led to the rise in silver and gold prices (Source: Blanchard, I. Mining, Metallurgy, and Minting in the Middle Ages: Continuing Afro-European Supremacy, 1250-1450. Franz Steiner Verlag, 2005. P. 971).
The further rise in bullion prices was due to four groups of factors:
- The Bubonic plague, that reduced Europe's population by 30-60 per cent in 1348-1420, causing the decline in gold production (Source: Alchon, S. A Pest in the Land: New World Epidemics in a Global Perspective. UNM Press, 2003. P. 21)
- Europe's trade deficit with East. Europe ran a permanent trade deficit with eastern countries. This led to the constant outflow of silver and gold from Europe and, therefore, to the decrease in the bullion supply (Source: Allen, L. The Encyclopedia of Money. ABC-CLIO, 2009. P. 188)
- The physical shortage of precious metals in the Late Middle Ages in Europe. The second "Great Bullion Famine" took place in 1392-1412/25. In 1455-1465 occurred the third "Great Bullion Famine." The scarcity of gold and silver made them valuable (Source: Blanchard, I. Op. cit. P. 971)
- The increase in military conflicts in the late Middle Ages. To finance war efforts, the belligerents needed money (i.e. gold and silver at that time). The increase in demand moved prices higher.
In 1464, under the influence of these factors, the gold price broke the upper limit of the ascending trend channel. In 1464-1476 it continued to rise, and in 1476 achieved a historical high of 1220 GBP per troy ounce (in inflation-adjusted prices). However, in the 16th century Spain flooded Europe with gold from the New World. This caused a period of falling gold prices. Only in 1597 they met a strong support area around 380 GBP per troy ounce. From the 17th century till the second half of the 18th century the gold price fluctuated within the range of 400-700 GBP per troy ounce. But during the Napoleonic Wars, when Great Britain went off the gold standard (Source: Bordo, M. White, E. British and French Finance during the Napoleonic Wars. NBER Working Paper No. 3517, 1990. P. 1) and received inflation of 30.02 per cent in 1800, it fell to the level of 230 GBP per troy ounce.
In the 19th century the gold price moved in the tighter range of 300-400 GBP per troy ounce. During WWI the gold standard was also suspended, and the inflation rate in Great Britain in 1917 stood at 21.02 per cent. Under these circumstances the gold price in 1918 reached an all-time low of 154 GBP per troy ounce.
The descending trend line (white line on the graph) was intact until the price bubble in the 1970s. And even with the sharp price upsurge in the 1970s the larger trend channel (parallel descending red lines on the graph) remained in force. The reasons behind the rise of gold prices in the 1970s were as follows:
- This decade was the worst for the developed countries since the Great Depression (Source: Frum, D. How We Got Here: The '70s. N.Y.: Basic Books, 2000. PP. 292-293). The inflation in the U.S. economy was 13.5 per cent, while unemployment stood at 8.5 per cent (Source: Shull, B. The Fourth Branch: The Federal Reserve's Unlikely Rise to Power and Influence. Greenwood Publishing Group, 2005. P. 130)
- The rumors that Ronald Reagan was going to return to the gold standard and that the gold price would reach $1000 per troy ounce spurred investors to buy gold, while it was "cheap" (Source: Katz, J., Holmes, F. The Goldwatcher: Demystifying Gold Investing. John Wiley and Sons, 2008. P. 187)
- Finally, the unstable world situation - the Vietnam War, the Iranian Islamic Revolution and the hostage crisis of 1979, the Soviet invasion of Afghanistan, two oil crises, Brothers' Hunt attempt to corner the silver market - for many this was "the decade of pessimism" (Source: Schwenk, A. Compensation in the 1970s. Bureau of Labor Statistics, 2003. P. 29 - pdf)
On Jan. 21th, 1980, the gold price achieved a relative high of 1191 GBP per troy ounce and then nosedived. The collapse of the gold price was caused by two factors:
- The Chairman of the Federal Reserve Paul Volcker started tightening monetary policy. The federal funds rate in 1981 was 20.0 per cent (Source: Shaffer, D. Profiting in Economic Storms: A Historic Guide to Surviving Depression, Deflation, Hyper-Inflation, and Market Bubbles. John Wiley and Sons, 2010. P. 114.). The prime rate in 1980 stood at 21.5 per cent (Source: Klebaner, B. American Commercial Banking: A History. Beard Books, 1990, P. 196.) As a result, inflation was significantly reduced from 13.5 per cent in 1981 to 3.2 per cent in 1983 (Source: Shull, B. Op. cit. P. 130.);
- On March 27th, 1980, Brothers Hunt failed to meet the margin call for $100 million. A steep fall in silver prices caused panic on commodity exchanges, sending the gold price lower (Source: Downes, J., Goodman, J. Barron's Finance & Investment Handbook. Barron's Educational Series, 2003. P. 809.).
During the 1980s and 1990s the gold price predominantly fell, reaching a relative low of 222 GBP in 1999 (in inflation-adjusted prices) - the so-called "Brown Bottom." The UK finance minister Gordon Braun at that time decided to sell half of the UK's gold reserves. Ironically, thereafter gold started to rise and in 2011 its annual average price surpassed the annual average price of 1980.
The major bull movement, however, occurred in 2009-2011. The world situation in the 2000s was so unstable, that "Time" magazine called it "The Decade From Hell." Only in 2008-2011 the world witnessed the global financial and economic crisis, sovereign debt crisis in the euro area, quantitative easing programs, Arab Spring, United States debt-ceiling crisis, and the U.S. credit rating downgrade. In tough times gold always serves as the only hard store of value. In 2011 the inflation-adjusted gold price achieved the upper limit of the ascending trend channel (the point of tangency in 2011 on the graph), and the drop below in 2012 seems imminent.
Here we have to use predominantly technical analysis, since the fundamental factors that are useful in explanation of past price movements, cannot give the precise date of the gold downfall. Certainly, the proponents of a secular bull market will argue that right now gold does not encounter any problems on the way to its further appreciation, but the historical records suggest that major shifts in price behavior can be completely unexpected.
To sum up, the following findings can be emphasized:
- The level of 200 GBP per troy ounce is the level of "the lowest fair price" for gold (the lower horizontal red line on the graph). If it falls below this support line, it recovers very rapidly
- The level of 800 GBP per troy ounce is the level of "the highest fair price" for gold (the higher horizontal red line on the graph). If it ascends above this resistance line, it falls rapidly (except the late Middle Ages). That is why gold is very expensive now. With the absence of fundamental imbalances between gold supply and demand as in the late Middle Ages, when the gold price was higher than 800 GBP per troy ounce for more than one century, the emergence of a gold price bubble is obvious
- In 2011 the gold price touched the upper limit of the ascending trend channel. The classical technical analysis tells us that the drop below in 2012 is very likely
- The level of 580 GBP per troy ounce is the first target of the decline (the higher horizontal blue line on the graph). This analysis is based upon the previous significant extrema
- If the gold price falls below this level (580 GBP per troy ounce), it will probably fall further to the level of 380 GBP per troy ounce - another significant support line (the lower horizontal blue line on the graph) and further to the lower bound of the trend channel. If the support line of 580 GBP per troy ounce remains unbroken, gold will start rising again. In this case the decline of 2012 will be only a price glitch
Thus, in 2012 the annual average gold price for the first time in 12 years should close in minus. Although nobody can predict the relative high the gold price will achieve in 2012, as the graph shows only annual average prices, it is logical on the eve of such developments to start dumping gold, at least by large ETFs. The probability of a price glitch, at least, is very high.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.