With gold prices and investment demand rising, gold has once again become a topic of conversation in polite society. This is good news for the gold mining community but it has its negative consequences. One consequence is that more people are pontificating on gold than in the past.
Gold always has attracted people who fervently believe things about the metal, regardless of their truth. This time around, the old-line prophets are being joined by a host of novices, adding to the cacophony in the market. On top of this, mainstream business publications continue to reduce their coverage of gold and other commodities markets, even in the face of the largest, most-sustained bull market in commodities since the 1940s.
Which prompts me to shed some light on some of the common myths associated with the gold market. One such myth is that gold prices trade closely to those of petroleum. Another is that gold prices trade obversely to the U.S. dollar’s exchange rate.
One hears with all-too-great frequency that gold trades closely with oil, or with the U.S. dollar. In fact, neither is true. The price relationship between gold and these other assets varies widely over time — and always has. The only periods when this does not hold true is when the prices of gold, oil, and the dollar have been fixed by government decree or market-dominant entities.
A common mistake is to take an average over time and conclude that it’s the normative relationship. For example, a gold market commentator will say that the gold-oil ratio ought to be 18.5 barrels of oil per ounce of gold, since this has been the average since 1968. The illogical extension of that thought is that the ratio, recently around 7.8, suggests that gold prices ought to rise forcefully relative to oil prices. In fact, the ratio says nothing of the sort. This ratio provides no real information or intelligence about where gold and oil prices ought to move, only where they have been.
The gold-oil ratio chart (see the accompanying tables) illustrates that this average masks an enormous range of experience, ranging from 10 barrels per ounce three times since the late 1960s to more than 35 barrels twice.
This shows that gold is currently underpriced relative to oil when compared against history. That neither means that gold prices need to rise, nor that oil prices need to fall. Whether either of those statements is true or false will be determined by the future trends in their respective commodity markets.
Another falsehood being bandied about relates to gold’s relationship with the dollar. Gold trades against the dollar, we keep hearing. In fact, the statistical correlation between gold price fluctuations and the U.S. dollar’s exchange rate has been 7.3% since the dollar was floated in August 1971. That means anyone trading gold off of the dollar would have lost more than nine times out of ten throughout history.
Recently, from July 2003 through March 2005, gold traded closely to the dollar — with an 83% statistical correlation to the dollar-euro exchange rate. That ended in March. In the second quarter, this relationship dropped to 36.7%. Gold was trading more in line with oil and other commodities, while the euro was weakening due to skepticism about European economic growth and political cohesion. Since the beginning of July, the euro has begun to come back in line with gold, oil, and other commodities.
Related to this is the view that the dollar should collapse in the near future, and that gold consequently will rise sharply. Yes, the United States is a debtor nation extraordinaire. The U.S. government and its constituents have problems with debt and overspending. The difficulty with projecting the imminent demise of the dollar over the next few years is the question of where the money will go. The world would dump dollars, if there were a suitable alternative. The euro? Yuan? Yen? Sterling? Gold? In fact, all of these probably will benefit over the next few years from exploding U.S. debt. The decline may not be as cataclysmic, though, as the prophets in sackcloth and ashes would have one believe. Too many creditors have too much at stake.
Let’s look at history. The dollar lost roughly one-third of its value from early 1985 into 1987. It then slid at a slower rate over the next seven years, before rising around 39% from 1996 to 2002. Now it has dropped sharply again, something less than one-third over the past three years. Does the cycle repeat itself? Does the dollar drift for a while, and then stage a rebound the way it did in the second half of the 1990s into 2002? Or is this the end of the dollar? A dispassionate, intellectually honest analysis of the future of currency markets does not lead to the foregone conclusion that the dollar must plunge in value within the next few years. Only simplistic analyses yield this conclusion. That is why the dollar has not fallen further already, and why the wisest currency market economists in the world are universal in their issuance of highly nuanced analyses concerning the future of the dollar and the international currency regime. The end of the dollar has been broadly forecast by prophets since the 1960s. Someday it will come. But when?
One often hears that no monetary system without gold as its base has ever survived. That’s true. But it is also true that every monetary system based on gold has met its demise. In fact, no monetary system other than the current one has ever survived. The lesson learned is that monetary systems end, not that monetary systems unrelated to precious metals collapse.
One of the most worrisome aspects about all of this is the degree to which market participants, from journalists to investors to mining managers, often refuse to consider to the veracity of the truisms they are being fed. Commentators say things about gold, its relationship to oil and the dollar, and other aspects of the market, and these often are accepted without critical analysis. If gold were a security, these people would be committing securities fraud. In the commodities markets, there are no laws protecting investors, gold mining executives, and others from a steady barrage of commentary that may be based on nothing more than a writers’ whim.
Gold market participants need to be that much more vigilant about their beliefs. The steady flow of bad information in the gold market, meanwhile, opens up opportunities for those who can distinguish good from bad, and who can position themselves for the corrections that inevitably follow markets that overshoot economically viable levels.
— The author is managing director of CPM Group, a New York, N.Y.-based precious metals and commodities research and consulting company. For more information, visit www.cpmgroup.com.
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