Gold in Uncertain Times

October 20, 2000

Investors have bought and held gold throughout history as a form of protection against many different types of uncertainty. Over many centuries gold has served investors well by protecting them from turbulent economic, political, and financial market developments.

Gold has not been called into duty by U.S. investors since the late 1980s. This does not reflect a lack of interest in gold, however, but rather the longest period of economic well being this country has experienced since the industrial revolution. It is not that gold has failed to serve as an insurance policy; investors have not felt the need to buy insurance - until now.

In the past few months market consensus has shifted from an euphoric view of economic utopia to a future clouded by higher energy prices, energy shortages, unusual interest rate patterns, sharp declines in volatile stock markets, and the possibilities of inflation and/or recession once again. Added to this are political uncertainties as the country faces a change in Administration, regardless of who wins the Presidential elections in November, coupled with recent renewed violence, unrest, and terrorism in the Middle East.

The speed with which the economic and political landscape has shifted is dizzying. In a very short period of time, oil prices have tripled from 1997 levels. Inflation fears are being rekindled, and the stock market has faltered. The DJIA is down 13% in the first nine and a half months of 2000, and the Nasdaq has wiped out around 24% of investors' wealth in Nasdaq equities. The yield curve in U.S. Treasury bills and bonds remains inverted.

Given all of this, gold may soon be called into service as a hedge and safe haven - not only against inflation, financial market weakness, currency market turbulence, and economic problems, but also against political unrest and uncertainty.

Some investors and commentators-mostly from brokerage companies that sell stocks and mutual funds- have noted that gold prices have not risen in recent weeks, as these changes have taken hold. That is not unusual. Even in 1978 - 1980, the dollar plunged, inflation rose to double-digit levels, the stock market seemed dead forever, and inflation-adjusted interest rates were below zero for a long time before investors moved into gold. The charts above show inflation was over 10% before gold prices started responding, in the middle of 1979. The dollar had already dropped sharply, in early 1978, before gold prices started rising. And, political conditions in the Middle East and elsewhere had deteriorated sharply long before investors began buying gold as a safe haven.

In recent months gold prices have languished, remaining at very low levels between $270 and $280, just slightly above the lows of the past two decades of $254. The question in the final quarter of 2000 is whether gold prices ultimately will respond to the current events.

History would suggest so, although there are some mitigating factors to consider. For gold prices to revisit the $825 level seen in 1980 would likely take a combination of a cataclysmic series of events, as was the case in the late 1970s. That may not happen, but as economic and political conditions worsen, gold prices should be expected to respond by rising, to some extent.

How high gold prices will rise depends on many factors, including the degree to which current conditions worsen. If the world economy escapes the gathering problems, as has been successfully accomplished several times in the 1980s, there could be a relatively small response in gold prices. If conditions worsen, the price increase could be sharp and volatile. The lower liquidity of the gold market today relative to other financial markets could add to the price reaction. Most likely events will unfold somewhere in between these two extremes, in which case the gold price response would be expected to be somewhere between the extremes of no price increase and the quadrupling of prices seen at the end of the 1970s.

Another key point to watch will be how fiscal and monetary authorities manage any crises this time around. They managed problems very effectively in late 1982, late 1987, and after that, but several key decision makers from that era have been replaced, and the newer managers have not yet had their mettle tested. Perhaps the most important point to make amid the current arguments that gold prices are not responding to current events is that the price response historically has lagged the appearance of events stimulative of higher gold investment demand. Although the situation today is different from that of 1978 - 1980, there are important correlations to draw. Historically, gold prices have reacted to bad economic conditions by adjusting upwards-often quite sharply-providing investors not only with capital preservation, but the opportunity for capital appreciation as well. A similar opportunity is unfolding in 2000, as gold prices tread water at low levels in the face of rising uncertainty. Given the lagged nature of the gold price response in the past, this may soon change dramatically.

The world’s gold supply increases by 2,600 tons per year versus the U.S. steel production of 11,000 tons per hour.

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