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Though written in late 2000, this fundamental analysis holds up well
Understanding the gold price, why it is where it is, why it declined by 40% from February 1996 to August 1999, why the gold industry got slaughtered and why the hedge funds made out like bandits, requires us to look at several aspects of gold and the gold market.
As you will see there is no conspiracy against gold. The major decline in the gold price did not occur because of central bank sales or producer hedging, as many people believe. Instead, a proper analysis of the gold market, and an understanding of foreign exchange markets with the role played by derivatives, sheds light on the real factors that determine the gold price.
These are not necessarily complicated matters as even enormous markets yield to basic economic principles.
[Editor note: While this entire series provides good insights, Chapter 3 stands out as particularly recommended reading material.]
Chapter 1 - What is gold?
Before we delve into the intricacies of the gold market, it would be useful to establish some common ground. You may not necessarily believe everything I propose in this chapter, but humor me. It is necessary to start somewhere and defining gold's role in our society seems to be an appropriate place.
The physical properties of gold
Gold is the most ductile and malleable element on our planet. A single ounce of gold can be drawn into a wire 35 miles long and gold can be hammered into sheets less than five millionths of an inch thick.
Next to silver, gold is also the best conductor of heat and electricity and the most reflective of light. But unlike silver, gold is very resistant to oxidation. Gold is in fact one of the most inert metals that can be found.
These properties are unique to gold and confer upon gold a very special status among the elements. Because of its unique physical properties, and the fact that gold is very scarce, it has long been a sought after metal.
On average, there is less than 0.0001% gold on earth. To find gold is very difficult. To find a large enough quantity of gold so that it would be worthwhile mining it, is a rare occurrence indeed.
Is gold just another commodity?
During the past few years it has often been commented that gold has lost its value as a store of wealth and it now amounts to nothing more than just a commodity. Gold's physical properties are well suited for applications in the electronics industry. In fact, in 1998 just over 15% of the fabrication demand for gold was for industrial purposes while the other 85% was jewelry demand. But if most of the gold in the world is being used to make jewelry, we should first ascertain the nature of jewelry.
Jewelry - commodity or money?
Imagine living two or three thousand years ago and being a successful businessman, traveling frequently to buy and sell goods. Gold is the most accepted currency since fiat money had not yet been created. Fiat currency is currency that can be created at will by a government. It has no convertibility to gold, or any other commodity, and has no intrinsic value. The more prosperous you become, the more gold you have. But where do you put all your gold?
Even if you were not traveling much, where do you store your gold? There are no banks or safety deposit boxes, and who can you trust? The most obvious solution is to carry your gold with you.
But gold nuggets and gold coins are cumbersome to carry around, especially for the more affluent. It would be much easier to wear the gold around your neck or wrist, for example.
It is no coincidence that jewelry, particularly gold jewelry, is a symbol of wealth. It is ingrained in our culture for a reason. Jewelry did not originate as a socially correct gift for the fairer sex; it came about because of practical considerations just like everything else we invented.
Jewelry still has exactly the same status today as it did thousands of years ago. It is much more than an ornament to adorn our loved ones. In India a bride wears all her jewelry, essentially her liquid assets, on her wedding day. In certain parts of the world people still save by buying chains of gold rather than putting money in the bank. Jewelry has its origin as a store of wealth and it still is today.
In the western world most people do not immediately realize jewelry's role as a store of wealth. Our societies have become extremely wealthy compared to the rest of the world and this opulence clouds our appreciation for jewelry, as it clouds our appreciation of money in general.
But men still give women jewelry and the majority of women, when given the opportunity to reflect upon the true value that gold jewelry holds for them, still recognize that jewelry is in fact a store of wealth. Men by contrast seldom pause to think about the nature of jewelry.
My contention is that jewelry's origin came about as a convenient and safe method of storing monetary wealth and that it still plays that role today. By extension, since jewelry represents 85% of the fabrication demand for gold, gold itself is not a commodity, but a store of wealth. Gold, whether in the form of coins, bars or jewelry, is money.
Recent currency crises
If you are unconvinced that government issued fiat currency is a pathetic form of money, consider the lot of those people who suffered through the Brazilian and other South American currency crises from 1992 to 1994, the South East Asia currency crises of 1997, or the Russian currency crisis in 1998.
Many of these people lost almost their entire life's savings because of the collapse of their respective governments' currencies. Gold cannot suffer such a collapse in value because gold cannot be created by any government at will. It is precisely for this reason that governments would like to convince the populace that it should disregard gold as a monetary asset and embrace its fiat currencies.
All previous experiments with fiat currencies ended in disaster. Our history books are littered with examples of empires that were built on hard work and destroyed by a devaluation of their currency. The current fiasco with the US dollar will no doubt have a similar ending, even though not many have the foresight to anticipate the catastrophe. If they did, it would of course never happen, because everyone would prepare for it.
That is the nature of catastrophes, very few people anticipate and prepare for them and so few people survive with their wealth intact. And because most people get blind-sided due to their ignorance, they always believe that it was some kind of evil conspiracy that caused them harm. There is an old saying that fools and their money are soon parted. Well, sometimes it takes a little longer, but it inevitably happens.
Paper currency is only as good as the credibility of its issuer. In essence it is the most pervasive con game on earth. Our confidence in paper money, whether it's dollars, euros or yen, stems from our confidence in the issuing governments. Once a government loses its credibility, the value of its currency declines rapidly, often to nothing. The devaluation of the Brazilian real from 1992 to 1994 is an example of how rapidly a fiat currency can lose essentially all its value.
Gold is money
Gold is the best form of money that we have. It has been shown over and over again that gold does not lose its value as a store of wealth. This was demonstrated in France after the French Revolution, in Germany after the World Wars, in many South American and South East Asia countries during the last ten years and of course in Russia very recently. Those who held a significant portion of their wealth in gold suffered far less than people who had no gold.
The US dollar as a reserve currency
In the United States and Western Europe there is significant confidence in governments right now and therefore these fiat currencies are relatively strong.
Would you trust your entire life's work to the whims of politicians and sleep well knowing that they are looking out for your best interest, or do you think it would be prudent to ensure that your financial well-being is protected by real money?
Gold is indeed the best form of money that we have and gold has not been demonetized. The fact that governments favor their own paper currencies above gold, because they can create them at will, does not mean that the rest of the world's population has to do the same. If all the governments in the world sold all their gold it would be the surest sign that our current social structure, with large omnipotent governments, has come to an end. Whoever owns the gold makes the rules.
The US dollar is the world's reserve currency for exactly that reason. After the US government confiscated its own citizens' gold in the early 1930's, it offered to buy gold from the rest of the world at a substantial premium to the market price at the time. In a very short period, the US government became the largest gold owner in the world. In addition, the US government promised to redeem its paper dollars for gold upon request. Because the US government owned the most gold, it made the rules from then on.
Up until 1971, foreign governments could convert their dollars, mostly held as a reserve currency, into physical gold. But in 1971 President Nixon, realizing that the rate of dollar redemptions would deplete the US's gold reserves, reneged on the convertibility of the dollar and the dollar became just another fiat currency. Unfortunately it was too late for the rest of the world. The US dollar was already the most widely held reserve currency and there was no substitute reserve asset that was backed by gold, except gold itself.
But for the governments of the world to return to the gold standard, which is what they should have done, would be to admit the fraud inherent in fiat currencies. This was politically less palatable than to continue using the US dollar as a reserve currency and take a chance on the US government. This mistake will continue to haunt all governments until the world returns to the gold standard.
Inflation of gold as money
If gold is money, then the annual production of gold from gold mines is equal to the inflation rate of gold. Annual gold production ranges between 1% and 2% of the total amount of above ground gold, i.e. gold that had been mined in the past.
That means that the inflation rate of gold varies between 1% and 2% per year and gold should lose that amount of value annually. But it doesn't. In fact gold retains its value over time because the inflation rate of gold should be seen in context of the world's population growth and long term economic growth. On average, the world's population grows between 1% and 2% per year and the long-term, real economic growth rate is the same.
This close correlation between the world's long term population growth, economic growth, and the growth in the above ground gold supplies is why gold maintains its value over time.
Chapter 2 - The physical market
For years gold bugs and mining companies have been predicting higher gold prices on the basis of the supply deficit in the gold market. The supply of gold has been unable to keep up with rising demand for the past eleven years and this is the source of these groups' great optimism. As is apparent, they have been wrong about the gold price. To understand why they are wrong, we first have to understand why they thought they were right.
The primary supply of gold
The annual, primary supply of gold, for the purpose of calculating the supply deficit, is defined as gold production from mines and scrap sales of gold.
Assuming a discovery is made, it could take several years to statistically prove that the gold is there and that it can be profitably mined. This usually requires drilling hundreds of holes and mapping the results to define the shape of the deposit and plan the most suitable mining technique. Then there are also metallurgical tests that need to be done in order to optimize the extraction of the gold. The cost of this feasibility study is often several tens of millions of dollars, depending on the size of the gold deposit.
If it can be shown that there is an economic gold deposit to be mined, the mine has to be constructed. Depending on the mining technique, construction can take anywhere from eighteen months to several years and the cost of constructing a mine can vary between 10 million dollars on the extremely low end to over 1 billion dollars on the high end.
The time it takes to discover a gold deposit, prove that it can be economically mined, and to construct the mine ensures that the supply of gold from mining cannot respond rapidly to changes in demand for, or the price of gold. If the price of gold should increase, it takes several years before there is any substantial increase in the production of gold. Mine supply is extremely inelastic.
The demand for gold
Fabrication demand for gold makes up the other side of the gold market. It too consists of two components, namely jewelry demand and industrial demand.
Elasticity, supply and demand
The amount of gold mined each year is four to five times larger than scrap supplies and therefore gold production from mines is more important to the supply and demand equation than scrap supplies. Similarly, jewelry demand is four to five times larger than industrial demand and therefore it affects the gold price much more than industrial demand. Note that the major supply of gold is inelastic and the major demand for gold is elastic.
The supply deficit
During the past ten years the annual supply of gold, including scrap sales, has fallen short of the fabrication demand for gold by a cumulative total of 2,764 tonnes. This is more than one year's total supply of gold from mining. On average the deficit amounts to 276 tonnes per year, 12% of the average annual mine production. In 1997, the supply deficit reached to 796 tonnes, a whopping 32% of that year's total mine production.
The gold price should be soaring
Considering that the supply of gold is mostly inelastic, this substantial supply deficit should have caused soaring gold prices, exactly as predicted by gold bugs and several gold mining companies.
Of course it is well known that the gold price did not increase in line with the supply deficit. In fact, from 1994 to 1997 the supply deficit increased by 348% while the gold price declined by 14%. Since 1996 the gold price has dropped by as much as 40%!
It is obvious that something else is at work here.
Why did the gold price not respond to the supply deficit?
Some suggestions have been that it is central bank gold sales that are causing the gold price to decline. Gold investors have also bemoaned the practice of hedging by gold mining companies, accusing them of digging their own graves.
Others talk about a global conspiracy against gold. It is always appealing to blame some sort of evil conspiracy for events that are not readily understood. But the idea of a conspiracy is quite absurd. Orchestrating a global conspiracy requires cooperation and secrecy on the part of the conspirators that is most improbable. Try getting consensus about which video to watch with a few of your close friends, an almost impossible task. Now try to organize a global conspiracy, in secrecy. Impossible.
Let's revisit the facts
Take a look at Chart 1. It's interesting to observe that when the supply deficit is small, the gold price is high and when the supply deficit is large, the gold price is low. This is exactly the opposite of what you would expect if the gold price was in any way dependant on the supply deficit of the physical gold market.
To make sense of the relationship between the gold price and the supply deficit requires a small paradigm shift. Consider that a supply deficit is exactly the same as a surplus demand. Total supply is always equal to total demand.
There are several sources of supply and demand in the gold market that were not discussed previously. These include mining companies' hedging programs, investment demand, hoarding of gold bars, as well as central bank purchases and sales. Changes in the aforementioned equal the supply deficit and could also be called the surplus demand for gold. It is therefore necessary to look at these items, as well as fabrication demand, mine supply and scrap sales, to understand the nature of the gold market.
Look at Chart 1 again, but think of the supply deficit as a surplus demand. The chart clearly shows that when the price of gold is high, the surplus demand for gold is low. When the price of gold declines, the demand for gold increases, and when the price of gold increases, the demand for gold declines. This is exactly what one would expect.
During the past ten years, from 1989 to 1998, there has been a net hoarding of gold in the form of gold bars, which increased the surplus demand for gold. On the other hand, central banks have been net sellers of gold and so have mining companies, as part of their hedging programs. Investment demand makes up the balance, and some years there has been net investment while at other times there has been net disinvestment. Note that all of these components of the gold market are highly elastic.
The increase in surplus demand from 1996 to 1997 was in response to the decline in the gold price. However, the decrease in the surplus demand from 1997 to 1998 was due to an enormous increase in gold sales resulting from the South East Asia crises, as these countries attempted to halt the decline in their currencies by selling gold. Were it not for the South East Asia crises, it is reasonable to assume that the surplus demand for gold would have been in the same order during 1998 as it was during 1997.
Recalling that the components of demand, jewelry fabrication, bar hoarding and investment demand, as well as certain components of the supply such as official sector sales, hedging and speculative positions are all highly elastic, it is reasonable to state that the surplus demand responds to changes in the gold price.
Gold Fields Mineral Services will announce the supply and demand figures for 1999 by mid-2000. Judging by the gold price, and the fact that the drop in demand from 1997 to 1998 was due to the South East Asia Crises, I predict that there will be a substantial supply deficit (surplus demand) for gold during 1999, in the order of 800 to 1,000 tonnes. [Ed. note: According to the GFMS Gold Survey 1999, total 1999 demand was on the order of 4,078 tonnes while mine production plus scrap supplies provided for 3,193 tonnes.]
Yet this immense surplus demand will not cause the price of gold to increase. Since 1996 the price of gold has not responded to changes in the supply and demand for physical gold. Hedge funds and certain other sophisticated investors know this. They have known this for some time and that is why they were able to short gold during the past three years with such success. But this short position is not responsible for the gold price decline either. [Ed. note: On this last point I would raise an important objection for the contrary. As you will soon read the author's own fine explanations of price determination in Chapter 3, you will see through the author's own work that such shorting would result in downward price movement.]
The true nature of gold and the gold price
Think of all the gold in the world as money, and the annual mine production of gold as inflation of this money supply. Since the inflation of gold due to mine production is roughly equal to worldwide economic growth, the value of gold in relation to other tangibles is quite constant over time, with minor fluctuations as one would expect in any market. History supports this view and the facts confirm it.
To be exact, it is necessary to subtract industrial fabrication from the annual mine supply to obtain a more accurate figure of the inflation rate of gold, since most of this gold does not return to the gold-pool as scrap material. But this is a small amount and is not relevant to our discussion.
Whether the gold is in the form of bars, coins or jewelry is irrelevant. All of these forms of gold are a store of wealth and can thus be thought of as money. All of these forms of gold are also highly liquid, and can easily be converted into paper currency. Granted, jewelry is the most illiquid form of money, but it is still money.
In any market the total supply always equals the total demand, that is obvious. But that also implies that to talk about a supply deficit in the gold market is fallacious, since the supply is of course exactly equal to the demand. Yet prices do fluctuate and basic economic theory holds that price is dependant on supply and demand.
The increase or decrease in gold supply and demand that would influence the gold price depends on how many dollars, or other currency, a buyer is willing to pay for gold versus the amount of currency a seller is willing to accept for his gold. These statistics also have to include all currencies in the world, not just the US dollar, since gold is held throughout the world. There is no basis for believing that the difference between mine supply, scrap sales and fabrication demand is equal to the total supply and demand for gold.
Gold is held in many forms, by numerous governments and billions of individuals. The willingness of all these parties to change gold for paper currency and vice versa is what determines the price of gold in relation to each different paper currency respectively.
There is no historical precedent for analyzing gold as a commodity
Not only is it incorrect to try and analyze the gold market as if it were the same as other commodity markets, there is no historical precedent for it either. Prior to World War I, the world was on a gold standard and hence gold was money, not a commodity.
Between World War II and 1971, the world was on a quasi gold standard, using the US dollar as its reserve currency while the US dollar was convertible into gold. Thus for our entire history, up to 1971, gold was always thought of as money and not a commodity.
Chart 2 - The price of gold in US dollars
As soon as governments ceased to determine the gold price by decree, its price increased from $38 an ounce to $850 an ounce. Was this increase due to a supply deficit? Of course not! And when the gold price decreased from $850 an ounce to settle in a trading range around $400 an ounce, was that due to a supply surplus? No.
The increase in the gold price from 1971 to 1980 was due to the massive inflation of US dollars that was never reflected in the gold price because the US government arbitrarily set the price of gold. The ensuing decline was because the gold price overreacted, as investors scooped up all gold related investments in the belief that the gold price would never-ever decline again. Much like today's stock market investors.
Since 1990 the gold price has been relatively stable, and the reason for that will become apparent in due course. But from Chart 2 it is clear that prior to 1990, the gold price was not responding to differences between physical supply and demand, it was entirely due to changes in the world's monetary structure, particularly changes in the value of the US dollar with respect to gold and other currencies.
Because the US dollar was the reserve currency of the world, and because all of these currencies were grossly inflated relative to gold prior to 1971, they all declined sharply against gold between 1971 and 1980. Since then, most currencies, including the dollar, have been relatively stable against gold, especially from 1990 onwards. But since 1996 the gold price has declined precipitously against the dollar.
What is it that changed in 1996 to cause the price of gold to abandon all reason and decline by 40%? Why is it that so few people in the world understood and profited from this decline? Perhaps more importantly, can we still profit from it now?
Before the last question is answered, we first have to make sure we can thoroughly account for the recent gold price decline. To do that, it is necessary to take a look at derivatives.
A brief note about central bank sales of gold
Central bankers are in charge of creating fiat currencies, so they do not believe in gold's role as money by definition. If central banks sell gold it should not be surprising to anyone. The world is no longer on a gold standard. Any central banker who professes that gold has a role to play in our monetary system is telling the world that he is a closet believer in the gold standard, since asserting gold's role as a form of payment is contradictory to asserting that fiat money can replace the gold standard in our monetary system.
Therefore, you may find this May 20, 1999 quote from Alan Greenspan quite interesting. "Gold still represents the ultimate form of payment in the world. Gold is always accepted." Mr. Greenspan offered this remark as one of the reasons why the United States should hold on to its gold reserves rather than selling it.
Chapter 3 - The Meaning of Derivatives: Futures and Options
Derivatives are financial instruments that derive their value from something else, an underlying asset. The most common derivatives are futures and options.
The price of a futures contract takes into consideration the market's anticipation of the future price of the underlying asset, current interest rates, the amount of time left before the contract is fulfilled and the supply and demand for the future contracts themselves.
Futures contracts are so common in financial markets that for many commodities, and other financial assets, there are standardized futures contracts that trade on exchanges, just like stocks. There are even futures contracts on stock market indices, currencies and interest rate differentials.
If you buy an option, you acquire a right to buy or sell the underlying asset and if you sell an option, you assume the obligation to fulfill the terms of the option agreement at the request of the purchaser of the option.
Option prices are determined by the same factors that influence futures prices.
There are many different options on a variety of underlying assets, including futures. Like futures, standardized options trade on exchanges. In the case of both options and futures, there is an extensive market outside of the regulated exchanges, called the Over-the-Counter market. All derivatives are just combinations of options and futures.
Derivatives markets are huge
The size of the derivatives market is monstrous. It is a multi-trillion dollar industry. This industry has ballooned during the past few decades, especially the last ten years, and has already claimed several victims. The danger, and allure, of derivatives is that one can control an inordinate amount of the underlying asset with very little capital. This is a double edged sword. Small changes in the price of the underlying asset can create eye-popping profits or cause instant bankruptcy, as many investors have found out.
Normal and abnormal derivative markets
If the size of the derivatives market is small in comparison to the size of the underlying asset's market, we have what I call a normal derivatives market. In such a market the price of the derivatives will depend heavily upon the price of the underlying asset and changes in the underlying asset will cause immediate changes in the derivatives market. In short, the prices of the derivatives are being set by the price of the underlying asset.
In an abnormal derivative market, the amount of derivatives being traded, based on a particular underlying asset, is so large that changes in the supply and demand for the derivatives causes changes in the underlying asset's price. Exactly the opposite of a normal market.
Which market is in control?
In both cases an arbitrage opportunity arises if there is a difference in the exercise price of the derivatives and the price of the underlying asset, as the expiration date of the derivatives approaches. For example, say that two months ago, when gold was $300 an ounce, a two-month futures contract allowing you to buy one hundred ounces of gold at $310 was sold. This contract is now approaching its expiration date, and assume that gold is trading for $315 an ounce. It is therefore possible to buy the contract, and exercise it, to lock in a profit of $500 ($5/contract).
If there are only a few of these contracts outstanding, relative to the amount of gold available to trade, then the contract value will increase as its expiration approaches by an amount that it is approximately equal to the difference between its exercise price and the price of gold, i.e. $500 per contract. On the other hand, if there are far more of these contracts outstanding than what there is gold to trade, then the price of gold will decrease as the expiration of the contract approaches, i.e. the gold price will fall to $310 an ounce. The real world is of course a combination of these two possibilities.
In all cases where there is a difference between the exercise prices of expiring derivative contracts and the price of the underlying asset, there is money to be made either buying or selling derivatives and buying or selling the underlying asset. The smaller of the two markets will require the least buying or selling, i.e. the least money, to change its price and therefore the price of the smaller of the two markets will change to approach the larger market. This convergence of the derivatives market with the physical market of the underlying asset on which it is based, as the derivatives approach expiration, is a well known phenomenon.
The size of the gold derivatives market
Late in 1997 the London Bullion Market, the most important market for gold in the world, announced the size of gold trading for the first time. Approximately 1,000 tonnes of gold traded through its facilities every day, which includes physical gold and gold derivatives. 1,000 tonnes of gold is just over 32 million ounces. Keep in mind that gold not only trades in London, it also trades in New York, Tokyo, Brussels, Hong Kong, Dubai, Turkey, Singapore, South Korea and other financial centers.
But for the sake of simplicity, and to remain conservative, assume that total world trading of gold is not much more than London Bullion Market trading. So, let us assume that gold trades on average only 1,000 tonnes per day. Remember that these are very conservative estimates based on the available information. The actual size of the market is by definition larger than this.
If gold trades five days a week, 52 weeks a year, it means that roughly 260,000 tonnes of gold changes ownership during the course of a year. 260,000 tonnes is almost 8.4 billion ounces of gold. To put this in perspective, the total amount of gold ever mined is only about 137,000 tonnes. All the central banks in the world together own only 31,400 tonnes. The amount of physical gold that trades every year is, by comparison, a minute 4,500 to 5,000 tonnes, and the annual trade deficit that everyone talks about is an infinitesimal 276 tonnes.
The physical gold market is less than 2% of the size of the derivatives market. The annual supply deficit is only about 0.1% of the total market and central bank sales, which everyone is blaming for the demise of the gold price, are only 0.12% of the gold market.
The price of gold
The value of annual gold derivatives trading is twice as much as the total amount of gold that has ever been mined, and this figure is based on a conservative estimate of the size of the derivatives market. But only about 5,000 tonnes, or 4% of the total amount of physical gold, changes hands every year. It is obvious that the physical gold market is absolutely dwarfed by the size of the derivatives market for gold. It is logical and inevitable that the derivatives market, not the physical market, determines the price of gold.
The key to understanding the gold price is to understand what drives the price of gold in the derivatives market.
Chapter 4 - Why the US dollar has the gold price on a tight leash
Most of the gold in the world is mined outside the United States. In fact, only about 14% of worldwide gold production comes from the United States. In addition, non-US residents own most of the gold in the world. Even though the United States government is the single largest owner of gold, more gold is held outside the United States than within the United States. Gold trades predominantly outside the United States, primarily in London, but also in many other financial centers. Yet in spite of all this, the price of gold is universally quoted in US dollars. It should therefore come as no surprise that the price of gold is highly dependent on the exchange rate between the US dollar and foreign currencies.
If this is true, then there should be a strong correlation between the gold price and the US dollar exchange rate. The difficult part is trying to define an appropriate average exchange rate for the US dollar to measure the gold price against. Such an average US dollar exchange rate would have to be calculated using a foreign exchange index.
An index was created by using 35 of the largest trading partners of the United States because these should also include the largest economies of the world, and have the most influence on the dollar. These countries together account for more than 50% of the world's GDP and the currencies were weighted by the countries' respective GDP's. Brazil was excluded from the list because the annihilation of the real had an inordinate influence on the index.
Chart 3 - The gold price and the US dollar exchange rate
The dotted line in Chart 3 shows the relative strength of the dollar versus the currency index. A decline in the dotted line reflects strength in the dollar. The increase in the dollar since 1996 is clearly visible and the correlation between that and the decline in the gold price is obvious. This is logical since the price of gold is quoted in US dollars.
There is no need for the international gold price to increase just because the dollar is strengthening. Instead, it is logical that the US based gold price will decline as the dollar strengthens. This phenomenon of course applies to all other tradable goods and services as well. As the dollar strengthens, the dollar denominated price of goods and services will decline, which is why the US's imports have surged since 1995.
To understand the gold price, we therefore have to understand the US dollar.
Chapter 5 - The US dollar
The trade deficit and net foreign investment
Exchange rate prices are subject to the same supply and demand fundamentals as any other object of trade. An increase in the supply of dollars would cause its price to decline (the dollar devalues) while an increase in demand for dollars would cause its price to rise (devaluation of other currencies by comparison to the dollar).
The United States has run a trade deficit for almost every year since 1970. A trade deficit means the United States imports more than what it exports and so, on a net basis, dollars move out of the country. This flow of dollars out of the United States, an increase in the supply of dollars, puts downward pressure on the price of the dollar relative to other currencies.
Again, total supply must equal total demand, and so the US trade deficit has to be offset by an equal amount of net foreign investment. The total amount of net foreign investment actually also covers net income receipts or payments as well as net unilateral transfers.
The value of the dollar on foreign exchange markets is thus dependant on the demand for dollars to pay for foreign investments in the United States in relation to the supply of dollars as a result of the trade deficit. Therefore the willingness of foreigners to invest in the United States is critical to the value of the dollar.
The relative size of net foreign investments into the United States versus the trade deficit gives an indication of foreigners' willingness to fund the US's trade deficit. Chart 4 shows the US dollar exchange rate, against the same index of currencies used in Chart 3, and net foreign investment less the trade deficit. Note that net foreign investment is larger than the trade deficit by an amount equal to the balance on income and unilateral transfers.
Chart 4 - Net foreign investment less the trade deficit and the dollar exchange rate
Since the early 1970's the United States has been running a trade deficit. Prior to 1985, the trade deficit was substantially larger than net foreign investment and the dollar devalued against most other currencies, as well as gold. The origin of the trade deficit was due to inflationary policies in an attempt to stimulate internal growth and to fund the cost of the Vietnam war. Between 1975 and 1995 the dollar lost approximately 50% of its value.
As an aside, the United States sold 35% of its gold reserves during the late 1970's to try and halt the decline of the dollar, to no avail. Gold rose from $35 an ounce in 1969 to well over $800 an ounce in 1980. Because the dollar is also the reserve currency of the world, most currencies lost value against gold, although not necessarily to the same extent as the dollar.
A stable dollar
At the onset of the 80's net foreign investment streamed into the United States driven by the allure of inexpensive US assets, as a result of the declining dollar. There was even concern that Japan would "own" the United States. By 1985 the amount of net foreign investment just about equaled the trade deficit and the dollar decline was halted.
Between 1985 and 1992 the trade deficit was more or less balanced by net foreign investment and the dollar remained relatively stable during those years. Note that the gold price was also relatively stable during that time.
A strong dollar
From 1990 to 1998 the US trade deficit rose from $80 billion to $164 billion, a 105% increase and it has almost doubled again since then. During the same time, 1990 to 1998, net foreign investment increased from $79 billion to $221 billion, a whopping 180%. The difference between these two items, which gives us an idea of foreigners' appetite for the dollar, climbed from -$1 billion in 1990 to $56 billion in 1998.
The most impressive change in demand for dollars occurred between 1995 and 1998 when the difference between net foreign investment and the trade deficit soared from $16 billion to $56 billion. This 250% increase in the demand for dollars is what fueled the rapid increase in the value of the dollar since 1996.
It is no coincidence that this is also the period during which the gold price, as measured in US dollars, declined most abruptly and significantly. Between 1995 and 1999 the dollar increased by 32% against foreign currencies as determined by our foreign exchange index. This correlates very well with the decline in the gold price, which at its peak was 40%, but on average is closer to 30%.
Why did the dollar strengthen?
Since 1995 there has been a major change in the dollar exchange rate. Events external to the United States caused concern in financial markets and there was a worldwide flight to quality. Net foreign investment poured into the United States, mainly as stock and bond investments.
The reason why the dollar strengthened so much has less to do with the United States than what most people believe. Our prosperity is not entirely due to the prudent leadership of our government, the acumen of Alan Greenspan, or productivity gains as a result of the internet. These are all important issues, no doubt, but the real reason why the United States is currently experiencing the boom of a lifetime has to do with external events.
Between 1992 and 1994 South American countries experienced severe currency devaluations. So much so, that the Brazilian real was completely demolished. Many other currencies suffered tremendously and this caused an increase in foreign investment into the United States as capital was fleeing to a more stable environment.
The South American currency crises was still fresh when Mexico's problems started and the peso lost 60% of its value between 1994 and 1998. This caused more jitters on foreign exchange markets and the dollar strengthened some more as nervous capital looked for safety.
But the Mexican peso was still rapidly declining, when in 1996 the South East Asia currency crises shook the world. This time the financial markets were seriously frightened, and by now investors in emerging markets had lost substantial fortunes. Money poured into the United States from all corners of the world, especially into US government bonds, but also stocks.
Investors were still in a state of currency shock, when Russia announced that it too would devalue its currency. The ruble lost 70% of its value during 1998 alone. It appeared that the only place on earth where money was reasonably safe was the United States, and so foreign investments streamed in.
In 1991 there was actually net investment out of the United States. In 1998, net foreign investment into the United States was more than 220 billion dollars. On an annualized basis, current net foreign investment is approximately $300 billion a year.
Another reason why so much money poured into the US has to do with the return on investments. During the 1990's the United States' economy was doing quite well, and its currency was doing extremely well against almost all other currencies for the above reasons.
But in addition to that, interest rates in the United States were higher than in most European countries and significantly more than Japanese interest rates. Foreigners could thus make relatively safe investments in the United States, get paid a higher interest rate than many other first-world economies would pay, and get the benefit of an increasing dollar.
In fact, this was so lucrative, that the yen-dollar carry trade got a little out of hand. It was possible to borrow yen at roughly 1% per annum, invest the proceeds in dollars at say 5% per annum and lock in a profit of 4%, in addition to the appreciation of the dollar against the yen. Because of the liquidity in bond markets, this was a very lucrative and attractive arbitrage for large investors.
These are the reasons why net foreign investment into the United States surged during the 1990's. It is also the real cause of the strong dollar and the effects of this influx of capital had far reaching consequences for the United States over and above the effects on the dollar.
A strong dollar stimulates more imports
By the time this influx of capital started, the United States was already running a substantial trade deficit. But as the dollar strengthened, exports became more expensive and imports became less expensive. This created more consumer demand inside the United States for foreign goods and stimulated imports. The trade deficit grew rapidly.
The self-correcting mechanism
Price, supply and demand has a self-correcting mechanism built into it. Unfortunately, or fortunately depending on your perspective, the strength in the US dollar was due to external factors that, for the time being, proved stronger than this self-correcting mechanism.
A growing trade deficit will tend to decrease the value of the dollar as more dollars pour out of the United States. This is what happened from 1970 to 1985. As the dollar devalues, US goods and assets become less expensive to foreigners and net foreign investment increases until the decline in the dollar is halted. The dollar will thus find its own equilibrium value as the trade balance and foreign investments offset each other.
A strengthening dollar, as we have had since 1992, lowers the cost of imports and increases the cost of exports to foreigners. This caused the trade deficit to expand. The increasing trade deficit should have caused the dollar to devalue but instead the dollar kept on rising.
This was due to the continuous increase in net foreign investment, as a result of international currency crises, in spite of an increasing dollar. The ability of the United States to withstand its trade deficit has very little to do with productivity, the internet, or the size of its economy. It is as a result of the massive net foreign investment that is currently pouring into the US and this influx of foreign investment is due mainly to problems outside the US, making U.S. investment relatively attractive, not absolutely attractive.
The US economy grew 23% from 1990 to 1999. It is impossible that this growth justified more than a 100% increase in the trade deficit and an almost 200% increase in net foreign investment.
An aberration and the possible opportunity of a lifetime
I cannot emphasize it enough. The strong dollar in the face of the growing trade deficit has as little to do with smart governing as the "supply deficit" has to do with the gold price. We are seeing the opportunity of a lifetime being created. Some people have already made millions off of it, perhaps many will lose that money again because they don't realize why they made it in the first place. Others will make even more as the rest of the story unfolds.
Investment capital moves fast, and it is fickle. When conditions change, what we now experience as net foreign investment could rapidly turn into net foreign disinvestment.
Trade deficits by contrast are slower to reverse. Once consumers have developed an appetite for foreign goods they don't change overnight. Trade deficits also involve longer term contracts between suppliers and wholesalers. These contracts won't be canceled at the first sign of trouble.
Five years ago, 20% of US marketable debt securities were held by foreigners. Foreigners now own more than 40% of these securities. When the dollar starts to decline against other currencies due to the trade deficit, these securities will become less attractive and find their way back to the United States at great cost to the dollar and dollar-denominated debt instruments.
When net foreign investment turns into disinvestment, it will no longer offset the trade deficit, it will add to the trade deficit. The implications for the dollar, the US economy and its stock and bond markets are dire. US residents will learn the hard way, just as everyone else in the world had to learn, that gold is our best store of value.
Recession or Depression
Barry Eichengreen, from the University of California at Berkeley, has shown using historical data that large trade deficits can in fact be eliminated by first world countries. The good news is that trade deficits can also be eliminated quite rapidly. However, the bad news is that it almost always requires a major and prolonged recession. Given the size and extent of the United States' trade deficit, I would not bargain on just a recession.
A quick recap
So far we have seen that the gold price is not responding to changes in mine supply and fabrication demand. The gold price is however dependent on the US dollar exchange rate and the US dollar exchange rate is determined by the amount of net foreign investment relative to the trade deficit. Therefore, to understand the gold price, as measured in US dollars, we have to understand net foreign investment.
As was shown, the net foreign investment was as a response to problems outside the United States in conjunction with higher US interest rates relative to comparable economies. It is therefore reasonable to assume that when worldwide conditions change, and the perceived risk outside the United States diminishes, a considerable amount of foreign capital will leave the US.
This will cause the dollar to decline and the dollar denominated price of gold to rise.
But is it correct to always think of gold in terms of US dollars? As mentioned, the US is only a small part of the world gold market.
Chapter 6 - The real price of gold
The price of gold varies depending on which currency it is quoted in. Not just in absolute terms, but in relative terms as well. For example, during 1995 to 1998 when the price of gold in US dollars declined by 24%, the price of gold in yen increased by 7% and in terms of South African rands, the price of gold actually increased by 20%. The gold price is specific to each individual currency.
It would be useful if we could measure the average price of gold. Then we would be able to see if gold actually went up, or down. We could also answer questions such as whether gold is still a store of wealth and whether it should still be considered as money.
A currency index
To get an notion of the average price of gold, the same currency index that was used to measure the US dollar against, was used to construct a "foreign" gold price index. The "average" gold price index was created by including the US price of gold in the "foreign" price index. This is thus the price of gold averaged over thirty-six of the world's largest currencies, representing 76% of the world's GDP. As before, the index was weighted by the countries' respective GDP's.
Chart 5 - The US price of gold, the "foreign" price of gold and the "average" price of gold
Central Bank sales, producer hedging and short positions
It is here that we can start to see the effects of central bank sales and producer hedging. Since we are now dealing with the average gold price in many different currencies, changes in the average demand, or supply, of gold versus the average supply and demand of these currencies becomes noticeable.
It is well known that central bank sales have increased dramatically since 1995 in conjunction with producer hedging and speculative short sales. Offsetting this was a record increase in jewelry demand. In all these cases there was a transfer of paper currency to or from gold. The net result of central bank sales, producer hedging and speculative short sales was to decrease the "foreign" (non-US) gold price from $400 an ounce to $340 an ounce, a 15% decrease. The "foreign" gold price in fact has not even declined below its 1992 price level.
In terms of US dollars, the gold price declined from $400 an ounce to $260 an ounce, a 35% decrease. But this decrease in the gold price was due to the relative supply and demand dynamics between gold and the US dollar only. It cannot be used as a proxy for worldwide gold supply and demand. It was widely publicized that during August 1999, gold reached a twenty-year low of $252 an ounce. This was for the most part due to the US dollar reaching historical highs against most other currencies, including gold, and was not indicative of the gold market as a whole.
In fact, gold has held its value over thousands of years for the reasons discussed in Chapter 1. For most of the world nothing has changed. But in terms of US dollars there has been a major collapse in the gold price since February 1996.
Prior to February 1996, there is a strong correlation between the average price of gold and the price of gold in US dollars. This is to be expected because we know that between 1985 and 1995 the US dollar exchange rate was relatively stable and therefore, so was the price of gold in US dollars.
The rapid decline in the US dollar price of gold since 1996 is not because gold is being demonetized, or because central banks are selling gold, or hedge fund short positions, or producer hedging. [Ed. note: But again we must ask, "what of the lesson provided to the contrary on this point in Chapter 3??"] The price of gold declined because the US dollar increased relative to other currencies, including gold. That correlation was conclusively demonstrated and logic confirms it.
We now know what caused gold to decline by 40% from a high of $418 an ounce in February 1996 to a low of $252 an ounce in August 1999.
This enormous gap between the "foreign" price of gold and the price of gold in US dollars will close when the trade deficit reasserts itself on the US dollar, as it inevitably will when net foreign investment is no longer sufficient to overcome the US's appetite for foreign goods.
Trying to predict small changes in the gold price and profit from trading only makes your broker rich, I know, I am a broker. Why worry about small fluctuations in the gold price when we can profit from the substantial potential increase in the US dollar price of gold as the dollar returns to its pre-1996 trading range?
Chapter 7- Investing in gold in the "New Era"
This article is not about the stock market, but it seems such a waste to come this far and not mention that the same circumstances that caused gold to decline by 40% are responsible for deluding millions of investors to believe in a "New Era".
It is no coincidence that the gold price decline started the same year as the US stock market shook off all its shackles and headed for the moon. We have already seen that events in the rest of the world caused an unprecedented influx of foreign capital into the United States, starting in 1992 and gaining serious momentum since 1995. More than just increasing the value of the dollar, this influx of capital, that amounted to well over one trillion dollars since 1990, also had some other consequences.
Most of the foreign capital was initially invested in the US bond market. The demand for US bonds drove up US bond prices. Higher bond prices of course result in lower interest rates. And the cycle began.
Lower interest rates stimulated consumer spending. More consumer spending boosted corporate profits, along with the benefits of lower borrowing costs. Growing corporate profits increased share prices and the stock market took off. This, in addition to interest rates that were still higher than Europe or Japan, and hence an attractive bond market, enticed even more foreign capital to flood into the United States. More foreign investment.
The benefits did not end there. As the dollar's value increased and the trade deficit grew, the US was able to import more and more goods at lower and lower prices. This, coupled to declining interest rates due to investor demand for US bonds, kept US consumer prices in check. Therefore the belief was created that not only had the business cycle been repealed (it should have ended in 1995) but economic expansion could continue indefinitely without inflationary pressures.
It gets better. The economic stimulation due to all this foreign capital, and soaring corporate profits, created jobs and US unemployment levels declined to unprecedented levels. In fact the unemployment figures got so low that it caused Alan Greenspan to fret about inflationary pressures. But alas, inflation was nowhere in sight. Now we had economic growth, declining interest rates, full employment and no signs of inflation.
The "New Era"
The United States achieved economic nirvana. The more consumers spent, the wealthier they became since consumers were also investors due to the broad ownership of stocks by US households. The United States became the envy of the world and millionaires were created on a daily basis. All the while pundits were embracing theories of increased productivity due to the internet revolution and a host of other bizarre concepts that have no basis in sound economic principles.
The "New Era" we live in has a precedent. Study the literature and events of 1920 to 1935. Even some of the terminology that was invented to describe our "New Era" is the same as then, let alone the absurd reasoning. By all historical and fundamental valuations the stock market today is exceedingly more risky than it was in 1929. Furthermore, investors are substantially more in debt and leveraged to the stock market than before the Great Crash. The proportion of the population with investments in the stock market is almost double what it was in 1929. The outcome of this investment bubble is impossible to predict; however, the extent of overvaluation leads me to believe that the aftermath of this mania could be much worse than the Great Depression.
Chapter 8 - How Do We Profit From Gold?
Investment analysis is a juxtaposition of risk, reward and probabilities. We are living in what is possibly the most dangerous times in terms of financial risk. Even T-bills carry risk: the risk of the dollar declining and thus losing buying power.
A lot of money has been made in the stock market during the past several years, but the financial destruction that might be looming on the horizon, could wipe out all of these gains and more. My best advice is to stay away from the stock market. And remember, I am a stock broker, so this is not self-serving advice.
Make sure you do not have any debt that cannot be paid off in a hurry and do not take out floating rate loans. Interest rates are at historically low levels. If you need to have debt, such as a first mortgage on your primary residence, lock in the interest rate for thirty years.
Keep the majority of your assets in cash and protect the buying power of the cash with an investment in gold and gold mining companies. Gold is still your best protection against financial ruin and offers excellent protection against the dollar.
Real estate prices are astronomical and home owners are up to their eyeballs in debt. That means that real estate is a very risky place to put capital. It could work out if the government sets a course of massive inflation but the amount of consumer debt could also cause a flood of bankruptcies that would depress real estate prices. US bankruptcies incidentally are at record levels during the most prosperous time the United States has seen in decades.
It is impossible to predict the future, or to know how this farce will unfold. The size of the derivatives markets in relation to their underlying assets should scare any thinking person into a state of paralysis. Derivatives have already caused serious damage - Barings, Orange County, Long Term Capital Management, Princeton Economics, to name but a few. More bankruptcies could follow and counter-party risk could become a major concern to all financial institutions.
Because of derivatives, I suspect that the dollar could decline rapidly. This in turn could cause the bond market to crash, interest rates to soar and the stock market to collapse. At the same time the price of gold would increase as a result of the declining dollar. [Ed. note: It is my opinion in this matter that here the author demonstrates a flair for understatement regarding the impetus for the subsequent gold price increase in such an event.]
If gold returns to its average price of the past ten years and the US dollar returns to its pre 1996 valuation, the gold price should be approximately $360 an ounce. A 15% increase in the price of gold, consistent with gold volatility during the last decade, would imply a gold price in excess of $400 an ounce. But due to the enormous short positions in the gold market I would not be surprised to see the gold price spike well above $400 an ounce, although I would expect it to settle back into a trading range between $350 and $450 an ounce.
If the world returned to a gold standard, or even a quasi gold standard, then the gold price could reach several thousand dollars an ounce, perhaps even several tens of thousands of dollars an ounce. I am not predicting that, only stating that given the amount of paper currency floating around in the world, a gold standard would require gold to be valued at significantly higher prices than what it is trading at.
If you are a speculator, short the dollar and go long gold. But be careful. There is a lot of political will in the world right now to prevent the collapse of the dollar, and by extension, an increase in the price of gold. It is likely that the major governments will do whatever is in their power to delay the decline of the dollar until it suits them. Just because a collapse in the dollar seems inevitable does not mean that it's imminent. My personal belief is that it is both inevitable and imminent, but that is no reason for you to risk your money.
If you intend investing in the shares of gold mining companies, there are a few things to consider over and above the investment merit of the companies under consideration.
South African gold mining companies
Many investors fondly remember owning South African gold mining stocks during the 1970's, when the gold price increased from $35 an ounce to over $800 an ounce. In certain cases investors received annual dividends from some South African gold mining companies that were more than what they initially paid for the shares. Could this happen again?
I don't think so. There are many differences between the increase in the gold price that I foresee and the events of the 1970's. There are also fundamental differences in the foreign exchange markets that will surely influence your investment returns from South African gold stocks.
Prior to 1981 the South African rand was fixed against the dollar. That means that during the gold price increase of the 1970's, the rand - dollar exchange rate remained constant. The full impact of the dollar-gold price increase was thus transferred to South African gold mining companies and their revenues soared. That created the tremendous profits that rewarded shareholders so handsomely.
But since 1981, the rand has been floating freely against the dollar and it has been devaluing steadily relative to the dollar. Due to the extreme depths at which South African gold mines are operating, the cost of extracting the gold is relatively high. The devaluation of the rand against the dollar has been the saving grace of South African gold mining companies for fourteen years now, but it is also this phenomenon that investors should keep in mind before buying South African gold stocks.
Consider that the dollar price of gold declined by 24% from 1995 to 1998. During that time the rand price of gold actually increased by 20%. This is because the rand devalued against the dollar, falling from R3.50 to R6.50 per dollar from 1995 to 1998. Because 20% of South African exports consist of gold sales, and because gold is quoted in US dollars, the gold price has a large influence on the rand - dollar exchange rate. Were it not for the devaluation of the rand during the past four years, the South African gold industry would have been decimated by the recent gold price decline.
Should the price of gold increase in terms of US dollars, as I propose it will in this article, then it is reasonable to expect that the rand would strengthen against the dollar. This reduces the positive impact that an increasing gold price would have on South African gold mining shares. Just as the weakening rand saved South African gold mining companies during the past four years, so will a strengthening rand be detrimental to South African gold mining companies.
There are of course other factors which also influence the rand-dollar exchange rate and therefore I do not expect the rand to regain all it has lost against the dollar during the past four years, but it is something to keep in consideration. An increase in the dollar price of gold would initially have a very positive impact on South African gold mining stocks. But international purchases of South African gold stocks, and the increase in the price of gold which makes up an extraordinary large percentage of South African exports, would create tremendous demand for rands in the short term. This could cause the rand to strengthen against the dollar and reduce the positive impact of higher gold prices on South African gold stocks.
Recent consolidation of the South African gold mining industry has left less than a handful of companies worth investing in. I am not suggesting that you avoid them all together, some of these companies have substantial investment merit. The marginal nature of the South African gold mining industry is what gives these companies such leverage to gold prices, but a replay of the 1970's is unlikely.
During the past four years, the 35% decline in the US dollar price of gold has created similar leverage in the US gold mining industry. But unlike the South African gold companies, US based gold mining companies will get the full benefit of an increase in the price of gold, because gold is priced in US dollars. In fact, the best leverage to the forthcoming gold price increase will be obtained from US based gold mining companies.
One thing to be very wary of is the hedge books of all gold mining companies. Imprudent hedging by gold mining companies has already claimed two victims, Ashanti Gold and Cambior Mining. When the gold price increases, there will be more.
Certain gold mining companies have hedged their gold production against a decline in gold prices by using derivatives and spot deferred forward sales. Some of these are prudent measures, and these companies will remain successful. But in many cases, the mining companies got involved in transactions they did not completely think through, and now they are locked into obligations which could destroy them if the gold price rose suddenly and substantially, as I believe it could. It is therefore crucial to analyze the hedge books of gold mining companies prior to making an investment in them.
Chapter 9 - Conclusion
It has been shown that the gold price is far more sensitive to changes in foreign exchange markets than fluctuations in annual mine production or jewelry demand. This is due to the fact that gold is money, it always has been and still is today.
The gold price as quoted in US dollars depends heavily on the US dollar exchange rate against other currencies. This is logical and obvious, but often overlooked.
On average, the gold price has not declined much during the past ten years relative to a basket of currencies. In fact, the gold price is currently trading at its ten year average price and has not fluctuated more than 15% up or down during the last decade.
In US dollars, the gold price has declined by 35% due to the strength in the US dollar. This strength in the dollar came about because of currency problems in the rest of the world, not because the United States has repealed the business cycle or achieved nirvana.
If the dollar devalues, as this report argues it will, the gold price in terms of dollars should rise. As such, it represents an excellent hedge against the dollar and offers superb protection of dollar denominated investments. Gold has not lost its value as a store of wealth.
For speculators, this could be the opportunity of a lifetime. Gold mines based in the United States will gain the most out of a weakening dollar, more than South African or Australian gold mines.
Buy gold and gold stocks while the dollar is abnormally strong and gold is historically cheap in terms of US dollars.
by Paul van Eeden
Copyright © 2000 by Paul van Eeden and theMiningweb.com. All Rights Reserved.
Paul van Eeden is a stock broker in California with Global Resource Investments. You can reach him at 800-477-7853 (760-943-3939) or by email at firstname.lastname@example.org
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