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Is the gold rally over?

(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.

What's important to note here is that the Fed's easy monetary policy is not just reflected in targeting basically a zero interest rate policy. Because the central bank believed that driving interest rates to zero was not sufficient to help the economy recover, in 2008 it began its policy of "quantitative easing. That consisted of the Fed expanding its balance sheet through a bond buying program, which has now exceeded $2 trillion. This extra stimulus fueled both inflation fears and the rush to gold.

The Fed is still keeping rates at zero, and it continues its bond buying program. So why has gold started to drop if monetary policy is still loose? The most honest answer: I don't know for sure.

Still, one logical explanation is that the market is anticipating, or has become fearful, that we might be nearing the time when we will once again experience a regime shift in monetary policy. Just as the Fed's bond buying program injected over $2 billion of liquidity into the markets, when the bank eventually reverses course it will be selling bonds and removing liquidity. Inevitably, the Fed also will start raising interest rates.

That's not a question of if, but when. The reason is that something that cannot continue will end. Either the Fed will make that decision or the market will do it for them. And markets look forward. They anticipate, moving prices even before events occur. That's why the stock market is used as one of the nine leading indicators of the economy.

The market appears to have become sensitive to comments by Fed members such as Philadelphia Fed president Charles Plosser, who recently warned about the risks of its current policy, even stating that it's possible the bank will have to raise rates earlier than their current target. Other Fed members such as Jeffrey Lacker, president of the Richmond Fed, Cleveland Fed chief Sandra Pianalto and St. Louis Fed head James Bullard  have issued similar warnings.

Smart investors know this. They know the risks are there that if we do have a shift in monetary regimes to a tightening of policy to prevent the inflation we all fear, gold could easily repeat its performance of 1980-2002. In other words, it could collapse even faster than it rose. It would be like pricking the proverbial bubble. Keep in mind we have already fallen almost $200 in just a few months.

As I noted, my crystal ball is always cloudy. That's why I don't focus on either forecasts or trying to manage returns -- that's playing the loser's game, the one Wall Street and most of the financial media want and need you to play. Instead, I focus on managing the things I -- and you -- can control: the amount of risk to take, diversifying those risks as much as possible, while keeping costs low and tax-efficiency high.

The bottom line is this: If you invest in gold because you value the diversification benefits gold can provide -- hedging the risks of loose monetary policy and some geopolitical events -- it's perfectly appropriate to have a small part of your portfolio in gold as part of your asset-allocation plan. Just be sure that you are a disciplined rebalancer, not one who gets caught up in the noise and emotions the noise can create. That's the only way you get the diversification benefits -- you would have been selling at $850, buying at $300 and selling at $1,700.

On the other hand, if you're a speculator, forewarned is forearmed.