Wednesday, July 7, 2010

The Many Faces Of Gold

¹²The Many Faces Of Gold

By Contrary Investor | June 2010

Who isn't talking about gold these days? Maybe that's more the appropriate question than not. Of course dial the clock back seven to ten years and serious discussions of gold set against the context of the macro credit cycle, monetary and fiscal policy, etc. were almost strictly confined to the perma bearish underground [[the TEOTWAWKI— 'The End Of The World As We Know It'— crowd: normxxx]]. But, certainly gold is no longer in the underground.

Well above ground and gaining more widespread recognition by the day as many of the former bearish underground rationales for accumulating and holding gold are now coming true right before our eyes and clearly entering mainstream debate, if not conviction. It's time for a quick little review, but what we hope to accomplish in this discussion is twofold. We want to have what we believe is very much an unconventional look at gold that we really have not seen in this conceptual format anywhere else.

As you know, charts of gold relative to the major global currencies are a dime a dozen. We don't want to waste your time as you can find them anywhere and everywhere across the net. Gold is breaking out really against all global currencies. That's not new news. The Dow and S&P expressed in terms of gold, etc. Pretty conventional stuff in terms of more mainstream commentary and analysis.

We're going to have a look at gold relative to what we believe are the important historic economic markers of the real economy itself. And it just so happens that this little view of life dovetails into the second purpose we have in presenting this review. We know you've seen a number of pundits predict $2,000 gold, $3,000 gold and even perhaps a moon shot to $5,000 gold and beyond.

Yet so much of what we see with these predictions is accompanied by little to no concrete numbers based rationales as to why any of these numbers might make sense or eventually become a reality. Well guess what? We'll give you some numbers based reasons as to why all of these projections could indeed come true based on actual historical precedent grounded in the reality of the real economy itself. Let's get to it with some preliminary thoughts.

First a little watch point for the three to four months coming at us dead ahead. It just so happens that literally just a few weeks back the large commercial players had a record short in gold as per the COT data. Either these sharp shooters will be correct and gold is setting up for a perhaps meaningful pullback, or this is rocket fuel for a short squeeze of perhaps some magnitude. We wish we could tell you which, if either, of these two events is coming, but no one knows with any certainty.

What we do know is that over the June through August time frame immediately before us, gold will be entering its historical calendar based period of relatively consistent seasonal price weakness. As you can see in the chart below, after that it's back to the September through February period of meaningful seasonal price strength. What we believe will be very important is to watch just how gold acts during the upcoming weak calendar based period. Much as gold has been ascending even as the dollar has done the same— really over the last three to four months— will the price of gold continue to move higher and essentially break ranks with past calendar based rhythm? Stay tuned as gold will be telling us a "story" about its ongoing bull market journey over the summer of this year.

A few more quick little looks back before we get to the economic comparatives we promised that cause us to "dream" about potential asset values and price trajectories ahead. Although this is sure to sound melodramatic, we'll suggest to you that the prior decade of the 2000's was a bit of a ground breaking exercise for gold set against the context of the postwar US economic period up to that point. The following chart is the month end price of gold from the early 1970's onward. Of course we have drawn in the official periods of US recession with the red bars. Notice anything?

Of course you do. From the 1970's through the 1990's, in the immediate aftermath of every official US recessionary period, gold prices declined. There are no exceptions, even after the very mean mid-1970's economic downturn when the trajectory of inflation in the US was about to change generational viewpoints and behaviors. As is clear, the price of gold has now risen after both the 2001 recession and the Great Recession we have just lived through.

This is more than noticeable change. Gold is saying something very different about the character of the current macro financial and economic environment. And it turns out it's not alone in voicing that opinion. What we also know is that in the near perfect clarity of hindsight, equity prices peaked on an inflation adjusted secular basis right in front of the very recession after which gold changed its post recessionary character— and that change in behavior has now been consistent right up to the present. But it's not just gold that has changed its supposed traditional behavior. Not by along shot.

Just what the heck changed in the early 2000's that would have disrupted what investors had come to expect from the behavior of gold and equities in general? Although it's just our little viewpoint of life, we believe the key change is captured in the narrative within the chart below. We're looking at total US credit market debt relative to GDP. The chart below really covers the bulk of the period over which we looked at gold in the above chart.

The official Fed numbers go back to the early 1950's, but unofficial numbers date back to the early part of the last century. Okay, here's the point. Historically the prior peak for this ratio came in 1934 very near 260%. Of course at the time this ratio was driven by a collapse in US GDP, not necessarily a spike in credit acceleration.

And guess what happened as we moved into the decade of the 2000's? That's right, we crossed the credit cycle "Rubicon" and boldly went where the US economy and financial system has never gone before— above the 260% historical peak in the ratio of total US credit market debt relative to GDP. Moreover, in the current cycle this phenomenon was not driven by a collapse in GDP, but a generational character change in the acceleration of credit outstanding! Implying? The US economy has never been this highly levered based on credit intake.

As gold bottomed at the time early in the last decade, was it one of the few asset classes to initially sit up and take notice of this historic change? Was it one of the few asset classes starting to price in the potential consequences of having crossed the proverbial credit market Rubicon of the prior historical peak in the credit market debt to GDP ratio? Was gold quietly saying then and has it been saying ever since, "okay, that's enough, I've had it"? The fact that this character change for the pricing of gold coincided with a secular equity bull market peak is no coincidence.

Once In A While You Get Shown The Light In The Strangest Of Places If You Look At It Right— But Onward.

Let's have a look at a number of relationships we believe are a bit unique in terms of the historic and current analysis of gold relative to the character of the real US economy itself. You'll have to bear with us on a few of these relationships and keep an open mind as we believe these are clearly a good bit non-conventional in nature. As we suggested to you at the outset of this discussion, we see little in the way of hard data quantification when we watch various pundits project bull market price possibilities for gold in current analyses.

Most of those numbers seem to have been pulled from out of the blue. But, as it turns out, many of these "guesses" actually represent realistic possibilities more often than not. Please remember, the correct characterization here is "price possibilities", not "price guarantees". Okay? As you already know, there are few guarantees in this wonderful world that are not rather somber in nature (death and taxes being the two most highly touted).

We'll start with a quick peek at the historic price of gold relative to the official CPI numbers. In other words, gold relative to the general 'reported' level of US price inflation, which we all know is understated. The first observation here parallels the comments about gold in post recessionary periods after 2000.

This ratio always fell in post recessionary periods over the 1970-2000 time frame. But that all changed over the last decade. We do need to wonder that if the CPI calculation itself has changed so many times under so many political administrations since the 1970's whether all of these historical numbers, and the gold relative to CPI ratio itself by extension, is directly comparable over that period? Probably not, but we need to work with what we have. Of course, what we have done in the chart is to equate the prior peak ratio seen in the late 1970's/early 1980's to the present level of the CPI. As stated in the chart, the peak ratio relative to the current CPI number would project an approximate $1,900 level for gold.

But c'mon, we just can't trust those CPI numbers, right? That current ratio would be much higher if CPI were reported properly, correct? Well, let's look at something that has not been adjusted in terms of its reporting and is expressed in nominal terms. Exactly as gold is priced in nominal dollars. Okay, here comes the unconventional stuff, as we promised.

Below is a look at gold relative to the history of average hourly wages. Yes, we know the ratios look a bit staggering in terms of percentage levels, but it's the simple division of the gold price by average hourly wages over time. At the peak of gold prices based on month end pricing which occurred in January of 1980, gold was priced at $681.50 while average hourly wages at the time clocked in at $6.19.

Yes, it took 111 times the average hourly wage to buy one ounce of gold. Imagine the average worker having to work close to a month (if we adjust for taxes on wages) to buy an ounce of gold. That indeed was the reality at the time.

As we detail in the chart, equating that peak ratio in January of 1980 to the current average hourly wage would project a gold price of a touch above $1,900. Imagine that, the projection is exactly on top of what we saw with the ratio of gold to the CPI at its own peak. Maybe that darn CPI was not too far off the mark? Again, although a lot of these gold bull market projections seem farfetched on face value, the reality of historical experience tells us they are clearly not out of the question.

Okay, here comes a wild one. The price of gold relative to bank loans and leases outstanding. And yes, another wild one in terms of the percentage ratio in nominal terms. At the moment, we're examining a $1,200 gold price relative to $6.9 trillion in bank loans and leases outstanding. That's why the ratio numbers look so crazy.

But as you know, it's not the exact numbers that make up the ratio that are important, but rather it's the historical levels of the ratio and where we now sit against historical precedent that's the key comparator. Okay, you've seen Doug Casey and a number of others throw around the $5,000 gold price as a possibility. Nuts, right? Simply ranting and raving. Pure gold bug stuff.

Although most would dismiss this number out of hand, we suggest you at least assign it some level of probability, however small, in terms of possible outcome. This ratio captured in the chart below is exactly why. And you already know that conceptually we are looking at a proverbial hard asset relative to a credit cycle based paper relationship. Again, think about the crossing of the macro US credit market cycle "Rubicon" level of 260% we discussed above.

Of course, directly related in concept to what we looked at above is the price of gold relative to the US M2 money supply outstanding at any point in time. Once again, the proverbial hard asset price versus paper money level relationship. Based on current M2 numbers and using the ratio at the historic peak, the price of gold projects to a bit over $3,900 per ounce.

As a total aside, and in the interest of not dragging you through another chart, imagine what you see above is a stock price. Would you buy it or sell it at this point? From a technical perspective it's just about the very definition of a perfect rounding bottom chart formation. As with virtually all of the charts we have shown you so far, we could draw in all of the higher highs and higher lows, perhaps in some cases excluding the 2008 macro market and temporary liquidity plunge. Technically they are all bullish chart formations and many "project" technically much higher.

As you'd imagine, we could go on and on with the comparisons of gold relative to real world economic markers, but will end it right here with a look at one last ratio related to US household net worth. Important? Why? As we see it, one of, if not THE, most important investment objectives especially for individuals looking ahead is the maintenance of purchasing power of existing capital. So, here's a quick peek at the price of gold relative to household net worth.

Again, we're comparing gold at hundreds and thousands of dollars with household net worth numbers in the trillions. But it's the rhythm of the historic relationship that's important here, as it has been in all of these comparatives. One last time, if we took the prior historic peak and equated it with current household net worth as of the latest official 4Q 2009 numbers, gold projects to $3,320.

We know you get it. We just hope it's helpful to put some real world longer term price and economic relationships behind these seemingly crazy gold price projections of the moment. Something in the $2,000-$5,000 range for gold is certainly no guarantee, but likewise not at all out of the question based on direct historical precedent. No ranting and raving. No pulling what seem like wild numbers out of the blue. Prices based on human behavior and decision making we have indeed directly experienced in the past.

Before moving on, a bit of very quick self examination. As you are all too aware, in the historical chart exercises above we marked all ratios to the prior peak seen in late 1979/early 1980 to come up with these potential projected gold prices. Just how fair is that? After all, that was a bubble peak that has stood the test of time up to the present as far as these relationships are concerned.

Yes, we've passed that gold price peak in nominal dollar terms, but in inflation adjusted terms we're still a good ways away. Fair enough, and a criticism that at least needs to be acknowledged. So we do. But we believe it's also more than fair to point out the very meaningful and really global macro economic and financial market differences between the current period and that of the late '70's/early '80s.

These differences? Well, do you have a few hours for us to go over them? The highlights of course being levels of leverage in the economy both domestically and globally— night and day differentials. Derivatives— loaded to the gills now versus nonexistent then. Currencies— currency meltdowns back then were relegated entirely to third world economies (with perhaps a few second world economies here and there) as opposed to the major developed G7 economies. And globalization was not even a concept at the time.

So, although we have indeed used prior peak comparatives, we believe we can all agree that the current global cycle is generational in terms of compare and contrast differences. Again, we're not making predictions here. We're simply pointing out how human beings have acted within historical context to price the barbarous relic that just may turn out to be not so barbarous after all, nor a relic for that matter. As always, keep an open mind.

[ Normxxx Here:  CAVEAT: As you are aware, the vast percentage of gold above ground is owned by the Central Banks. Until the last few years, the CBs were not accumulating gold and, indeed, were net sellers for the most part. But, in recent years, most CBs have become net buyers— it's about the only safe way to move out of dollars.

Nevertheless, the CBs can be expected not to take kindly to any explosive increase in the value of gold (especially in dollars); such an event would quickly devalue their own currencies, since by far the bulk of foreign reserves are in dollars (China and Japan together holding in the neighborhood of $2 trillion dollars between them). Therefore, any sudden upward moves can be expected to be quickly squelched by a relatively tiny sale of gold from the CB's gold hoards. This means that any upward movement in the price of gold will be very volatile and probably take place over
years as the CBs also accumulate gold— in between engineered price drops to shake out "the speculators".

My modest suggestion would be
NOT to buy any gold using leveraged money— and be prepared (especially psychologically) to weather drops in price of as much as 50%. Timing gold and gold mining stock purchases is a very complicated subject and well byond the scope of this paper or this comment. Richard Russell may have the best idea— accumulate gold with 'spare' money and never intend to sell except in the direst of emergencies (think of it as your legacy to your heirs).  ]


The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

No comments:

Post a Comment