Is the gold rally over?

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(MoneyWatch) "Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning." So said former British prime minister Winston Churchill in a speech in London in 1942.

Gold closed the first day of trading in 2013 at $1,694. Two months earlier on Oct. 10, 2012, the metal had finished at $1,792, its highest close ever in 2012. On Friday, it closed at $1,616. And for the past few months, it has been defying all the "gold bugs," the famously avid investors who swear by gold. Is this just a temporary respite in the bull market that began in 2002, with gold having closed the prior year at $271? Or, as Churchill might have it, is it the beginning of the end, with a repeat of the experience of the 1980s on the way?

As readers of my books and blog know, I don't make such forecasts because I know there are no clear crystal balls. One can create, and many are predicting, a scenario that would have gold continuing to soar. And I continue to get calls on an almost daily basis from investors who are certain that the Federal Reserve's easy monetary policy will ensure that gold will continue to rise. On the other hand, as I have pointed out, this isn't a certainty. Other scenarios are possible, if not likely. Let's see why this is the case.

• Ignore the "buy gold now" crowd
• Answering Peter Schiff on gold
• The arguments for and against investing in gold

One of my favorite expressions is that there is nothing new about investing, only the investment history you don't know. And that makes knowledge of financial history critical to successful investing. So let's take a quick look at gold's performance over the past 40 years and examine what drove that performance.

The first thing we want to address is that one of the main premises behind investing in gold is that it's a good hedge for inflation. But that's true only if your investment horizon is extremely long, perhaps a century. Over the very long term, gold has provided virtually no real return, basically maintaining its purchasing power. And if gold was a good inflation hedge, we would expect to see a high correlation between the two. Yet since 1968 gold and inflation have been virtually uncorrelated. Through 2012, the annual correlation was just 0.08. The following example makes this point well.

On Jan. 21, 1980, the price of gold hit the then record high of $850. By the end of the year, it had fallen to $590, a drop of over 30 percent. And by March 19, 1982, it reached just $316, a fall of 63 percent. On March 19, 2002, gold was trading at $293, below where it was 20 years earlier. Note that the inflation rate for the period 1980-2001 was 3.9 percent.

Thus, an investor in gold who was unlucky enough to buy at the peak would have lost over 65 percent in nominal terms by March 19, 2002, and since the purchasing power of the remaining 35 percent of his investment lose an additional almost 4 percent a year, bringing the real loss in purchasing power to about 85 percent. If that can happen, gold cannot possibly be considered a good hedge against inflation.

So if it's not inflation that explains the price movement of gold, what does? The answer is monetary policy: Is it "loose," which creates the risk of future inflation, or "tight"?

Again, let's answer that question by looking at the historical evidence. A simple way to determine if monetary policy is loose or tight is to look at the real rate on one-month Treasury bills. Since 1926 the real rate has averaged about 0.6 percent. When the real rate is negative -- in other words, the inflation rate is higher than the yield on the Treasury bill -- we can say that monetary policy is loose.

In December 1972 gold averaged about $43.50. As noted above, just eight years later gold was trading at $850, an almost 20-fold increase. During this period, the real yield on one-month Treasury bills was negative each and every year, averaging a return of -1.8 percent (The nominal yield average was 7.5 percent.)

Loose monetary policy led to the soaring price of gold. Beginning in 1981 we entered a new regime for monetary policy. Each and every year through 2001, the real yield on one-month Treasury bills was positive, averaging 3 percent (The nominal yield averaged 6.5 percent.)

With the recession caused by the events of Sept. 11, 2001, we once again saw a shift in monetary regimes. The real Treasury yield was negative from 2002 through 2005 and again from 2009 through today. Note that the three years in between, 2006-2008, the real rate averaged less than half the real rate of 3 percent it averaged from 1981 through 2001.

In short, monetary policy has never really been tight since 2001. For the full period 2002-12, the real yield averaged -0.7 percent. More importantly, it has averaged -2.2 percent since 2008 -- even more negative than it was from 1973 through 1980. Note that gold closed 2007 at $834. When monetary policy turned very loose again, gold prices soared almost $1,000 to its peak in October 2012.

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[cheryl_m]

Larry, to what extent do you think the run up is caused by concern about US sovreign debt and our political leaders' impotence in addressing it? I don't see that concern abating any time soon.

[LarryswedroeCBS]

Cheryl
I am sure that is part of the reason, and it's all linked, the deficit and the loose monetary policy.
However, I would not be so pessimistic. We already made a huge dent (though not enough) with the big tax increase. There is another big dent coming on March 1 either by congressional action or by sequestration, doesn't matter it's coming. That is really slowing the problem down. We are no where near a Japan or a Greece situation as debt to GNP now about mid 70s and not projected to rise that much with these changes.

And remember, if something cannot continue it will end. Either by people recognizing change is needed or by the market's forcing it. I'd be more optimistic, besides it's a lot more fun going through life that way. Now that doesn't mean your plan should not include considering the risks of failure.

Best wishes
Larry

[cheryl_m]

Thank you Larry!

[fazsha1]

I have had the vast majority of my assets in gold, silver, and the precious metals stocks since 2005. I don't hesitate to buy when I have cash, whether the price has gone up or whether it has gone down. I know where the eventual price will be - much, much higher - and so I do not try to time my purchases, because the market's daily movements are unknowable and volatile. This strategy has served me very well. I have "lost" a lot of money the last 18 months in my gold stocks, but again, since I am a long term investor, and cannot predict short term movements, I don't worry about that. The long term is all I care about, and it is all about gold.

[MaJoOh]

Hi Fazsha1,

Just curious: what country are you from (or are you currently living in since 2005)?

I'm going to make the assumption that you are not here in the US. I'm further going to guess that even the most fervent gold-bug here in the US will not have the "vast majority" of assets in precious metals... Will anyone contradict me? Curious minds want to know.

Here in the US, we have data going back at least a century on various asset classes, and which were very nicely summarized by Jeremy Siegel in a classic book "Stocks for the Long Run". It's pretty clear from the data that as Mr. Swedroe says, "Over the very long term, gold has provided virtually no real return, basically maintaining its purchasing power." And that stock returns far exceed that of every other asset class - especially precious metals and real estate.

Stocks are the best long-term investment - I have (hopefully) decades to go before I sleep the long sleep - and so in contrast with you Fazsha I am 100% in stocks (mutual funds and individual stocks). And if I am lucky enough to retire at 65 (unlikely - I'm planning for the worst case of retiring later) the actuaries say that the average male should live another couple decades in retirement - so I again plan to have most of my retirement funds in stocks (perhaps rotating to dividend stocks).

I don't see precious metals in my present or future.

Besides - have you seen these guys:
https://www.youtube.com/watch?v=dVzR0kzklRE
https://www.youtube.com/watch?v=duEzrOvSb98
https://www.youtube.com/watch?v=BltRufe5kkI

Planetary Resources is a company funded by Google execs and other deep/successful pockets - and I can tell you - you won't want to be in precious metals when this comes to fruition.

Think about what happened to the Spanish Empire when their armadas brought back all the New World gold and silver - it CRUSHED their gold-based economy.

Be safe dude, diversified US and International stocks.

Take it from me - through 2 big recessions and huge stock losses - I'm shining brighter than gold... :)

[theaceswt2]

Being in the jewelry business and understanding the past gold market, next time gold takes a dive, I will stock up and hold knowing that it will go up sometime. I still think gold can be a good investment if you buy at the right time. With that being said, I don't think right now is the time to stock up.
______________
Ken's <a href="http://www.labeloutlet.com">Asset Labels</a>

[MaJoOh]

"Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning."

From one of the finest English speakers in the history of the language.

Sets you up for a pretty high bar there Mr. Swedroe. But you've written a nicely balanced and rational article on the highly irrational price of gold.

But there, I believe, is the key assumption of your article - that prices of any asset have a rational underpinning. That assumption drives your search for a correlation with inflation or monetary policy, or other external factors.

But I believe that a significant, and possibly major, component of price (gold price, real estate price, tulip bulb price, etc.) is the emotions buried under the economic jargon of "demand". And therefore, I am not surprised that the price curve deviates significantly from your monetary policy prediction. People fear inflation or loose monetary policy or government debt levels or the Arab Spring or Iranian/N. Korean nuclear programs or the first black liberal president or any number of other extrinsic factors. This fear, or the abatement of the fear, drives people into gold.

Robert Shiller's "Animal Spirits" is one of the best books discussing this emotional component of economics. You know, Shiller, the dude who predicted the 2001 crash from the Internet bubble in his book "Irrational Exuberance" - and then in the next edition of the same book predicted the 2007 crash of the real estate bubble.

I believe gold is in a massive bubble. It is driven by fear. The bubble will be popped by optimism and a recovering economy. "Popped" is such an innocuous and innocent word. This will be a blood bath. Slaughter. Destruction. Armageddon. Run for the hills you fools... :)

[Bojax39]

"Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning."

Now this isn't the worlds most stupid statement. But it is, perhaps, a statement from the worlds most stupid. What happened to our ability to construct coherent English?

[LarryswedroeCBS]

BOJAX
FWIW, that statement which you called stupid is considered one of the greatest lines in the English language, written by one of the greatest orators of all time and a great writer as well
Best wishes
Larry