A Historical Review of the American Gold Market

January 16, 2002

Part 1

Steven C. Kennedy

January 2002

Many investors are now once again starting to watch the American gold market and are asking themselves the question, “Has the market bottomed out, and is the market now in the very early stages of the next major bull market”.  On the surface it appears that there is good reason at this time to be asking themselves this question when one considers the international economic and political uncertainty that exists.  Hopefully the following will assist investors in reaching a conclusion that in all reality may make the difference in whether they survive financially or not in the next few years.

The first item to be examined is whether or not the long-term business cycle is still in play.  Those who are familiar with cycles are well aware of the K-Wave Theory which states that approximately every 55 years on average the American economy goes through an economic cleansing to adjust for the economic excesses of the past.  The question which is on the minds of many today is “Has the US economy entered the Winter phase of the K-Wave cycle, and if so, what effect will this have on precious metal investments?”

In the book “The K-Wave” written in 1995 by David Knox Barker, he clearly identifies the key events that comprise the K-Wave cycle.  He, as has others cycle analysts, initially breaks down the long cycle into two distinct periods of development - the advance and the decline.  From that point, the long cycle is divided further into the four seasons that has proven to assist market researchers in developing an increased understanding of how the long cycle evolves over a period of time.  Included within the advance period of the cycle are the seasons of spring and summer.  Included within the declining period of the K-Wave are the seasons of fall and winter.  It is estimated that each season in time extends from 12 to 16 years in duration on average, and therefore results in advancing and declining periods of 24 to 32 years in duration on average culminating in the long cycle of 48-64 years.

The importance for investors in understanding the K-Wave cycle is that its development over time eventually results in an economic depression as the system adjust to the excesses which developed during the seasons of spring and summer.  In reviewing historical data and economic booms and busts which have taken place in the United States, it can be seen that the US has experienced since its founding three separate K-Wave cycles.  (Please note that all dates are approximations and believed to be within 2-3 years.  Furthermore as stated above, seasonal cycles can expand or contract and on average last from 12-16 years in duration).

¨       First United States long wave cycle

                        Advance period - Spring season              …………1789 - 1802      13 years

                        Advance period - Summer season           …………1803 - 1816      13 years

                                    Total years of advance                                                26 years

                        Decline period - Fall season                    …………1817 - 1829      12 years

                        Decline period - Winter season                …………1830 - 1844      14 years

                                    Total years of decline                                                  26 years

                                    Total years of K-Wave                                                 52 years

¨        Second United States long wave cycle

                        Advance period - Spring season              …………1845 - 1858      13 years

                        Advance period - Summer season           …………1859 - 1871      12 years

Total years of advance                                                25 years

                        Decline period - Fall season                    …………1872 - 1884      12 years

                        Decline period - Winter season                …………1885 - 1896      11 years

                                    Total years of decline                                                  23 years

                                    Total years of K-Wave                                                 48 years

¨       Third United States long wave cycle

                        Advance period - Spring season              …………1896 - 1907      11 years

                        Advance period - Summer season           …………1908 - 1920      12 years

                                    Total years of advance                                                23 years

                        Decline period - Fall season                    …………1921 - 1932      11 years

                        Decline period - Winter season                …………1932 - 1948      16 years

                                    Total years of decline                                                  27 years

                                    Total years of K-Wave                                                 50 years

¨       Fourth United States long wave cycle ( ? )

                        Advance period - Spring season              …………1949 - 1966      17 years

                        Advance period - Summer season           …………1966 - 1980      14 years

                                    Total years of advance                                                31 years

                        Decline period - Fall season                    …………1981 - 1999      18 years

                       Decline period - Winter season                …………2000 - 2011      11 years           

                                    Total years of decline                                                  29 years

                                    Total years of K-Wave                                                 60 years

As can be clearly seen in the data provided above, the duration of the seasons, periods, and a complete K-Wave cycle has proven to expand and contract in time.  Therefore, the best that one can take away from the information above is that there appears to be a long economic cycle that occurs in the United States on a repetitive basis on average about every 52.5 years.  The advancing and declining periods of time have averaged 26.25 years or fifty percent of the average long cycle.  The spring season on average lasted 13.5 years, the summer season on average lasted 12.75 years, the fall season on average lasted 13.25 years, and the winter season on average lasted 13 years.  This therefore can provide a general indication to investors of future economic activity that will again repeat in the United States economy under the assumption that this cycle continues to be valid.

K-Wave Cycle Events

As was stated earlier in this presentation, every cycle is comprised of events which if followed closely by investors will assist them in determining where in the long cycle the economy currently is positioned. With this information, the investor will be able to see clearly in advance that the economic trend is nearing, or at a point where a major adjustment is preparing to take place which therefore allows the individual or business to position investment funds appropriately to take advantage of the opportunity that is on the economic horizon.  Again, understanding the long wave allows the investor to maximize returns and minimize financial risks throughout the long cycle.

Once more, credit is given to Mr. Barker for his fine work in presenting the events which are assigned to the four seasons of the K-Wave cycle.  As a result of his efforts, investors can now follow developments as they occur within the US economy and discover both profit and financial security while others face the risk of financial disappointment.  What now follows are the events or trends within each season of the long cycle as presented by Mr. Barker in his book “The K-Wave” that have been identified as key leading indicators for investors to watch.

The K-Wave Spring Season

¨        Stocks up, Bonds down, Commodities Up

¨        New optimism rises in general population

¨        Economy grows solidly

¨        Stock prices rise consistently

¨        Very low inflation but steady advance

¨        Raw material and commodity prices rise very slowly

¨        Real estate prices rise very slowly

¨        Interest rates begin to rise

¨        New technologies and innovations creating whole new industries

¨        New banking system healthy with no failures

¨        Recessions shallow and brief and recoveries strong and long

The K-Wave Summer Season

¨        Stocks down, Bonds down, Commodities up

¨        Inflation heats up

¨        Military conflicts arise

¨        Debt levels increasing

¨        Stocks stagnate nominally and crash in real terms

¨        Rising expectations

¨        Rising prices coax industry into overshooting world demand

¨        Runaway inflation in late summer

¨        Raw materials and commodity prices spike up at the end of summer

¨        Farm land prices peak

¨        Interest rates peak

¨        Rate of long wave economic growth and expansion peaks

¨        Primary recession at the end of the K-Wave summer

The K-Wave Fall Season

¨        Stocks up, Bonds up, Commodities down

¨        Fall comes after the primary long wave recession

¨        Worldwide overproduction and overcapacity

¨        High debt levels continue to grown throughout

¨        Global system awash in cash

¨        Financial speculation

¨        Economic growth rate slows significantly from the long wave advance

¨        Interest rates decline

¨        Global stock markets boom

¨        Laissez-faire political posture and deregulation

¨        Early deflation and disinflation

¨        Falling raw material, commodity, and farm land prices

¨        Commercial and residential real estate prices peak in the late fall

¨        Expansion by acquisition and takeovers

¨        Slower capital investment pace

¨        Banking system weakens and failures begin

¨        Trade protection pressures build

¨        Psychological optimism for society - Roaring 1920’s and 80’s

¨        Economic growth slower than spring and summer

¨        Greed runs wild

¨        Individual investors follow the herd into stocks

¨        Final speculative stock blowoff at the end of fall

¨        Record new stock offerings - IPO’s

The K-Wave Winter Season - See the discussion on economic depressions below

¨        Stocks down, Bonds up, Commodities down

¨        Global stock markets enter extended bear markets

¨        Interest rates spike in early winter and then decline throughout

¨        New stock offerings end

¨        Economic growth slow or negative during much of the winter

¨        Some runaway deflation and falling prices

¨        Commercial and residential real estate prices fall

¨        Trade conflicts worsen

¨        Social upheaval and society becomes negative

¨        Bankruptcies accelerate and high debt eliminated by bankruptcy

¨        Stock markets reach bottom and begin new bulls in winter

¨        Overcapacity and overproduction purged by obsolescence and failure

¨        Greed is purged from the system

¨        Recessions long and recoveries brief

¨        Free market system blamed and socialist solutions offered

¨        Banking system shaky and new one introduced

¨        New technologies and inventions developed and implemented

¨        Real estate prices find a bottom

¨        New work ethics develop since jobs are scarce

¨        Interest rates and prices bottom

¨        Debt levels very low after defaults and bankruptcies

¨        View of the future at low ebb

¨        Bright spots appear and social mood improves

¨        There is a clean economic slate to build on

¨        Investors are very conservative and risk averse

¨        A new economy begins to emerge

As is apparent in the events listed above, one might easily conclude that the United States economy is very near to the end of the fall season and will soon be heading into the winter season of the K-Wave cycle.  Although the events listed above do not necessarily occur in the exact order given, and also because it has been shown that seasonal cycles can overlap, expand and contract in duration, it is only important that investors recognize that certain events are taking place at a similar point in time which then can place them within a particular season as they relate to the entire K-Wave cycle.

There is one point though with regards to the winter season of the K-Wave that must be discussed and is imperative that investors understand.  In that regard, the events listed above would be indicative of an economy which was experiencing a “deflationary” economic depression.  Unfortunately, not all winter seasons will follow a deflationary path.  Although to date the United States as a nation has experienced several deflationary depressions, it has not experienced a “hyperinflationary” depression recently.  What is critical to understand is that the wrong investment decisions made at this point in the cycle could, and in high probability would, result in devastating financial loses never to be recovered.  This is why it is of extreme importance for investors to understand completely what the difference is between the two types of depressions, and then also to know what are the appropriate steps to take not only to preserve their assets and maintain their financial well being during a most difficult time, but also the steps to take advantage of the new opportunities which will present themselves.

The Winter Season - Deflationary or Hyperinflationary

To explain in a simplified fashion, the event which will indicate whether an economy is headed toward a deflationary economic depression or a hyperinflationary economic depression is whether or not the money supply and credit is severely contracted or expanded throughout the economy.  If the money supply and credit is contracted ( late 1920’s in the US ) then one should expect that the economy will experience a deflationary depression.  If on the other hand, the money supply and credit is greatly expanded in an attempt to revitalize the economy in order to prevent a deflationary depression, then the possibility of developing into a hyperinflationary economic depression becomes a real possibility.

Probably the best two examples that can be given that relates to a hyperinflationary experience in the United States would be the Continental Currency fiasco where within six short years after they were first issued the currency became worthless, and the “Greenbacks” issued during the Civil War period which also failed as a monetary unit.  Although both were similar in that they were both paper currency, the Continental Currency maintained convertibility into species until it was discontinued whereas, the convertibility of the Greenback was suspended and became the first inconvertible paper fiat currency to circulate in the US economy.  The following table clearly illustrates what can happen to fiat currency in an economic system if hyperinflationary pressures (expansion) takes hold.

Value of Continental Notes in Silver Coins

Source:  Alexander Del Mar, The History of Money in America, (Hawthorne: Omni, 1966)

Date                             Total Notes Issued                   Approx. Value per $1.00 Silver Coin

November 1775              $    5.0 million                            $  1.00 in Continental Notes

November 1776              $  19.5 million      290 %             $  1.00 in Continental Notes       

November 1777              $  31.5 million      530 %             $  3.00 in Continental Notes          200 %

November 1778              $  86.0 million    1620 %             $  6.34 in Continental Notes          534 %

November 1779              $226.0 million    4420 %             $26.00 in Continental Notes        2500 %

(no more issued)

November 1780              $226.0 million    4420 %             $73.00 in Continental Notes        7200 %

As is clearly evident in the data presented in the table, the following facts should be noted:

1.       As the quantity of currency expanded (inflation), the Continental Notes depreciated in value.  Due to the depreciation, prices for goods (in this case silver) and services would have responded by rising in absolute terms.

2.       During the expansion and depreciation of the currency, there is a lag time prior to prices responding.  In the case above, it was two years of expansion before silver prices began to adjust upwards.

3.       During periods of hyperinflation, the percentage gain for precious metals at some point along the destructive path will surpass the percentage rate of currency depreciation therefore not only maintaining but improving investor wealth or purchasing power.

4.      A hyperinflation can occur in an economic system whether the currency is redeemable or not into precious metals.  A tipping point is reached, confidence is lost, panic sets in, and then prudent investors flock toward precious metals for financial security.

5.      Historically, once a nation removes the link (gold standard) from its currency which had restricted its ability to expand its currency at will, eventually that fiat currency is destroyed and replaced.

6.      In summary, precious metals along with other investment alternatives will initially fail to keep pace with the rate of currency depreciation, yet precious metals will preserve assets long term while other currency based (paper) investments will be destroyed should a hyperinflation take place.

During a deflationary depression, the money supply and credit is contracted which therefore strengthens the currency and causes the price of goods and services to decline.  In this case investors know that cash in the hand is king while at the same time, cash deposits in a bank is at risk due to potential loan defaults resulting from bankruptcies taking place throughout the economy.  Investors are also well aware that the equity markets, although not all sectors, are subject to dramatic and sustained losses as bankruptcies increase substantially due to both rising unemployment and decreasing business revenues.

The best documented example of what a gold investor can anticipate during a deflationary depression would be the United States Crash of 1929.  Due to the fact that there have been numerous books written concerning this period of American history, the focus in this presentation will be limited to how precious metal investments responded.  Keeping in mind that during a K-Wave Winter Season (deflationary) the price for commodities decline in value, this was not the case though for precious metal stocks for the obvious reason that precious metals serve as a hedge against economic and political uncertainty.  I strongly urge the reader to review the editorial written by Dr. Vronsky, “1998/99 Prognosis Based Upon 1929 Market Autopsy” that appeared on the Gold Eagle website on 06 June 1998.   His excellent presentation clearly shows how Homestake Mining, serving as a proxy for the industry, performed beyond expectations while other sectors declined substantially under the prevailing severe economic conditions.

Based upon the last K-Wave deflationary cycle that the United States economy experienced, one can conclude that investing in precious metal mining companies was a very successful way for investors not only to protect their financial assets, but also to acquire additional wealth. The remaining question is how well did physical precious metals perform during the deflationary period?  In order to determine this, it now becomes necessary to readjust the discussion from thinking in terms of absolute price, to thinking in terms of the purchasing power of precious metals.  Purchasing power is far more important to understand and apply that is the absolute price.

PURCHASING POWER

To understand the concept of purchasing power is to understand the relative value relationship of an asset (precious metals) to prices of other goods and services during various economic conditions. Without going into great detail, the purchasing power of precious metals can be summarized as follows:

¨       During periods of inflation - currency and credit expansion - precious metals will rise in absolute terms, but as pointed out above in the discussion regarding hyperinflation, even precious metals will fail to keep pace with currency depreciation under a fixed-price system until such time that a monetary panic takes place.  Therefore even though the price of precious metals will increase, the purchasing power is negative relative to prices of other goods and services until the panic begins at which time, not only do precious metals increase in absolute terms but also increases in purchasing power due to a limited supply.

¨       During periods of deflation - currency and credit contraction - precious metals will fall in absolute terms, but will increase in purchasing power as the economy contracts.  In other words, the price of precious metals do not fall as quickly as other goods and services traded in the economy.  In fact, as the contraction worsens over time the purchasing power of precious metals actually increases at a faster rate. 

To provide the supporting evidence of this, the following table based on historical data illustrates the purchasing power of precious metals during various periods of economic activity.  The source for this material was provided by Roy  W. Jastram from his book “The Golden Constant” published in 1977.

According to the data provided by Mr. Jastram from 1808-1976, it is obvious that each period where the economy was inflationary commodity prices in general rose at a rate faster than the price of precious metals which resulted in a loss of purchasing power.  The data also indicates that during those periods where the economy was in a deflation, commodity prices in general fell faster than the price of precious metals which resulted in an increase of purchasing power for precious metals.  That was at least true until the inflationary period from 1970-1976 where the data clearly shows that not only did commodity prices in general rise by 66 percent, but the purchasing power for gold also was for the first time positive at 110 percent.  In other words, the price of gold rose in absolute price more than commodity prices in general.  What was it that caused the trend to change in 1970 after more than 160 years, and what if any impact can be expected from this change of events in the future?

The actual event which caused this to happen was the dissolution of the London Gold Pool in 1968 and the emergence of the two-tier market in that year.  Thereafter, monetary gold would be used for official settlements only within a closed system of central banks with the United States agreeing to exchange to other nations from its own gold reserves at $35.00 per ounce.  The other tier was for private buyers who could now purchase legally on the open markets at prices set by forces of supply and demand.

As a result, it is now possible to make the statement that during inflationary times, the purchasing power of precious metals will increase at a greater rate than commodity prices in general, and during deflationary periods the purchasing power of precious metals will increase as the absolute prices of precious metals will decline less than the absolute prices of other goods and services in the marketplace.  Therefore from an investment standpoint, if the goal is to improve purchasing power during times of economic instability, then precious metals will be able to do so whether the economy experiences inflation or deflation.  Precious metals have once again returned to their original purpose which has always been to maintain ones purchasing power over long periods of time.

Yet just as is the case with all other investment vehicles, precious metals will always be traded according to cycles and short term technical analysis.  Therefore, one can and should expect that precious metals will experience bull markets and bear markets.  Obviously if the economic system was not manipulated by the government and the central bank by expanding and contracting the currency and credit in circulation, the role of precious metals would simply be looked upon as a long term investment with the sole purpose of maintaining wealth until retirement.  Unfortunately this is not the case, and therefore, an understanding of cycles and technical analysis is required.  By understanding TA, an investor is able to fine tune the timing of the market which then provides higher probability entry and exit points.  Part 2 of this presentation will examine TA as it relates to the historical performance of gold in the US.

Part 2

Part 3

10 karat gold is 41.7% pure gold.