Item of the Week: Chart
March 29, 2006

Gold, DOW and Inflation - Old

Gold, DOW and Inflation - New

Notable Similarities?


Note that we're using the Federal Reserve as our source for inflation data for the 1974 to 1984 period and Gillespie Research data for the 2001 to 2006 period.  The government's methods of inflation indexing, collection and analysis has been mucked with so much since the Nixon administration, most notably under the Clinton and Bush II administrations, that it's necessary to use Gillespie's ShadowStats.com data to get an accurate picture of what's going on.  Use the Fed's current data and recent commodities price increases are a complete mystery.  Plug in Gillespie's numbers, and the price increases in commodities, including gold, begins to make sense.  What doesn't make sense is that while the commodities markets haven't been fooled by the bogus government stats, apparently either the bond markets have been fooled or bond yields are lower than you'd expect given the real rate of inflation because of ongoing vendor financing of U.S. consumption by Asia via the purchases of U.S. treasury and agency debt.  Or on a risk-adjusted basis, even with inflation running at 7%, a 10-year U.S. treasury bond is still a good deal at 4.5%.

U.S. citizens were not permitted to own gold bullion for 42 years, from 1933 until January 1975.  After that, the last gold bull market began.  It got off to a slow start.  Private and institutional investors had not had any experience investing in gold for 42 years.  Plus, right after the gold market re-opened in the U.S. in 1975, inflation fell dramatically, from 10% to 2.5% and with it the price of gold.  Even the following year when inflation shot back up to 12.5%, the price of gold increased only modestly, as market participants were slow to catch on to what was happening.  But gold continued to climb modestly even as inflation fell again between 1977 and 1978 as 
the first wave of buyers -- the early adopters -- started to show up.  Then, a couple of years into the bull market, the second wave of buyers entered the market and gold took off in its second stage of growth 1979, even though inflation was relatively tame that year compared to recent spikes. That price rise anticipated the spike in inflation that occurred in 1980 when both inflation and gold peaked in its final bubble wave in 1980.  Back then you couldn't find an investment book that didn't tell you to buy gold and other hard assets and stay away from stocks.  That was the exact opposite of what investors should have been doing because in came Paul Volcker to take over the Fed from Nixon's pal Burns.  Volcker put the hammer down, cranking interest rates up in 2% rate hikes at times.  None of this baby-step stuff that the Fed's doing today.  Inflation collapsed from 18% in 1980 to -2.5% in 1983.  The U.S. economy fell into a deep recession for most of that period.  Imagine what a 2% rate hike would do today?  It'd get inflation back under 5% from 7% in a hurry, that's for sure.

What does this mean for us today?  After a 20 year bear market that started in 1980 and ended in 2001, investors have been as slow to catch on to the new bull market in gold, as well as other commodities including silver and platinum, as they were after the previous bear market in gold, or rather non-market in gold, as U.S. citizens were not allowed to own it.  The DJIA has for the past several years been rising, much as it did between 1978 and 1981 when inflation and gold were also rising, but in inflation-adjusted terms in both periods the DJIA declined.  The painful period of adjustment that the Volcker Fed created set the U.S. up for a long and massive expansion that during its healthy pre-bubble phase from 1982 to 1995 that saw the DJIA grow in inflation-adjusted terms by nearly 400%. 

The crucial question is whether the rising price of commodities is again predicting a future rise in inflation.  We believe that it is.  We will see this inflation spike at some point and the price of gold with it.  The second wave of gold investors are getting on board as we enter the next phase of the bull market, not only gold but silver and platinum as well.  At some point commodities will too reach a bubble phase.  The bookstore shelves will again be stuffed with books that tell you to buy hard assets, your mailman and neighbors will be lecturing you about gold, and it will be time to get out.  The gold price then?  We've been estimating $2,500 - $3,000 for several years and don't see any reason to change this.

At some point the source of inflation will be addressed by the Fed in a manner
similar Volcker's.  This time the job will be to put an end to the cycle of asset bubbles that have been driving the economy since the birth of the Frankenstein Economy around 1995.  When this happens, the U.S. will once again go through a painful transition but will, in the end, come out ahead for the reasons it has in the past.

Sources:

Previous Items of the Week:
March 6, 2006: Distribution of Income Gains by Income Bracket
March 22, 2006: Roubini and Others Speak at CATO Conference on
Monetary Institutions and Economic Development

March 25, 2006: Net Foreign Acqusition U.S. Financial Assets

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