Economic environment near perfect for gold to shine


SERIOUS MONEY:ON THIS day in 1982, the secular bear market that had weighed on stock returns since the late 1960s reached bottom – with share prices almost 65 per cent below their secular peak in real terms and no higher than levels first reached way back in 1954.

As stock prices stumbled and erased years of upward progress, gold rewarded disillusioned equity investors who sought its protection. Indeed, by the summer of 1982, gold’s purchasing power had jumped almost fourfold from the level that prevailed when the downtrend in the major stock market averages got under way 14 years earlier. It rose even though the high real interest rates required to fight runaway inflation had terminated the secular bull in the precious metal two years previously.

Fast forward to today and the downgrade of US government debt by Standard Poor’s, alongside the escalating euro zone sovereign debt crisis, confirms the primary downtrend in Western stock markets that started more than a decade ago, is alive and well.

US stock prices at current levels are almost 45 per cent below their secular peak in real terms, such that all capital gains since the spring of 1997 have been erased.

Meanwhile, gold continues to frustrate its critics, as the price of the precious metal edges ever higher and is up almost fivefold in real terms since the equity bubble began to deflate more than a decade ago.

Once again, gold has served owners well and proved to be an effective offset to lacklustre stock market returns, even though investors’ primary concern during the current secular bear has been the potential for demand-side deflation, not the disturbingly high inflation that precipitated the downtrend in stock prices during the 1970s.

Secular bear markets in stocks are characterised by a downtrend in the multiple that investors are willing to pay for one dollar of trend earnings and are precipitated by movements away from price stability towards runaway inflation or demand-side deflation arising from the unravelling of unsustainable debt balances. These are the same conditions in which the diversification properties of gold spring to the fore, as the accompanying economic uncertainty increases the precious metal’s allure.

Gold’s performance through the inflationary 1970s, following Nixon’s decision to suspend the precious metal’s convertibility into US dollars for official holders, is well known and has contributed to the universally accepted premise that the yellow metal is an effective inflation hedge. The conventional wisdom stands in sharp contrast to the late Prof Roy Jastram’s conclusion in his 1977 classic, The Golden Constant.

Prof Jastram analysed the behaviour of gold prices in the UK from 1560 to 1976 and in the US from 1800 to 1976. His work revealed that the precious metal proved to be an excellent store of value through the long sweep of history, but his analysis also showed that it was an ineffective inflation hedge over relatively shorter intervals, as its purchasing power declined during inflationary episodes.

The real value of gold, for example, dropped by more than 20 per cent in the UK in each of the periods 1702-1723, 1752-1776 and 1793- 1813, while it lost two-thirds of its purchasing power from 1897 to 1920. This can be explained by the precious metal’s monetary role in the Gold Standard and, by definition, the purchasing power of money declines during inflationary episodes.

An update to Jastram’s work by Jill Leyland in 2009 reveals gold has served as an effective inflation hedge since the collapse of the Bretton Woods system of exchange rates four decades ago, as individuals sought the protection of the precious metal during periods of rapidly rising prices.

Jastram’s study also showed that the purchasing power of gold tended to increase, often markedly, during deflationary episodes, which again can be explained by the precious metal’s close links to the monetary standard.

Since gold only performed well under deflation when the Gold Standard was intact and has served as an effective store of value since the end of dollar convertibility, some commentators believe it would perform poorly, should the developed world succumb to a destructive debt deflation.

The logic is wide of the mark. Individuals scramble for liquidity and flee financial assets during deflations, but the deteriorating credit quality of currency issuers and the resulting loss of confidence mean that gold is typically preferred to paper currency as a hoarding vehicle. To quote former Federal Reserve chairman Alan Greenspan: “Gold . . . is relevant wholly because of the historic and widespread perception of gold as an indicator of a flight from currency.”

Thus, should the US economy enter a recession or should the euro zone sovereign debt crisis continue to rage, the resulting deflationary pressures and loss of confidence in currency would, in all likelihood, result in a higher gold price.

Gold’s diversification properties are not only apparent through a secular bear market in stocks, but also in the face of periodic crises that lead to substantial declines in equity values. As Jill Leyland remarks: “Men and women have turned to gold in times of distress, whether political, economic or personal.” Indeed, the verdict of history shows that gold has gained in value during each of the most savage downturns in stock prices of the past 50 years, including 1973-74, 1987, 2000-2002 and 2007-2009.

Gold is the ultimate hedge against instability and uncertainty. Given a return to price stability is unlikely any time soon, while tail-risk in the form of inflation or deflation is high, the environment is near-perfect for gold to shine. The recent parabolic upward move however, suggests that it would not be advisable to initiate positions at current levels. Nevertheless, far-sighted investors should raise strategic weightings on weakness.