Gold Has More To Run, Whatever The Benchmark

At my last entry on gold, I discussed gold's relationship with CPI. But gold is also related to (if not more) monetary policy and monetary inflation - in other words, the growth of money supply or inflation caused by money supply.

The most relevant factor in money supply related to gold is M3. If we look at the M3 money stock for the last 30 years, the picture is not pretty at all. Basically, M3 has grown from around $1 trillion in 1977 to over $10 trillion today. The US government actually stopped publishing M3 a short while ago. This is probably not for the reason claimed - to save $1M on data compiling - since M3 is one of the most important economic figures published and studied by economists and the financial world. The real reason is probably that M3 has been running out of control, rising exponentially especially during last 10 years, about 12-13% per year recently. Obviously this 12-13% growth on M3 is several times higher than the 2-3% published CPI index.

Gold doesn't tie exactly one on one to M3 (since we are not returning to gold standard as in the early 1970s), and I don't know what the ratio should be, but as we can see, the monetary inflation reflected by M3 is much worse than CPI. Can you imagine what gold price would be if one day we decided to go back to gold standard? It would be 10 times the average gold price in 1970s when our M3 was less than 1/10 of today's level.

Besides CPI and M3, there are several other indexes people compare with gold. One of them is DJIA vs. Gold, a favorite ratio for Newmont's former President and Vice Chairman, Pierre Lassonde. If we use DJIA to represent paper assets, and gold for hard assets, Mr. Lassonde noticed that in last 100 years, DJIA/Gold has reached between 1-3 five times, so he thinks that sometimes in the future, the ratio could drop back to the same range.

I don't know at that time what the DJIA level would be, but if during a bear market DJIA dropped half of its value, landed at 7,000, and we conservatively used the ratio of 3, gold would still be over $2,000. As Mr. Lassonde famously said, he expects that gold will have 3 zeroes after its 1st digit, and it is just a matter of what the 1st digit is.

Another popular ratio which commodity investors often look at is Gold vs. Oil. During the last 30 years, the gold/oil ratio has fluctuated between 8 to 30, and average at 15. We have all heard about $100 oil coming, but not many have discussed its implications to gold. Even using the average ratio of 15, gold would be at $1,500. I expect that at some point in the future, that gold/oil ratio would achieve a much higher level, probably around 25.

We also know gold was up from a $35 bottom to a $887.5 peak in 1970s, a spectacular 2500% run. I don't expect gold will achieve the same return this time, since the $35 per ounce was a suppressed price then, controlled by the government. I feel the free market price, if it was traded at the time right before the government abandoned the gold standard, is probably around $80-$100 per ounce. If so, the real gold ramp up in those 9 years is around 800%. I hope that we will have a similar return during this gold bull market as well, from $250 to $2,000.

At the same time, I also disagree with many other more bullish gold bugs who give a stratospherically high predicted price, such as in the 5 digits. The problem with gold at that level is similar to silver at $50 in late 70s - there won't be any buyers. If no buyers, the market becomes imbalanced and will crash, just like the then silver market.

I think this is also or at least part of the reason that gold crashed in 1980. How many people at that time could afford to buy $800 gold? If gold reaches sky high quotes, it means all kinds of paper assets such as currencies (US or foreign), stocks, bonds etc. etc. are pretty much worthless, so who will be left and how would they come up with the money to buy gold?!

Comments

[hitesh]

GLD, IAU, GDX
Gold Price, Long Ideas

[Uncle Bill]

Hey Thomas. The XAU hit two standard deviations above its 90-day mean price -- based on option market expectations -- last Thursday with the index around 172. The index ran from 120, where it was two standard deviations below its 90-day mean price, to 170 in a month. It's pulled back a little since, which indicates to me this is a technical, speculator-supported market rather than a fundamental event. Furthermore, the option implied volatility for XAU is 38 -- one of the highest among sector indexes. This past run equated to a year's worth of performance by the index based on the option implied volatility estimates. And finally, the correlation between the major market indexes and XAU has to be the highest in history. This is a trader's market, and traders should be selling XAU.
http/impliedrisk.blogs...

[David Lentz]

There is the implicit assumption that inflation lies in the future, due to the central banks' creation of credit to fill the vacuum of imploding bad debt.

However, there is another argument that says we are headed down the path not to inflation (which assumes the central banks overdo their goal), but deflation (which assumes that the central banks are unable to counter both the implosion of credit and the contraction of confidence, which lowers the velocity of money substantially). You can check out the discussion over at Minyanville.com in the item titled "Is the Fed Deflating?".

If indeed it is a case of deflation and not inflation (and the charts would seem to support such a view), this could still be good for gold, not as a hedge against inflation, but as a refuge against chaos in the currency markets as the wheels come off the apple cart.

[thomast2]

David, I actually read that article. Maybe it is true that M3 is not a good figure to look at, but too many other factors argue for gold's rise. I actually think it might be stagflation, or recession plus inflation, as Jim Sinclair always indicates and what actually happened in 1970s. There are many more reasons for gold's rise which I will discuss in the future.

Bill, I appreciate you share your thoughts on the strategy and your other comment at my earlier blog.

[the_Bird]

I don't see the validity of comparing the DJIA to gold prices, at all. Gold is gold; it's an asset without intrinsic earnings ability. DJIA represents companies that have and will continue to grow profits out into the future. GE, as a proxy for the DJIA, earned $0.15 per share in 1981 and is expected to earn $2.20 this year; of course it's stock price (and the DJIA) has gone up over time to reflect this. How does that bear ANY relationship to what value gold might have?

The gold that someone bought and put in a vault thirty years ago is the exact same gold that's sitting in that vault today; General Electic obviously is not. There's just no logical relationship between those two values.

[thomast2]

Thanks for your comment. I will actually discuss more on this in the future but since you mentioned it, I will give a quick note here. DJIA represents paper asset, gold is the king of all commodities and represents the hard asset. They are both assets but people have changed their preference from time to time and from one to another. For example, in 1970s, no one cared about stocks, or so-called nifty fifties were all down 50-90% from the peak, while people were buying into gold as inflation and asset protection vehicle. Gold was out of favor between 1980-2000 and I am arguing that we are seeing a financial asset rotation back to gold. Thanks again.

[Dr know]

One of the best analysis I have seen