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01/14/03 04:39:20 PM PST
by David Penn

From gold bugs and gold standards to massive derivative speculation, the yellow metal is back.

All that glitters is not gold, goes the saying. But as far as investors are concerned, gold seems to be the only asset class with any shine at all. Gold mutual funds — as noted in Barron's "Mutual Funds" section for December 16, 2002 — look poised to deliver returns to gold bugs that would make even the luckiest dotcom speculator salivate with envy.

An exaggeration? Consider the Gabelli gold fund AAA, which is up 75.91% year to date, or perhaps the Rydex Precious Metals Investor fund, up 43.49% year to date. Taken as a group, gold-oriented mutual funds are up some 50% in 2002. And these returns come in the wake of impressive returns in 2001 (almost 19% on average).

Gold fund returns in 2000 were underwhelming in most instances: the Gabelli Gold fund (GOLDX) was down about 15.4% in 2000, the Vanguard Precious Metals Fund (VGPMX) down 9.5% — though when compared to a Standard & Poor's 500 that was down about 10% for the year, it is apparent a changing of the guard in which stocks stepped down and gold stepped up was at hand.

Marc Faber, money manager and publisher of The Gloom Boom and Doom Report, notes in his essay "A gold opportunity" that he recommended back in late 1999 that Bill Gates should sell his Microsoft shares and purchase gold with the proceeds. Although this was both clever and prescient, Faber's more important point was that "the bull market for US financial assets, including equities and bonds, which had started in 1982, had come to an end in year 2000, and that from here on a new leadership would emerge in an asset class other than US stocks." That new leadership still may have arrive (Faber himself is especially keen on Asia). But for the time being, that asset class appears to be gold.

I introduce these comments by Marc Faber — and others to be introduced shortly — to make an important point about gold, a point on which both gold's proponents and detractors agree: Gold is, as Addison Wiggin of The Daily Reckoning observes, "not really an investment . . . it is merely an insurance policy that pays off when other people's investments go bad." In some respects, gold is every bit the "barbaric relic," every bit the "yellow metal" with — all things equal — little chance of appreciation in value. Gold pays no interest, experiences no capital appreciation, and moreover, can be expensive to store in large quantities, especially when interest rates are relatively high.

Gold, outside of its various applications in industry and luxury, is a store of value, and investing in gold is, in many ways, like moving forward because everyone else has taken at least one step backward. Thus, a bet on gold is in effect a bet against the US dollar, and is, at a more extreme level, a wager against paper money of all denominations. And as a bet against paper money — upon which the global financial system is based — gold is in the long run a gamble against the system of worldwide finance itself.

This helps explain the derision with which gold investors have been met in the marketplace. For the past 20-odd years, a bet against the "system of worldwide finance," largely sponsored by the US, has been a terrible bet — and the dollar price of gold suffered as a consequence.

As the secular bull market in financial assets took off in the early 1980s, the price of gold — driven upward in the 1970s by a confluence of events including inflation, geopolitical concerns (Communism on the march in Central America and Africa, for example), and weak economic growth — was crushed. An understanding of gold's bull market only underscores the significance of the "crushing" gold took when it peaked.

From the time President Nixon severed the last connections ("convertibility") between the dollar and gold in 1971 (the "closing of the gold window," as it was known, a move that was at the time widely applauded by economists and Wall Street), gold rose from its fixed exchange rate of $35 an ounce to $65 an ounce by the end of 1972 and over $100 an ounce by the end of 1973. Gold temporarily peaked at $190 in 1974 before dropping back to $100 an ounce by 1976. But the election of Jimmy Carter and the failure of Ford's Whip Inflation Now campaign saw gold embark upon its greatest bull run.

From a low of $100 an ounce in mid-1976, gold hit $170 by the end of 1977, $220 by the end of 1978, and $650 by the end of 1979. The final top came early in 1980, at over $850 an ounce. Where did this rapid appreciation in the price of gold come from? Had gold become rarer? Were new applications for mined gold being discovered by the world's top scientists and geologists? No, the lump of gold in 1973 was no different from the lump of gold in 1978. The difference lay in the value of the dollars it took to buy that little lump.


The Federal Reserve Board managed to support the value of the dollar by attempting to control the money supply, specifically by tightening it and removing dollars from circulation. This contraction brought on a number hardships for many industries that had thrived during the inflationary period, industries such as agriculture and homebuilding, but it also ended inflation as the combination of fewer dollars (by way of contraction in the money supply) and weak demand for dollars (by way of the recession that contraction helped induce) drained excess currency from the system.

The clearest sign of this (although not a sign the Federal Reserve board admitted to following) was not just in interest rates, which had begun to moderate from their dizzying early 1980s heights, but also in the price of gold, which had decisively entered a bear market by early 1981. In fact, gold continued to fall until early 1985, when after reaching a low of about $290, the yellow metal began to appreciate. By the end of 1986, gold was back to $400 an ounce, and at its peak in 1987, gold fetched upward of $500 an ounce.

But this brief bull market in gold — spurred on in part by the easy-money Fed policies meant to help stimulate a stagnant economy still reeling from its hard-fought victory over inflation — was the last such move the gold market would see for some time. Gold fell from $500 an ounce in 1987 to a low of $335 an ounce by early 1993. And after a brief, inflationary runup to a high of $410 between 1993 and 1995, gold was back in a full-fledged bear market, falling as low as $250 in 1999 and again in 2001.

If gold increases in value when the value of the dollar declines, then the secular bear market in gold since the early 1980s must have accompanied a rise in the value of the dollar. And just such a secular rise in the value of the greenback did occur over the 1980s and 1990s, though not without occasional shocks and setbacks.

The secular shift from a weak dollar to a strengthening one reflected a Republican-led shift in US government economic policies to promote economic growth through a combination of tight monetary policy (firm interest rates) and loose fiscal policy (supply-side tax cuts) in the 1980s. After a period of economic difficulty from 1987 to 1993, this pro-growth plan was recast by Democrats into a loose monetary policy ("accommodative Fed") and tight fiscal policy (deficit reduction) combination. This oversimplifies both Reaganomics and Clinton/Rubinomics, but the effects in both instances led to booms in financial assets — particularly in stocks and bonds, respectively — and a secular bear market for the ultimate antifinancial asset, gold.

As you might imagine, there are other forces many people and speculators believe are at work in the gold market — forces with intentions nowhere near so benign as those of President Ronald Reagan and President Bill Clinton. At their mildest, these forces include major money center banks which, feeling the disinflationary wind at their backs, have bet heavily against a rising gold price through derivative hedging and speculation. These derivative positions held by institutions such as JP Morgan act as short (selling) positions on gold prices.

Beginning with gold mines and producers who were being driven out of business by falling gold prices, hedging against the falling price of gold turned into outright speculation as the gold bear market worsened and intensified in the second half of the 1990s. But there are those who believe that the central banks of the world — who championed free-floating exchange rates — have played a more active role in depressing the value of gold, jealous as they are of gold's role as an impartial arbiter of the soundness of the world's currencies (and the US dollar in particular).

By deliberately depressing the value of gold by selling huge quantities of the yellow metal when the gold price began to rise, central banks — in the minds of some gold bugs — are keeping the public ignorant of the real price of gold and thus from truly knowing the value of their paper money. As far-fetched as this conspiracy theory may seem, concerns about the falling price of gold were significant enough by 1999 that the leading central banks of the world signed the famous "Washington Agreement" (officially, the "Central Bank Gold Agreement"), which affirmed that gold would remain an "important element" in central bank reserves. Further, the agreement stated that central banks would limit their gold sales.

Although the agreeing parties represented only about 40% of the world's gold reserves, the central banks of countries such as the United States and Japan along with the International Monetary Fund agreed informally that they were in support of the policy. The initial term of the agreement is five years; it is due to expire in September 2004.


Is this decision to strongly limit gold sales (additional supply being seen as forcing the price of gold down to levels that imperil gold mining and production) the basis for the bullish case for gold that has been put forth with increased vigor in recent months?

The price of gold spiked initially on the heels of the Washington Agreement, but over the following year, gold settled back down to its multiyear low around $260 an ounce at the beginning of 2001. Since this bottom "test," the price of gold has been rising. By the end of 2001, gold had risen to $290 an ounce, and by late in 2002, gold was more than $340 an ounce.

There are a number of fundamental explanations for gold's rise in recent years, and the influence of the Washington Agreement, both materially and psychologically, cannot be underestimated. The signals sent to gold miners and producers — as well as to those by-then hapless gold investors — were clear: the massive selling of gold by central banks, many of which were more than eager to encourage participation in the boom in financial assets that was taking place at the time, was over.

In its simplest expression, part of the contrarian case for a new secular bull market in gold is based on this notion. Essentially, some contrarians argue, gold has been down so long that the Washington Agreement represented a sign that those who control the supply and value of money (that is, the central banks) had seen enough. It is almost as if, not realizing that a rising gold price was a symptom of inflation (not a cause of it), the central bankers believed their crushing of the gold price was a de facto crushing of inflation. And with currencies like the US dollar reaching multi-year highs and financial assets of all sorts booming, who could argue?

Many of those who did argue, however, did so primarily by questioning the nature of the boom in financial assets in the first place. These critics — many of them taking their cue from the Austrian school of economics championed by Nobel laureate Friedrick Hayek, as well as scholars such as Ludwig von Mises and Murray Rothbard — point to the increasing reliance on central bank­created "credit" as the main reason for the boom in financial assets that took place in the 1980s and 1990s. In the absence of the safeguards provided by a gold-linked currency, this credit has been an almost irresistible tonic for politicians seeking to stimulate the economy by artificially depressing interest rates in times of economic difficulty. As von Mises framed the issue in his classic text on economics, Human Action:

The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression [recession], is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom expansion brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.

Thus, it should be little surprise to those who follow the Austrian school of economics that the Washington Agreement, a compact that if nothing else testified to the confidence of central banks in the wake of their "victory" over a rising gold price, occurred less than a year before the secular bull market in stocks topped out and began to retreat. Nor was there much surprise among their ranks when gold began to rise in 2000 and continued to rise — almost without interruption — through 2002.

Although the popular cry was that a price-killing deflation had begun — a deflation characterized by shrinking asset prices (though stocks were falling faster than bonds), rising debt levels, and narrowing profit margins for companies — those Austrians who followed the credit expansion precipitated by the Federal Reserve board's readiness to inject more credit into the money supply at the first sign of economic crisis suggested that the "money" inflation of the 1970s had simply been transformed into a "credit" inflation in the 1990s. Both the anti-deflationists and the anti-"credit inflationists" are correct. Observers such as Marc Faber note that:

The solution is a painful but necessary and healthy (and, it is to be hoped, brief) liquidation of excessive capital projects. But Greenspan's aggressive rate-cutting will only allow weaker players to complete their projects and so prolong the capital-spending boom. The day of reckoning may be delayed, but it cannot be put off indefinitely. Regardless of central bankers' monetary policies, every capital-spending boom is followed, sooner or later, by massive corporate profit deflation and a very painful deflationary recession.

So do fellow travelers like Prudent Bear's Doug Noland assert that:

To disregard credit excess, endemic speculation, and asset bubbles is a failure of monetary theory and central bank policy. And to ignore that contemporary monetary processes predominantly inject liquidity into the US economy through the financing of asset holdings (real and financial) is to miss the very essence of contemporary economic analysis. Now that the supposed risk of "deflation" is the focus of considerable attention, it has become clearer in my mind that the nature of the discourse only detracts from the key financial and economic issues of our time.

This reasoning also explains how people like Marc Faber can suggest that whether the US economy — and by extension, the world economy — moves into deflation or inflation, gold is likely to be a reliable store of value and, moreover, one that is likely to increase. In the deflationary scenario, gold is a hedge against the risk of systemwide financial crisis on the order of a Great Depression. In the inflationary scenario, gold is simply a store of value against which the dollar depreciates. Again, Faber notes:

In fact, I could see gold move up in both a deflationary as well as an inflationary environment. Deflation would bring another tidal wave of corporate and sovereign debt defaults — thus more uncertainty — while inflation would not very favorable for financial assets, especially not for bonds. Moreover, investors should realize that, last year, gold was the world's strongest currency, since it even appreciated against the US dollar.

The bullish case for gold is supported not just by the market contrarians and not just the Austrian economic theorists, but also by the technicals. With the test of the 1999 lows in the first quarter of 2001, gold — as measured by continuous futures contracts — has made steadily higher lows as well as steadily higher highs. From the low in the fourth quarter of 2001, an unbroken rising trendline can be drawn to connect all of the intermediate-term lows of 2002. While perceptive analyses have suggested that the technical perspective for gold is not necessarily bullish (see Jacob Singer's December 2002 piece on gold, "Gold Anyone? Cup-With-Handle Formations Say 'No,'" Advantage), it seems to me that — barring an intermediate correction — the case for a shift from secular bear market to secular bull market has indeed taken place in gold.

Figure 1: The bottom in 1999 proved false. The rally following the bottom in 2001 suggests that the lows of 2001 were real.


The bullish case for gold has one obstacle: What kind of gold should investors consider? Those looking to diversify into gold have a variety of options, from ready-made gold mutual funds such as those mentioned to gold coins to gold futures contracts. The question of which gold-based investment vehicle is especially relevant to gold-stock investors who have not seen the sort of appreciation in their holdings that owners of gold futures have enjoyed. This question is relevant even for those looking to choose from among the various "gold shares."

For example, there are two widely followed indexes of gold stocks. The first, which is followed widely in the mainstream press, is the Philadelphia gold and silver index ($XAU). This index is a capitalization-weighted index of nine companies involved in the gold and silver mining industry. The index was down 24.2% in 2000, up 4.2% in 2001, and is up 44% in 2002 as of mid-December. Compare this to the second widely followed gold shares index known as the Gold Bugs index ($HUI). Bugs stands for "Basket of Unhedged Gold Stocks," which turns out to be an important distinction.

Many of the gold-mining companies that make up the Philadelphia gold and silver index have engaged in hedging their gold supplies — in other words, these gold companies have actually bet against a rising gold price as the gold bear market continued. While a profitable practice for the individual firms that engaged in gold hedging, the strategy diminished the ability of these companies to provide investors with true exposure to the gold market. This became a significant issue when the price of gold bottomed in 2001 and began to rise.

This is readily apparent when comparing the performance of the hedged gold companies of the $XAU with that of the unhedged gold companies of the $HUI. The $HUI index was down 44.7% in 2000, reflecting the bearishness of gold. But in 2001, while the $XAU featured returns in the middle single digits, the $HUI finished the year up 55.8%. Year-to-date in mid-December 2002, the $HUI is up more than 118%. Below is a comparison between the performance of the $XAU and $HUI:


Thus, it seems that investors looking for exposure to the gold bull market are best off in unhedged gold shares such as those that make up the Gold Bugs index or $HUI, as opposed to some of the larger and more commonly known gold-mining companies of the Philadelphia gold and silver index or $XAU.

For many, the larger question is this: Does this gold bullishness support some of the more far-reaching predictions, such as the idea of gold reaching $1,000 an ounce? While such eye-popping projections have been offered by people like John Hathaway of Tocqueville Asset Management, they remain far from the consensus view of most economists and even most commodities analysts. However, a rule of thumb in investing remains that bull markets in asset classes have a tendency to take investors higher than they would have believed in their wildest dreams. (Well, perhaps not their wildest dreams — after all, there were books on Dow 36,000 in the late stages of the secular bull market that only recently ended).

Not only that, in his essay "Timing your leap into the unpopular," Faber makes much of the notion that the pattern of entry into new asset class leadership is such that successive waves of investors (like those who bought and held gold in 1978, or Japanese stocks in 1988, or Nasdaq stocks in 1998) tend to drive prices higher than even the initial, prescient speculators would have believed possible. So perhaps a more reliable barometer of how high gold could go might be found in the commentary of mainstream analysts and economists who've spent much of the past two decades dismissing the notion of a gold bull market. As Faber said of the "wisdom" of central bankers,

They could have sold their gold in 1980 and 1982 for around $800 and they could have bought the Dow Jones at 800 and they could have bought Treasury bonds yielding 15%. But the brain-damaged central bankers, they waited over 20 years to sell the gold below $300, and to invest in Dow Jones­type of investments at over 10,000, and in bonds at around 5%.

In other words, when the "brain-damaged" begin selling, the smart money starts buying. And to judge by the move that gold made in 2002, it appears that the smart money has already heard the message.

David Penn may be reached at


Bortolin, Tony [2002]. "Predicting The Price Of Gold," November.

Faber, Marc [2002]. "Timing Your Leap To The Unpopular," September.

_____ [2002]. "A Golden Opportunity," April.

_____ [2002]. "The Next Big Thing," interview with Jim Puplava, Financial Sense Online at November.

Grant, James [1992]. Money Of The Mind, Farrar Straus Giroux.

Hathaway, John [2002]. "Do Investor Preferences Make Any Difference To The Performance And Valuation Of Gold Equities?" June.

_____ [2002]. "The Investment Case For Gold," January.

Noland, Doug [2002]. "The Anatomy Of A Maladjusted Economy," December.

Prechter, Robert [2002]. Conquer The Crash, John Wiley & Sons.

Singer, Jacob [2002]. "Gold, Anyone? Cup-With-Handle Formations Say 'No,'" Advantage: December.

Wiggin, Addison [2002]. "Thoughts On The Forever War," December.

Yergin, Daniel, and Joseph Stanislaw [1997]. "Nixon, Price Controls, And The Gold Standard," The Commanding Heights, Touchstone Books.

Charts courtesy of TradeStation (TradeStation Technologies)

Current and past articles from Working Money, The Investors' Magazine, can be found at

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine,, and Advantage.

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