Since reaching an all-time high of about US$1900 in 2011, gold prices have dropped by over 35%. The other week gold fell to a three-year low. Is gold cheap, underpriced? Is it time to get back on the gold gravy train? What does the future hold for gold?
In answering what is next for gold, it may be instrumental to see the reason for its meteoric rise. The primary force behind gold’s rise in the 2000s was investors’ conviction that gold would act as a haven against a long-run increase in inflation and the related debasement in the value of the U.S. dollar. Moreover, buying gold afforded one protection against a myriad of unknowns unknowns, both political and financial around the globe. The latter reason was a popular belief.
The former was the real reason. Let me explain with the help of the accompanying chart (click chart to see details).
There are two primary factors that affect the value of gold – both related to inflationary expectations. One is money supply (M1) and the other the velocity of money (M1V). Velocity of money flatlined between 1984 and 2004. Dollar changes of money supply did the same between 1984 and 2007. Combining velocity of money and the dollar change in money supply reveals a picture of relative stability between 1984 and 2007. Over that period gold prices flatlined too. The sharp rise of gold did not start until velocity of money started to rise in 2004 and the money supply (M1) took off in 2008. Between the end of 2007 and the end of 2011, gold rose by about 140%. The velocity of money rose from about nine times in 2004 to about 11 in mid-2008. Money supply went from an average monthly dollar change of US$58 billion per month in 2008 to about US$300 billion per month in 2012. The dollar change in M1 peaked at the end of 2011 and has been going down since. In 2013 it has averaged about US$240 billion per month with the latest available month in 2013 hitting US$200 billion. The velocity of money peaked in mid-2008 at about 11 times and has been going down ever since, with the latest data showing money velocity at 6.6 times.
The declining combination of these two key variables has led to a sever downgrading of inflationary expectations by investors. There was nowhere for gold to go but down as there is an 80% correlation between gold prices and the four quarter moving average of dollar changes in M1 times M1V. As this moving average started to sharply decline in mid-2012, so did gold prices.
The miscalculation investors made in gauging the directional momentum of gold prices and its duration was that they focused on only one of the drivers of inflationary expectations and its effect on gold prices – the money supply and its apparent influence on inflationary expectations from historical experience. For example, M1 had been increasing at an annual rate of about 11% between the end of 2007 and 2012. A similar increase in the 1967-1974 period led to inflation of about 9% in 1974-1981. During the inflationary years of 1974-1981, the U.S. dollar fell and gold prices rose – the G10 index of the exchange value of the U.S. dollar went from 100 in July 1974 to 84.6 in July 1980, whereas gold soared from about US$200 to US$600 over the same period. As a result, investors reckoned that the dramatic expansion of M1 and the phenomenal, for historic standards, increase in the liabilities of central banks around the world would increase inflation in the long run and debase the value of the U.S. dollar. And gold would be a safe haven against both. But investors forgot or misjudged the other necessary condition for inflation to pick up – velocity of money. In the 60s and 70s, money supply was rising at the same time that the velocity of money was increasing. Between 1960 and 1979 M1V rose from about four times to about eight times. This fuelled the effect of money supply on inflationary expectations.
The experience since 2008, however, has been different. Money supply was increasing at the same time that M1V was falling sharply, neutralizing the effect of money supply on inflationary expectations. M1 increases also started to decelerate since July 2012, reinforcing the downward pressure on inflation. This realization caught up with gold prices, particularly vigorously over the last year or so.
History’s lesson? In the long run, gold is not a good investment. It may be a good short-term investment. To make money in gold, investors must be good market timers. But that’s not easy for most – it is hard to identify the peaks and the troughs. Investors had been buying gold on the expectation that the price would keep rising and they would be able to sell at a higher price. Yet, commodities and gold are cyclical. They go up and down in price; they do not go only up.
If you had invested $1 in gold in 1802, it would have grown to only $1.95 in real terms by the end of 2006. A study by Merrill Lynch looked at the performance of 10 different asset classes over different rolling periods between 1970 and 2007 – the worst-performing asset class was gold. In fact, history shows that the longer you hold gold, the worse it is.
What happens now? As long as M1V continues to stay low, gold, as an investment, will disappoint. But watch out for when M1V bottoms out. This is because, while the increases in M1 have significantly slowed down, M1’s dollar changes are still high by historical standards. And inflationary expectations can flare up as fast as they were extinguished.