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Is the Luster Returning?

After a decades-long slide,
gold may be telling us something

By Rick Lombardi
Barron's
June 2000

(Charts not reproduced here)

In the 104 years since a defiant William Jennings Bryan
delivered his fiery "cross of gold" speech before the
Democratic National Convention in Chicago, not much has
changed. Gold's role as an economic linchpin, a store
of value and medium of exchange remains hotly debated.
There has been no in-between and no room for the
dispassionate: Depending on the point of view, the
metal is either reviled or revered by statesmen,
bankers and investors alike.

Surely, 20 years of disinflation in the U.S. have not
served to quell the argument. Down 65% in nominal terms
from its peak in 1980, gold has baited investors with
various fits and starts to no avail. Even taking into
account a favorable supply-demand imbalance, the metal
has continued a downward drift and now rests at a level
equal to its approximate cost of production.

Besides an apparent lack of consumer inflation, the
cause for the metal's decline may be traced to two
factors. First, central banks around the globe and the
International Monetary Fund have used the proceeds from
their continuing sales of bullion to reduce outstanding
debt. Second, gold has served as a cheap source of
capital for more profitable pursuits -- namely, stock
market speculation. (Under this scenario, a bank or
hedge fund borrows bullion at the lease rate of 1%-2%,
sells it short in world markets, and invests the
proceeds elsewhere.) In recent years, the cumulative
effects of these actions have maintained constant
pressure on the price of gold, emboldening its
detractors while irritating its fans.

Still, there are signs that gold is beginning to signal
a secular shift in the investment landscape. Despite
its nominal value, its relative value suggests that the
fundamentals behind the current bull market have been
transformed, increasing the risks to holders of
financial assets. The evidence of a secular shift may
be found by examining the current environment and the
expectations of borrowers and lenders. When acted upon,
such expectations show up the prices of both tangible
and financial assets and persist until one has reached
a valuation extreme relative to the other. Then the
laws of supply and demand kick in, causing expectations
to adapt and prices to correct.

Why target gold? Despite its performance as an
investment over the past two decades, its reputation as
an indicator has remained relatively intact. Indeed,
gold often has been cited as rock solid evidence, by a
growing contingent of economists and market pundits,
that inflation finally has been rendered dead -- an
event, they argue, that has yet to be fully discounted
by domestic financial markets.

Taking these factors into account, what, in fact, is
gold signaling now? The accompanying charts suggest
that the money supply is now plentiful enough to serve
as a catalyst for significantly higher levels of
inflation. As shown, this observation is supported by
dividing the growth rate of the Fed's Adjusted Monetary
Base by that of the price of gold to arrive at a
measure we call the Gold Valuation Index. Even though
the current behavior of gold appears to be consistent
with that of consumer inflation, the index indicates
that the base, or what economists call "high-powered
money," is as much in oversupply now relative to the
value of bullion as it was just prior to the
accelerating inflation of the 'Seventies. (Turning the
equation around, the index also indicates that bullion,
at $288 an ounce, is as inexpensive relative to the
Monetary Base in the year 2000 as it was at $35 an
ounce in 1970.)

Though this development has yet to manifest itself in
the price of gold, its impact is starting to appear in
other, consumable assets -- namely energy and the CRB
Index, both at 10-year highs. Other prices, too, are
unlikely to remain immune. The chart that contrasts
historical rates of change in the CPI with monetary
conditions signified by the Gold Valuation Index
illustrates the inverse relationship between the money
supply and consumer prices. Using quarterly data
spanning the past 45 years, the analysis indicates that
secular shifts in consumer inflation have tended to
occur following peaks or troughs in the index.

Mere coincidence? For an answer, consult the chart that
compares the behavior of the Gold Valuation Index to
that of the S&P 500, adjusted for changes in nominal
gross domestic product. The S&P 500-GDP series shows
(a) to what extent the stock market values current
dollar economic output given current credit conditions
and (b) the amount of goods and services that may be
exchanged for one unit of the S&P 500.

Though each index presented here incorporates two data
series that are discrete from those contained in the
other, they remain highly correlated. Peaks in stock-
market valuation have tended to correspond to periods
of high inflation. In each instance, a secular shift in
the relative value of financial assets was accompanied
by a valuation extreme in the price of bullion.

What are the long-term ramifications for investors? The
index suggests that investment capital, seeking its
highest return, may begin to migrate toward undervalued
assets as the process of arbitrage unfolds and
corrections in both tangible and financial assets
ensue. At that point, inflationary pressures resulting
from monetary oversupply will likely shift from the
capital markets to the real economy (including the cost
of labor), boosting prices and reducing real growth. In
all likelihood, the subsequent increase in the cost of
capital and the destabilization of corporate cost
structures should serve to put pressure on what are
already well-above-average price/earnings ratios.

Does this suggest that the future will be characterized
by an entirely hostile stock market? Not necessarily.
In the 10-year period that the Gold Valuation Index
last journeyed peak-to-trough, the S&P 500 rose to 125
from 84 to generate an annualized nominal return of
just over 4% (ex-dividends). However, adjusted for
inflation, its annual real return fell to minus 3.5%.
(The price of gold, in the meantime, rose 18-fold.)
With exposure to the stock market at an all-time high,
investors may wish to adjust their allocation
strategies, given historic precedent. If they do, they
will have affirmed one of Bernard Baruch's invaluable
maxims: "I made my money by selling too soon."