Gold Fire Sale
Adam Hamilton July 28, 2000 3966 Words
The most important fundamental issue to understand prior to committing capital to an investment is valuation. Initial valuation is usually what makes a particular investment decision a towering success or a dismal failure. Even risk takes a backseat to valuation. Imagine you learn of a perfectly risk-free investment that pays $100 cash every year. In this mental exercise, imagine there is zero risk of default and no exogenous factors that can affect the future stream of cashflows spun off by the investment. Is this a good or a bad deal? There is absolutely NO way of evaluating that question without the initial valuation. If you pay $1 for the $100 annual cashflow stream, you are a hero and deserve to be in the hallowed investor hall of fame with Graham and Buffet. If you pay $10,000 for the same $100 cashflow stream, you are a goat and will soon be flat broke, or worse! EVERYTHING else about investing pales in importance in comparison to initial valuation. After all, the path to investing success is summarized in the all important axiom, “Buy LOW and Sell High!”
No one, not even the most rabid stock market bulls, will argue that the US equity markets are UNDERvalued. The fact that equity valuations far exceed all historic norms and historic excesses is undisputable, and is a straw man … easy to knock down and easy to prove. In historic times following equity overvaluation, the asset of choice to own has been gold. Are we entering another “golden age” for the recently much maligned yellow metal? Is gold overvalued or undervalued at the moment? If it is overvalued, there is no sense in buying it. If it is undervalued, however, the potential returns on gold as the fractures cascade through the US equity bubble could be legendary. A vast array of methods exists to analyze gold valuation. In this essay, we will focus on examining the current gold valuation (around US$280 per ounce) from the perspective of current general commodity valuations and the current interest rate environment.
Commodities may be defined as a physical substance that is essential and fungible. Fungible simply means any one unit of a commodity is perfectly interchangeable with any other unit of the same commodity. For example, a bushel of a certain grade of wheat is functionally identical to another bushel of the same grade of wheat. An ounce of gold is an ounce of gold … no particular ounce is less valuable or more valuable than any other ounce. As a further qualification, in order to be classified as a commodity the physical substance must be bought and sold by speculators and hedgers in a commodity or futures exchange. Today certain intangible purely financial products, including equity index futures and foreign currencies trade on exchanges and are called commodities, but they are ethereal and fall short of the classical definition of a commodity.
In both the ancient and modern worlds, it is almost impossible to overstate the importance of commodities. Every empire in the history of humanity only became an empire because it was able to acquire adequate amounts of crucial commodities (by purchase, theft, or conquest) and it was able to distribute those commodities internally to satisfy the perpetual needs of its populace. The great cities of world history could not have formed without careful management of scarce commodities. One of the greatest empires ever, built by the incredible Romans, offers many compelling examples of just what lengths a state will go to obtain commodities. Today, many of us tend to make the false assumption that the ancients were primitive. Sure, they didn’t have color TV or microwave ovens, but their amazing accomplishments in finding, producing, and distributing commodities are almost unequaled to this day. In order to feed the growing population surrounding the city of Rome, for example, the Romans built a huge fleet of grain freighters that sailed back and forth between various Roman ports and the breadbasket (at the time) of Egypt. Some historians estimate there were hundreds of dedicated wheat ships, and, amazingly enough, many were comparable in size to large commercial freighters today (excluding supertankers). Some of these vessels had crews exceeding 275 men! The fleet sailed whenever weather permitted, only sitting out a few months of winter when the Mediterranean tended to boil with fierce storms. The Caesars of Rome realized that without wheat to make food, the empire would rapidly disintegrate. In another spectacular achievement, which some consider on par with the Pyramids and Great Wall of China as a wonder of the ancient world, the Romans literally destroyed a mountain to get gold. In what is now known as the Medulas in the Leon province of northwestern Spain, Roman engineers pulled off a feat so audacious the results are still easily visible to this day. The Romans found mountains full of gold, and they needed vast amounts of gold to finance their ever campaigning legions, which were continually busy terrorizing the world. In order to recover the gold, the engineers dreamed up an ingenious plan to replace conventional mining techniques, which were considered too slow. The engineers began building dams high in a neighboring mountain range to catch melting snow in huge reservoirs. They built mammoth canals, many miles long, from the mountain reservoirs to the mountain containing the gold ore. In the shadow of the gold filled mountain, on a broad, almost flat valley, they dug a complex network of canals and catch basins. Finally, the engineers laid out careful plans on how to burrow into the gold bearing mountain, with slaves performing all the brutal physical labor necessary to build the intricate network of tunnels. When the project was finished, the primary mining tunnels covered an area of almost 4 square miles, with many complex interlocking vertical levels. The total canal system included over 60 miles of carefully constructed waterways. Before the slaves were even out of the mine, the Romans gave the order to seal the exit shafts. The great dams in the mountains were then burst, and a deluge of water roared through the canals and into the honeycombed mountain containing the gold. The intense hydraulic pressure literally shattered the mountain in a matter of minutes, and the whole monolithic chunk of earth and rock disappeared and washed into the broad valley below full of canals and catch basins. Another group of slaves painstakingly removed the dirt and rock debris from the catch basins and recovered the valuable gold ore. The Romans were able to recover an enormous amount of gold with relatively little labor. The spectacle of the mountain imploding had to be one of the few things in the ancient world that compared in fury to a small thermonuclear explosion! The empires’ of antiquity entire existences revolved around commodities.
In modern times, although many believe otherwise, commodities are still vastly more important than intangible financial assets. Another thought exercise… Visualize any large city of 1 million people. Now take away all external sources of money and capital for two weeks, what happens? Some businesses will fail as they are unable to scrounge up sufficient working capital, some people will not be paid, some projects will be delayed or cancelled, but life will go on. Now visualize the same city, but eliminate all external sources of commodities. With no wheat or food products, the unfortunate residents will be out of food in less than 72 hours, and riots will begin within days as hungry people demand food. With no oil or petroleum distillates, commerce will soon grind to a halt and the city will immediately cease to be productive. The same thoughts may be expanded to encompass entire countries in our modern world. Capital and financial instruments are definitely important, but they are a distant second in importance to crucial commodities, even in our current high technology global economy.
Today, one of the easiest and best proxies to monitor the commodities markets as a whole is the Commodities Research Bureau Futures Index (CRB). Created in 1957, the index was designed and calculated to provide a dynamic perspective on price movement trends in a broad base of important commodities. Although the CRB originally included 28 commodities, it has been pared down to represent 17 important commodities today. These include corn, soybeans, wheat, cattle, hogs, gold, silver, copper, cocoa, coffee, sugar, cotton, orange juice, platinum, crude oil, heating oil, and natural gas. The calculation of the index is quite complex, but the results are a balanced view of general price levels and trends in the entire commodities market.
Although gold has always been and always will be the undisputable king of commodities, it has a relatively small influence on the CRB index. Naturally, the correlation between general commodity price levels and the price of gold has been quite high in the recent past. By analyzing the CRB index and gold, we can begin to determine whether gold is undervalued or overvalued relative to the broad basket of important commodities. Here is a chart of the CRB Futures Index and gold since 1960…
The correlation between the CRB and gold has been a stellar 0.91 since 1960. One of the first attributes of these data series that stands out is the incredibly calm and sedate commodity price levels that existed before 1972. The CRB traded close to 100 from its inception to 1972, as stable commodity prices greatly aided the booming economy in the United States in the 1960s. On August 15, 1971 President Richard Nixon led the United States of America to default on its international obligation to redeem dollars for gold. This notorious date of infamy is represented in the graph above by the vertical black dotted line. As the last vestiges of the gold standard were severed, prices of everything began to gyrate wildly, in volatility that continues to this day. Without the discipline imposed on the dollar by gold, the new unbacked fiat dollar is still being created out of thin air at a relentless pace, resulting in incredible inflation and price volatility since that fateful day. In the last 40 years, there have only been five major rallies in the CRB, which are numbered in the graph above. The green dots represent the starting point of each rally, and the red dots represent its termination. How did gold perform during these major CRB rallies? Extraordinarily well!
The numbers in the left column in the table above correspond with the five major CRB rallies outlined in the previous graph. Drilling further down into the CRB rallies, we learn that the average major CRB rally boosted the index by nearly 60%. The rallies lasted an average of 32 months, with only one significantly shorter rally. Interestingly, in these times of rising commodity price levels, gold more than doubled the average gain of the CRB, weighing in at an impressive average 126% gain. Only once, in the third major CRB rally lasting from late 1982 to early 1984, did gold decline in value. This is likely attributable to several factors. First, when that particular CRB rally began, gold was trading at $436 per ounce, above its recent historical average price. From 1974, just after private gold ownership in the States was once again legalized, until today, the monthly closing gold price has averaged $337. Second, the CRB rally was shorter and of a smaller magnitude than the other CRB rallies. Finally, the third rally was a temporary upward jump in a down trending CRB, and did not begin at a long-term CRB bottom. Over all, the data is quite compelling in favor of major CRB rallies being accompanied by major rallies in the price of gold. Has a new CRB rally (number six) recently begun? What does it bode for gold?
Observing monthly data since 1995, we can see the CRB appeared to make a major bottom in early 1999. In the last 18 months, the CRB has risen over 20%. Gold, however, has been uncharacteristically lethargic as the CRB rockets up. History would suggest the CRB rally has a high probability of lasting until the autumn of 2001 (32 months), and approaching a CRB Futures Index level of nearly 300 (+59%). Historical experience also leads us to believe gold should jump from $287 when the CRB rally began to an incredible $650 per ounce (+126%) before the CRB turns decisively south again! Even being more conservative, we should at the very least expect gold to move substantially above its 25 year nominal mean price of $337 per ounce. A modest 20% gain in gold from $287 would lead to a price around $350 per ounce. Looking at gold relative to the CRB, it appears that gold is substantially UNDERvalued at $280 and ready to make a great leap to the upside. With the CRB arrow now in gold bulls’ quivers, we will take a brief look at gold’s current valuation from another perspective... the current interest rate environment.
Just as every commodity has a price, the price of money is known as interest rates. General market interest rates are very dependent on current inflation. Today, the widely accepted definition of inflation in Wall Street circles is an increase in general price levels. This is not entirely correct, however, as inflation can be more specifically defined as an increase of the money supply at a faster rate than the rate new goods or services are produced in an economy. The word “inflation” is not a reference to inflating prices, but a reference to an inflating money supply. Money can be saved, taxed away, or spent, and inflation results when relatively too much money is chasing relatively too few goods. As money becomes less scarce, it takes more of the money to buy everything, and general price levels increase. Throughout history, the vast majority of inflation has been caused by reckless growth of the money supply by governmental authorities. This is perhaps best exemplified in John Law’s experiences in France in the 1720s, which were immortalized by Charles Mackay in his 1841 opus magnum Extraordinary Popular Delusions and the Madness of Crowds. John Law, a British rogue who murdered a rival in a duel and had to flee England for France, managed to convince the French King that endless prosperity would ensue if only enough paper currency could be printed to supply the needs of the French economy. When business was booming, the French government was to provide more of this inherently worthless fiat (backed by nothing, just paper) currency, and when business slowed, the government was to buy back the fiat currency. What had seemed like a good idea at the time ended up almost destroying France. With more money chasing relatively fewer goods and services, uncontrollable price inflation raged in France. Gold rocketed up in value, signing the ultimate veto on the worthless French scrip. In a vain attempt to fight gold, the King of France outlawed private gold ownership and attempted to fix the gold price. Gold has won every battle against fiat in history, however, and soon broke free of the French government’s shackles to reach astounding valuations. Many would say France has never recovered from this episode in history, as its current financial and commodity markets are much smaller and much less important than European neighbors England and Germany. The consequences of unrestrained currency growth can be dire indeed for a nation…
Interest rates and gold have long had a strong positive correlation. During times of high inflation, interest rates climb as creditors demand enough of a return to offset their annual loss from inflation. If inflation is at 10%, for instance, and general interest rates are at 12%, the real rate of return for the creditor is only 2% annually. 10% inflation means a dollar spent a year from today is worth only 90% of a dollar spent today. Inflation can be very insidious in eroding investor wealth, as most people saving and investing do not realize they are losing their purchasing power through inflation until it is too late. Although inflation is not the only variable affecting interest rate levels, it is certainly one of the most important. Gold tends to shine its brightest in times of inflation. There are a myriad of interest rates we could analyze in relation to gold valuations, but we will use the prime rate in this essay. The prime interest rate is the lending rate which banks charge their most credit-worthy customers. Many important consumer interest rates are pegged off the prime interest rate as well, including mortgages, automobile loans, and credit card debt. Before we jump into gold valuation relative to the prime rate, here is a quick graphical look at CRB futures and the prime rate since 1960 for reference…
As expected, the CRB and the prime interest rate have a significant positive correlation. When price levels of commodities are high, generally inflation is a concern and creditors demand a higher return on their money. Interest rates rise. Gold has a similar relationship with the prime rate…
The correlation between gold and prime holds up quite well until 1995, when it plummets from 0.69 to 0.26. In general, as is easily observable above, higher interest rates coincide with higher gold prices, as gold is the ultimate asset to hold during times of money supply inflation. Of particular interest is the recent spike up in the prime, once again nearing 10%. US equity bulls believe Greenspan and the Fed are done raising interest rates, but many respected international and foreign economic entities have publicly and forcefully stated several more rate increases will be necessary to slow down the meteoric US economy to prevent it from burning up and crashing. Although the Federal Reserve does not directly set the prime rate, prime is largely determined by the Fed decreed federal funds interest rate. In general, the higher the prime rate, the higher the inflation in the economy. The higher the inflation rate, the higher the price of gold ascends. Gold valuations tend to be much higher when the prime rate breaches 10%. The table below outlines gold valuations relative to the prime rate since 1974. Each month of this timeframe is analyzed, with the prices of gold in months with a prime rate above or below 10% independently averaged to sketch where gold valuations hovered in differing interest rate environments.
From 1974 to 2000, when the prime rate was greater than 10%, gold had an average price of $383. When the prime rate dropped under 10%, the average gold price declined to $310. As 1974 to 1979 was largely a permanent devaluation of the dollar versus gold, 1980 to 2000 may be a more representative sample to interpolate to our current market situation. From 1980 to 2000, when the prime rate exceeded 10%, gold had an average value of $421 per ounce. When prime dropped below 10%, gold managed to hold on to $358. With interest rates marching northward, and gold currently valued at $280, the current gold price looks like an incredible bargain by historical standards. Even erring on the extreme conservative side, we should expect, at an absolute minimum, gold to gain between 18% (1980 to 2000 … $358 to $421) to 24% (1974 to 2000 … $310 to $383), as the prime rate once again exceeds 10% in the near future. That would conservatively value gold at $330 to $350. There is also a high probability that gold will once again break the $400 level as interest rates continue to rise, however, mimicking its behavior of the last 20 years.
Examining current gold valuations from the perspectives of general commodity price levels and the general interest rate environment has yielded conservative valuation estimates on the ancient yellow metal of $330 to $650 per ounce, much higher than the current market price of gold. This quick and dirty guerilla technical analysis on gold valuation, however, leaves out critical bullish fundamentals for the timeless yellow metal that are highly likely to push it to stratospheric heights exceeding $1500 per ounce when the gold bull market commences…
The US economy is booming, and five years of unprecedented M3 money supply growth is coming home to roost, putting tremendous upward pressure on prices. Equity markets are at dizzyingly high levels, the highest in history. In every era and nation when markets even became close to being valued this dearly, a terrible bust followed the unsustainable boom. The dollar is paradoxically at lofty levels while the trade deficit continues to grow, eclipsing records each month. Oil prices are rising as global oil demand is beginning to exceed the easily available oil supply. Many nations of the world are gearing up for war, including China, Russia, India, Pakistan, Iran, Iraq, Syria, and Turkey. The Palestinians are threatening to unilaterally declare a state in the middle of the tiny country of Israel, potentially throwing the whole Middle East into war. We are moving into the historically volatile fall season, where markets traditionally get hammered. (maybe that is why they call autumn “fall”) Parts of Asia are recovering from their disastrous 1998 currency crisis, and these countries are perpetual strongholds of gold demand. As prosperity increases in the southern Pacific Rim, gold demand will continue to rise from that region of the world. Each of these incredibly important fundamental developments is, in and of itself, very bullish for gold. Put together, it is almost impossible to build a case for gold NOT to rise dramatically in the near future!
Finally, there is what may be the ultimate bullish fundamental for gold. In order to finance investments in the raging US equity markets since 1995, many money center banks borrowed mind-boggling amounts of gold from central banks that they promptly sold to invest the proceeds in the stock market. GATA (www.gata.org) has estimated that the equivalent of all of the gold to be produced in the world for many years to come will be required JUST to pay back the gold loans to various central banks around the world. Without pause since 1995, gold loans have continued to rise. A day draws near, however, when more gold will be purchased to pay back the central banks than will be borrowed, creating a potential once in a lifetime mega rally in gold. Tens of billions of dollars will be dumped into the physical gold market, which is extremely thin. The price of gold will have to rise to incredible levels to reach new equilibrium prices. As an alternate scenario, some inherently unpredictable exogenous event may spook the gold shorts, causing some of them to rush to buy to cover their gold liabilities. As this initial buying spree launches the price of gold vertically, many other entities short gold will become concerned and begin buying physical gold to close out their own short positions, and a sharp, fast, vicious circle to the upside will be sparked. The net effect when the dust clears will be the biggest short covering rally in the history of the world, and gold bulls will reap a harvest that will make 5 years of NASDAQ capital gains look like chump change.
Many factors affect the price of gold, and they are almost unanimously bullish. The probability increases daily that these individual technical and fundamental positives will accrue into a massive rogue wave, catapulting gold to incredible levels. Currently and briefly flirting with 20 year lows, the markets have been generous enough to put on a fire sale in gold. For what will ultimately be pennies on the dollar, today one can acquire gold no one else wants at an unbelievable bargain. With all the turbulence and excitement coming down the financial and geopolitical turnpikes, however, this fire sale will not last for long!
Adam Hamilton, CPA July 28, 2000