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Jeffrey Dow Jones
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Jeffrey Dow Jones is the managing editor for Alpine Advisor. He has previously worked for PaineWebber/UBS and Ford Motor Credit Company, and he spent the last decade co-managing a group of hedge funds. He holds a degree in Business Economics with a specialization in Computer Programming from The... More
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The Trade of the Decade: A Guide to Investing in the 2010s
  • Six Things Most People Don't Know About Gold (Part 2) 0 comments
    Jul 6, 2010 9:34 AM | about stocks: GLD
    (Part 1 of this series is available here.) 

    2) We’re nowhere near the real peak back in 1980.

    One of the most famous events in the gold market was its run to $850/oz back in 1980.

    Almost three decades later, gold finally made a new all time high, but it was an all-time high in nominal terms. Adjusted for inflation, we’re still nowhere close to what we saw in 1980.

    Here’s a chart adjusting the price of gold for inflation (using today’s dollars):

    image

    That being said, it’s important to keep in mind that the 1980 peak was a speculative bubble and comparing today’s price, in either real or nominal terms, to that speculative peak is nearly worthless. It’s like saying that home prices can go up another 100% from here because that’s where prices were in 2005. Or like arguing that JDS Uniphase stock could go back to $1,000 per share because that’s where it was trading during the heights of the dot-com bubble.

    The price of gold is, however, at the high end of what has basically been a 40-year trading range.   Movement beyond this range will be contingent upon steadily increasing demand or a weakening dollar which, given the mess we’ve got up ahead, is certainly within the realm of feasibility.  There are much better theses on which to base a bullish case for gold than clinging to a prior peak.

    As for what might happen to gold should another speculative bubble develop, the below chart may give you some idea.  I’ve charted some of the major bubbles in history against each other, using the beginning of each bull market as a starting point:

    image

    It’s important to understand that what we’ve seen in the gold market since 2001 is not a bubble. Not yet, at least, though we may be getting close.  Nearly every super-bull market in history has concluded with a final phase of speculation and hyperactive demand, and whether or not we’re currently in that phase seems to be the debate du jour.

    That’s not to say gold is empty of short-term upside.  Should another speculative frenzy develop, that chart may give you a sense of how crazy things can get.  Gold could double from here, or triple.  It’s up to you whether or not you want to make that shaky bet, and whether you think you can get out at the top and avoid the nastiness that follows each one of those bubbles in the chart above.

    Keep your eye on both the investing public for hints at speculative demand and the Federal Reserve for guidance on monetary policy.  Should the Fed start taking some of these dollars out of the system and tightening up monetary policy to bolster the strength of the dollar, it would very likely be very bad for gold.

    Since Europe started freaking out about its sovereign debt, the Dollar has grown stronger.  Despite that, gold has powered forth.  Is that indicative that we’re now in the bubble phase, that nothing can drive down gold prices until we make it to the end of the line where the world wakes up from its collective hysteria and says, “whoah, maybe this has gotten out of control?”  Perhaps.

    All those gold ads on TV are probably another indicator that we’re moving into that realm.

     

    3) It’s best thought of as a “neutral currency”.

    The most important thing to understand about currencies is that they are a relative value proposition.  Currencies don’t have an independent, absolute value the way other assets do.  Instead they are globally priced in terms of other currencies.  Or even other assets, which can be a little counter-intuitive.  Last Halloween I went to the grocery store yesterday and there was a big box of pumpkins outside where they were strangely pricing dollars in terms of pumpkins.  The sign said $1/4lbs pumpkin.  Apparently one dollar is actually worth 4 pounds of pumpkins.  How many pounds of pumpkins does one ounce of gold cost?  About 5,000 pounds of pumpkin!

    As I’m sure you’ve noticed, economists have a strange sense of “humor” and one thing we like to do for fun is price one thing in terms of another thing.

    It’s especially interesting to use gold for this.  For example, let's price the stock market in terms of gold.  The first chart is log scale, the second is linear scale:

    image

    image

    There are a lot of ways to interpret those charts.

    When priced in terms of a “neutral currency”, the dot-com market bubble really stands out.  That was an epic bubble, folks.  What’s interesting is that the stock market’s second run back towards new highs in 2007 wasn’t really an equity bubble at all.  It wasn’t even really a bull market.  To somebody that used gold as their currency – or even a lot of other foreign currencies – the highs in 2007 were just another stop on the way down in a gigantic bear market.  That second little peak in the stock market was actually due to dollar weakness!

    Here’s a chart of the Dollar Index (DXY) which measures the value of the US Dollar against a basket of foreign currencies:

    DXY-Jun10Kind of remarkable, no?  The dollar is on balance about 35% less valuable relative to a basket of other major currencies than it was at the beginning of this decade.

    In the summer of 2001 I went backpacking through central Europe, pretty much at the exact peak in the USD.  At the time I was astonished at how cheap everything was over there.  Hostels in Germany and Austria were only $5-10 dollars per night, while a very nice bed & breakfast in Venice cost me about $60.  Greece was ridiculously cheap and the (wonderful) food was only slightly more expensive than “free”.

    I returned to Europe in the summer of 2007 – not quite the low in the US Dollar, but pretty close.  Needless to say, the experience was substantially more expensive.  My dollars didn’t take me nearly as far, but fortunately I had a couple more of them to offset their loss in global purchasing power.

    Unless you traveled beyond US borders, you probably haven’t noticed such a drastic change in your own purchasing power in the last decade.  Most people don’t have a very good sense of how valuable the dollars we hold in our bank accounts are relative to other currencies and assets.  But if you’ve owned gold, effectively a neutral, global currency, you’ve noticed it trend straight up and a big reason is the decrease in value of the dollars in which it’s denominated.

    The point here is that since it’s priced in dollars, gold is very dependent on the relative value of those dollars and the future price of gold is inextricably linked to the fate of the world’s paper currencies.  Dollar-denominated gold will perform much better when the US Dollar is under substantial pressure.  Dollar strength typically tends to be a fairly large headwind for gold.

    The difference is subtle, but Gold is your hedge against dollar weakness, not inflation.

    4) Trading it will drive you bonkers.

    Like I said a few months ago: Gold never moves the way you think it will.  It never tells you what you think it’s telling you.  And it does strange things for even stranger reasons that no sane person can hope to understand.  Investors who own gold for the long haul love it, but I’ve yet to meet the trader who hasn’t been driven completely insane by the gold market at some point in his career.

    The reason why it’s so tough to trade is that it’s so difficult to predict where gold is heading over the short run.

    Gold-Jun10

    Does that chart keep moving higher over the next few months?  Do you really trust gold to adhere to follow pattern?  It looks like an easy answer, and were it anything other than gold, I might take a shot at answering it.

    Over the long run, it’s easy.  Gold will exhibit inverse correlation with the dollar and over the long, long run the dollar is a sure bet to get weaker relative to the amount of goods (or other currencies) that it can purchase.  I think the single best bet an investor can make today is that 100 years from now each US Dollar will buysubstantially fewer goods & services and be worth substantially less against a hard asset like gold.

    Check this out:

    image

    The red lines measure the trailing 1-year inflation rate.  The green line, measured on the right axis, shows the purchasing power of the dollar.  Today each US Dollar is worth about 96% less than it was worth in 1900.  You can see that dollars are a bad investment over the long run, and incidentally, this is why people demand interest when holding dollars on deposit at a bank.  If I’m going to let you hold one of my dollars for the next year, you’d better give me more than my one dollar back a year from now because I can be fairly confident that that one dollar will be a little less valuable relative to what it can purchase.

    The more inflation that’s expected, the more interest that’s demanded.  This is why it’s usually a little better to look at something like the bond market to get a read on future inflation than the gold market.

    Gold doesn’t necessarily go up when inflation is expected and it won’t necessarily rise to the degree to which inflation is expected.  Sometimes it does.  But usually it doesn’t.

    Interest rates are a much better indicator here.  They typically go up when inflation is expected, and the more they go up, the more inflation the market’s expecting.  Predictable reactions like this make bonds a whole lot easier to trade than gold.

    ---

    Stay tuned for Part 3!



    Disclosure: Long GLD

    Disclosure: Long GLD
    Themes: Gold, Commodities, Metals Stocks: GLD
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