Is the gold rally over?

Pile of Gold Jewelry - coins, chains, necklaces, earrings, rings and other scrap gold.

(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.

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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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.