COMMENTARY — Gold’s behavior predictable

.BRobert Hoye

There is an old saying in physics that if you keep your database short enough, it will fit your theory. The views of both goldbugs and goldphobes seem conditioned by events over only the past 25 years.

There have been six great financial booms in modern history, and the value of gold has declined through each one. However, the latest bear market has prompted a number of explanations. As interest rates rose from minus 4% to 9% by 1985, downtrending prices were explained by high carrying costs for gold. This theory, however, seems unable to explain the decline of gold prices by two-thirds since then, as interest rates declined by about the same amount.

For the past five years, the fundamentals of supply and demand have been improving enough that gold prices, in rising, could have remained unaffected by the central banks’ selling of gold. Those sales are small in comparison to the annual bullion trade.

Forward selling by producers had been an explanation for low prices until last year, when prices dropped below the cost of production.

Recently, the discovery of “deflation,” accompanied by threats from Swiss and British policymakers, precipitated a dramatic loss of confidence in gold. Ironically, central banks with speculative monetary policies have voluntarily sold gold when losing reserves, whereas, under a gold standard, they would have involuntarily lost gold reserves until forced back to responsibility.

Fortunately, history provides a record of reasonably reliable behavior of gold disinvestment through each spectacular new financial era. An intriguing slant is that in all previous financial eras, gold and money were synonymous, so it’s tempting to conclude that gold, in plunging during our bubble, has been acting remarkably like money.

Although considered unique by each set of participants, the six financial eras, beginning with the South Seas Bubble in 1720, share remarkably similar characteristics. Of these, the main ones, as the boom ended, drove down gold prices and real long interest rates to significant lows; both then recovered.

While it’s a little early to conclude that the global bull market is over (a number of lesser stock markets either crashed or are experiencing a bear market), characteristics that have supported the boom seem to be changing.

Typically, once these booms end, real gold prices increase under circumstances designed to confound your average goldbug. Very good times for gold have occurred with the serious deflation, both of financial and tangible assets, that results from a great bull market. Weakening labor and energy costs enhanced mining profitability such that gold shares substantially outperformed the broad market.

One of the most formidable events in starting a credit contraction has been the sudden forced liquidation of insupportable speculative positions in lesser stock and bond markets, as well as in currencies and many commodities.

Recently, six out of the seven indicators integral to a financial boom turned negative, providing a warning.

Thanks to the details available from the last two booms, in 1929 and 1873, there are some developments evident within the key year that anticipated previous reversals in gold to a long recovery.

After rising this past spring, base metal prices began a bear market that anticipated a business recession. Financial speculation in lesser exchanges (Vienna, for example) culminated in June and was followed by credit distress, which eventually encompassed the globe.

The yield curve is another important change. Its climb from a period of inactivity in each of the key years, beyond anticipating financial sobriety, was associated with a rise in real gold prices.

Through 1997, the curve ascended slowly, anticipating minor gold rallies by 10 to 19 trading days. The bond-to-bill spread, in flattening from 177 basis points in September, indicated 14 trading days in advance that gold would decline from its price of US$337 per oz. As the curve steepened after Dec.

23, it indicated 12 days in advance that would hit a low — this time, US$278 per oz. The latest decline has been accompanied by a flattening of the curve that seems to be approaching cyclical excess.

As the real price of gold has been conforming to its pattern through a financial bubble, far too much attention has been paid to the supposed influence of central bankers. Gold would have declined with or without selling by the central banks.

As with previous new financial eras, it has been easy to describe borrowing short and lending long as “liquidity.” In all previous cases, this was employed to speculative exhaustion, and severe deflation in both financial and tangible assets followed. Within these conditions, credit gained in complacency collapsed in suspicion (such as happened in Asia), and prudent investors turned to the real liquidity and value inherent in gold.

In a long database, once the securities boom ended, the real price of gold increased for three years, with a gain based on annual averages of about 30-40%.

— The author, a former exploration geologist, is president of investment consulting at Quantum Research