The Big Gold Picture

Gold has been a topic of discussion garnering great interest in the investment and economic community in the years following the Financial Crisis of 2008. A lot of this is down to the fact that ones’ views on gold tend to act as a proxy for their general economic ideology, in particular with respect to central banking and monetary policy. Those who have adopted Keynes’ characterization of gold as a ‘barbarous relic,’ and their pejoratively-termed opposition, ‘gold bugs,’ are seemingly vindicated or shamed with every tick on the gold chart. As I described in more detail last fall, it was the heavy sell off in gold last spring that triggered a celebratory mood amongst the ‘barbarous relic’ camp. At the time, I mentioned the gold sell off tangentially, but it really deserves a closer look on its own, which I will do here.

Since that sell off, there has been a torrent of articles and blog posts which jovially describe the 30%+ decline in gold since the September 2011 highs. The gleeful tone – which has been colloquially termed as ‘goldenfraude’ – isn’t exactly surprising given the underlying ideological battle mentioned above. The latest such article comes from Barry Ritholtz, author of The Big Picture blog, writing in Bloomberg. Although he claims the ’10 Reasons Why Gold Bugs Lost Their Shirts’ is not meant to engage in ‘I told you so’ sort of goldenfraude, the article reads that way with its treatment of gold as a cautionary tale for the masses. Perhaps I’m being overly cynical, but at the very least it contains many of the arguments put forth by the goldenfraude crowd. Nevertheless, I will use that article as a reference point, supplementing my take on gold in general and where we currently are after the 2013 price action.

What Gold is, and When to Own It

First things first (WARNING: Any ‘barbarous relic’ types reading this should prepare to roll your eyes until they fall out, but I implore you to bear with me and read on once you put them back in their sockets): gold is money. One of the most interesting dynamics in the gold discussion that often isn’t mentioned is the fact that in Nixon closing the gold window, gold only ‘ceased’ being money as a matter of political expedience, as opposed to a market based decision that the intrinsic properties of gold were no longer suitable for the tasks assigned to money.

Of those tasks, the main one is a medium of exchange. In the context of this discussion, however, the most prevalent task is the ability to store value. To the extent one does not spend all of his/her income, the question of how to store the value of unspent income until some sort of buying opportunity arises is important. Gold is merely one of the options one has to effectively store value. As Ritholtz shows in the following quote, the process is not as simple as ‘I want to save/store value -> I must buy gold.’

When used properly, the metal is a potentially valuable tool in an investment arsenal. There are times when it makes for a profitable part of a portfolio, as in the 2000s. There are periods when it is a speculative and dangerous trade — such as the 2010s. There have also been decades when it does nothing, earning no return, generating no income, essentially dead weight to a portfolio, as in the 1980s and 1990s.

Having set the frame of gold as potential vehicle to store value, we must understand the conditions under which this potential is realized, relative to other possible stores of value. Quite simply, these conditions are the persistence of extremely low to negative real interest rates. It’s not a particularly difficult concept to understand, and it explains virtually all of the movement in the gold price over the last 42 years.

Ritholtz writes that gold has ‘no fundamentals,’ as opposed to something like stocks, and in fairness that is a common view. Warren Buffett wrote famously that he would rather own farmland and 16 Exxon Mobils than all of the gold ever mined. The flaw in that argument is that gold and stocks are not in direct competition with one another for one’s investment dollar. The purpose of gold, as written before, is to store value, while the purpose of stock investments is ostensibly to create value. As such, the correct comparison is not between gold and stocks, but between gold and other potential avenues to store value, such as cash or government bonds. The one fundamental data point that aids in this comparison is the real interest rate.

The above is the real interest rate (3 month T-bills minus CPI, left axis) versus the gold price (right axis). The basic relationship I mentioned above has held throughout the series – namely gold does well with persistently low to negative real rates and vice versa. The 80s and 90s period, during which gold was ‘dead weight,’ was characterized by a persistence of positive real rates, most of that time persisting over 2%. The two bull markets, in the 70s and 2000s were characterized by a persistence of negative real rates. It is important to note that within these bull markets, corrections coincided with spikes higher in the real interest rate, however the bull market remained intact owing to the fact that real rates remained negative and stayed there. In other words, that interest rates became less negative resulted in a correction to, rather than a reversal of the bull market. The bull market of the 70s only ended when real rates spiked to 6% in short order, and remained positive for the next two decades. The spikes higher in 2006 and early 2009 were short lived, as such, they proved to be corrective periods in the gold bull market, versus the end of said bull market.

Putting 2013 in Context

Below is the gold bull market, beginning in the late 90s and early 2000s

While 2013 was undoubtedly a bad year for gold, the long term trend is still intact, a fact that I denoted last February in a strictly technical assessment of the long term gold chart. Writing then, with gold at $1650:

Since the last top in September of 2011, gold has consolidated. My personal belief is that there is one more leg lower in this consolidation, the question being how low that leg travels. A reaction lower to the 1500 area meets nicely with the upper trendline, and a move lower to the 1100-1200 area in 2013 would meet with the lower trendline. The long term trend dating back to 2001 remains intact with either move, but for the short to medium term I would be surprised if the 1923 high was breached.

A little over 2 months after writing that, gold did reach the lower target of $1100-1200. Even I wasn’t prepared for the swiftness of the move lower; I was expecting a much more gradual decline. Even so, my assessment remains: gold is still in a bull market. Technically speaking, the above chart agrees with that. With respect to the fundamental driver of gold, the real interest rate, it is clear from the chart above that the real rate bottomed and rose sharply in late 2011. This has coincided with that $1923 top, 2012 range, and 2013 decline. Crucially, this rise in real rates has not ventured into positive territory, meaning that the basis for a secular reversal of the bull market does not yet exist.

Rather, I believe that the 2011-2013 period marked the end of the first leg of the gold bull market. Within that first leg, there were two distinct phases, with regard to sentiment and perception. The white box encapsulating 2008 and 2009 in the chart above is the time frame separating those two phases. The first phase went from 2001, when gold bottomed at roughly $250 and went to its initial test of $1000 in early 2008. After that initial test of $1000, gold sold off roughly 30% to bottom at just under $700 in the depths of the Financial Crisis. From there it rebounded, and in early October 2009, it broke out over $1000. That breakout, through the September 2011 high of $1923 represents the second phase of the first leg in the bull market.

In describing why gold went lower after the September 2011 high, Ritholtz and many other mainstream commentators get a few things wrong about the ‘gold narrative.’ From the Bloomberg piece Ritholtz writes:

On Wall Street, storytelling is a big part of the sales process, and gold was no different. Even though it had broken out in 2005, the Great Recession and bank bailouts of 2007-08 created a fertile environment for the Gold Narrative. It was a perfect combination of factors: Huge government intervention, a move away from true “free markets,” coordinated central bank actions, unprecedented quantitative easing and zero interest rate policies would inevitably cause a huge debasing of currency and hyperinflation, or so the story went. Gold is a haven in times of stress and a hedge against inflation when economies accelerate. It was underowned and yet an attractive alternative to assets with low real returns. Based on the amount of total outstanding fiat currency, gold would hit those $10,000 price targets.

The problem with all of this was that even as the narrative was failing, the storytellers never changed their tale. The dollar hit three-year highs, despite QE. Inflation was nowhere to be found. If anything, deflation was the greater risk.

And later on:

More than any other investment, gold seems to involve a stream of fantastic tales of imminent societal collapse. Every potential problem gets blown up into a coming apocalypse. Fiat currency leads to worldwide collapse, as the dollar falters and hyperinflation appears. All paper money is going to be worthless, so you better have some gold if you want to feed your family.

As I wrote before, the gold narrative is excruciatingly simple: real interest rates. That’s it. Yet Ritholtz and many other commenters erroneously portray the story behind gold as some sort of combination of a nominal inflation hedge and a protection against the world ending. During the first phase of the bull run, from 2001 to 2008, the ‘narrative’ Ritholtz describes didn’t exist. There was no ZIRP, no unprecedented QE (just really really low rates), no coordinated central bank actions. Rather, we had a Greenspan driven economic boom and seemingly endless wealth creation. Of course, it turned out to be unsustainable, but that we were in the final days of the Great Moderation didn’t concern most people at the time. If gold was really just an ‘end of the world’ trade, it wouldn’t have risen from $250 to $1000 during that time. The world doesn’t have to end for gold to rise, the only thing that has to end is the existence of positive real interest rates – which is what happened at the turn of the century.

To be fair, the ‘narrative’ Ritholtz and others describe did play a factor in the second phase, from 2009 to late 2011. During the entire bull run, gold has been treated with, at best, lukewarm enthusiasm from the investment crowd. Consider the following exchange from 2005 between Peter Schiff and Mark Haines (skip to the 3:00 mark).

After Schiff mentions that gold had risen (note the insistence on highlighting the real interest rate versus the nominal rate), Haines says that the average person doesn’t care about gold, but rather the price of bread, milk and a college education. Similarly the average investor cared (and still cares) more about the price of Exxon Mobil and Farmland, as per Buffett. To the extent that gold was viewed in a positive light on Wall Street owed to the simple fact that after 2009, the bull market, already in its eighth year, couldn’t be ignored.

The likes of Schiff, Marc Faber, Jim Rogers and others advocated gold’s rise during the first phase for the right reasons (the real interest rate). Phase two saw a cacophony of Wall Street voices advocating gold for the wrong reasons (the ‘narrative’ Ritholtz and others describe). As Ritholtz describes, there was money to be made for Wall Street in pushing that narrative:

One of the fundamental changes in this gold cycle has been the creation of a variety of new gold-related products. The mac daddy has to be the gold exchange traded fund (GLD). Called the “innovation that opened gold investing to the masses,” it allowed people to invest in gold without opening futures accounts.

Ritholtz goes on to describe a litany of other products that Wall Street wheeled out to take advantage of the acknowledgement that gold was rising, and his point there is a valid one. Much of the buying by large, Johnny come lately speculators and investors has taken place in this second phase, at lofty levels which have long since gone, no doubt putting these positions under severe pressure. The issue is that as ‘irrational’ as some of the post 2009 ‘narrative’ might have been, it was not the foundation of the gold run. That foundation is the existence and persistence of negative real interest rates and that hasn’t gone away.

Where Do We Go From Here?

In order to answer that, as we currently sit at just over $1200/oz, I’ll look in the past for a possible guide. In the Bloomberg piece, Ritholtz suggests that ignoring history is a risky proposition, and rightly so. He writes, of gold’s historical performance:

Gold has run up only be to trounced in repeated massive selloffs: 1915-20, 1941, 1947, 1951-66, 1974-76, 1981, 1983-85, 1987-2000 and 2008.

Given the closing of the gold window in 1971, it is fair to view the post 1971 episodes in a different manner to the ones prior. The first such episode in Ritholtz’ list, 1974-1976 is by far the most interesting in the context of this post, because of its similarity to the 2011-2013+ time period. For reference, the above gold vs real interest rate chart has been focused on the dates in question.

Prior to the decline, the price of gold experienced a massive run up, which coincided with a real interest rate persisting at low to negative levels. A spike lower in the real interest rate into firmly negative territory propelled the gold price higher, doubling from early 1974 to its peak. The 47% decline in gold from peak to trough coincided with a spike higher in the real interest rate. Sentiment wise, the death of the gold bull had been pronounced loud and clear. Consider some of the reporting in 1976, courtesy of Casey Research:

“Though happily out of the precious metal, Mr. Heim is no more bullish on the present state of the stock market than any of the unreconstructed gold bugs he’s had so much fun twitting of late. He’s urging his clients to put their money into Treasury bills.” New York Times, March 26.

“Though the price recovered to $111 by week’s end, that is still a dismal figure for gold bugs, who not long ago were forecasting prices of $300 or more.” Time magazine, August 2.

“Meanwhile, the economic conditions that triggered the gold boom of 1973 through 1974, have largely disappeared. The dollar is steady, world inflation rates have come down, and the general panic set off by the oil crisis has abated. All those trends reduce the distrust of paper money that moves many speculators to put their funds in gold.” Time magazine, August 2.

“Wall Street’s biggest brokerage houses, after having scorned gold investments during the bargain days of the late 1960s and early 1970s, made a great display of arriving late at the party.” New York Times, September 12.

You’d only have to change the dates and the figures in order for that to be applicable to many of the things Rithotlz wrote, and many of the general perception that currently exists with respect to gold. However, the 1974-1976 episode proved to be a correction between the first and second legs of a bull market.

As one can see, the correction of 1974-1976 gave way to a 700% plus rally over the next three years. The catalyst was the persistence of a negative real interest rate. What finally killed the gold bull was not the spike into positive real interest rate in 1980. The persistence of that real interest rate in positive territory was what led to a 20 year dormancy in gold prices.

Today’s picture is not so different from where we were in 1974-1976. A spike in real interest rates has coincided with a precipitous drop in the gold price. However, given the persistence of negative real interest rates, the likelihood is that what has been witnessed over the last 18 months has been a correction in a bull market, as opposed to the cessation of that bull market completely. Time will tell of course, and it isn’t necessarily obvious that the correction is over. It could very well be that gold tests $1000 again, which makes sense given the psychological nature of the figure, and it being the level upon which breaching originally led to a protracted increase. Should one wish to credibly argue that the secular bull market is indeed over, it would require an explanation as to why real interest rates will rise to, and persist at, firmly positive levels. Given the indebted nature of the economy as a whole, and the reliance of a negative real rate environment to support debt driven consumption, it isn’t out of order to suggest that the persistence a positive real rate would be catastrophic, and policy makers would fight against it tooth and nail should it materialize.



  1. Nice attempt to justify gold bullishness but I do think the narrative for buying gold extends far beyond real interest rates. Most of the things that Ritholtz pointed to have some or a lot of basis in fact. These narratives — especially that of out-of-control inflation, collapse, etc — have been if not totally discredited, severely injured. Of course, real rates turning more negative could certainly reignite secular interest for gold, and indeed probably reignite the narratives (indeed, spiking inflation is one route to deeply negative real rates). But I am doubtful. The inflationary puff is weak — America is awash in cheap goods and services, and Bernanke’s printing still has not made up for the below-trend private credit creation since 2008. I doubt stronger inflation will emerge, and I am bearish on gold for 2014 (I was neutral entering 2013, turning bearish in April).

  2. Thanks for the comment. I agree that most of the things Ritholtz said are factual – I just disagree with the general interpretation of those facts as it pertains to what has happened in gold. My point was that those narratives mostly gained prominence from 2009 onwards – after gold had already quadrupled. They don’t explain why gold went up from 2001 to 2008. Only the real interest rate explains that. Rather than being the baseline driver of the gold bull, those narratives contributed to selling the story to Wall Street speculators and other institutional investors, who were eager to buy anything that could boost returns in a low yield environment. People talk about a bubble; If i can refer you to that ‘bubble cycle’ image for a second. I feel that we’re in the end of the ‘awareness’ phase, which culminates in a sell off. Note that according to that interpretation of bubbles, that awareness phase is when the institutional money gets in, which is what happened. I don’t really see any evidence of a mania because the public at large is nowhere near involved.

    I can’t stress enough how much the real interest rate trumps everything else with respect to gold. I can’t see how Yellen can allow the real rate to remain positive. It took a real rate of 6%+ to kill the 70s gold bull and that plunged the economy into a deep recession. Even a real rate of 2-3% would do the same to our current economy, given the explosion of debt the current economy has in comparison to the early 80s. The fact that we have ‘no inflation’ to me only means Central Bankers will ultimately push until they do get it, like smacking the bottom of a stubborn ketchup container until the whole thing explodes all over the place.

    Ultimately, I’m looking at the end game here. Unless you think that the Fed will allow a deflationary collapse to play out to the bitter end, I can’t see how this is the end of the gold bull. It was never going to go in a straight line, and the disinflationary hiccup of the last 18 months has led to real interest rates becoming less negative, which is bad for gold, in a relative. But the persistence of a negative real rate will still be a positive thing for gold over time. It doesn’t matter if you’re losing only 1% now by staying in cash, when before you were losing 3%. You’re still incentivised to find something else other than cash to store value. And that’s where gold comes in.

  3. imo gold has just had a normal correction of a bull move that occured from 01 to 2011. we retraced at 43 percent of the entire move. but the question is what is gold. its actually a store of value imo. which has lasted thru the ages. gold is always worth something, fiat currencies not really ha ha. right now people value stocks. i mean home depot isnt that much different than it was when it bottomed around 17 dollars in 08 ha ha. yet now it trades at 82. so it is valued and people will come up with some reason why it should be where it is. guess what at some point it wont be valued anymore and gold and silver will be. exactly why this occurs no one knows for sure but cycles do exist in nature and in human interaction. right now i think we are about to see a reversal of this and stocks will no longer be valued but gold and silver will be . just my take but that is what i see in the charts fwiw

    1. Very interesting discussion both in the above article and here:

      We seem to be living in exceptional times with debt, risk, interest rates and Government market interference all at abnormal levels. I have become worried enough that since last December I have moved most of my stock assets to physical gold. Not sure if this makes me a ‘gold bug’ or not? (I have never held any before now).

      I am fortunate. Provided I can keep what I have and get what I have been promised I should have enough wealth. My problem is that it appears increasingly likely that I will not be able to keep what I have nor get what I have been promised.

      I fear that there will be some serious dislocations in the financial markets in the next few years. It may be caused by the end of tapering, reverse tapering, Greek debt, Japanese money printing or any number of things waiting in the wings. All this will be good for gold and bad for an overpriced stock market.

      But Barry Ritholtz does make one very good point “The Danger of One-Way Trades: What would make you reverse your biggest present holding? What facts or situations would force you to change your views and sell? If your answer to that question is, “Nothing,” you have a huge, devastating flaw in your approach to investing.”

      Yes an excellent point which I had not given enough thought to. One which I believe you have provided some excellent insight into. The time to get out of gold will be when positive real rates return or threaten to return.

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