Ignore gold investment myths - and look to the Fed

Gold's bull market continues, the noisy setbacks of 'hot money' aside.

And as the price keeps on rising, so more and more private investors looking to put their money to work after 6 years watching gold outperform stocks and bonds are joining the search for information and advice on the metal.

But plain facts about gold are just as hard to come by as they are when you're trading equities or bonds. Falling for the No.1 gold myth, for instance, would have cost you 14 cents in the Dollar at today's prices.

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It signaled 'sell' back in October last year and it signaled 'sell' again on Tuesday this week, just before gold shot 3.5% higher in one session to reach levels last seen at the quarter-century peaks of May 2006.

Gold investment myth #1 : 'gold's bull market is all about oil'

Listen to any pundit or metals analyst talking about the price of gold today, and chances are they'll tell you to watch oil. The price of crude, in fact, has become crucial to the bull market in gold or so you might think.

'We need oil to break and hold above $60 for gold to rise further,' agree the traders and dealers interviewed by Reuters and Bloomberg each day. Yet by mid-February, oil had failed to hold above $60 per barrel. Gold, on the other hand, stood nearly 10% higher from when oil's bull market broke down last fall.

What link there is failed to hold firm even during the 'commodity bull' that saw hedge funds pile into both oil and gold over the last half-decade or so. Crude oil first turned higher in 1999; gold didn't get started until 2001. Oil's major leg up began in 2002 and peaked in mid-2006; gold's uptrend remains rock-solid today.

More importantly for active gold traders, short-term fluctuations in the gold price have next-to-nothing to do with movements in oil. From 1983 to 2006, the average correlation between their weekly price changes was a mere 0.10. Yes, the connexion improves if you look at the three years ending Dec. '06. It rises to 0.33. But the correlation would be nearer to 1.00 if gold really was 'all about oil'.

Gold investment myth #2: gold relies on base metals

Compare gold with base metals, and it's the same story. Even though the correlation of gold with copper, zinc, nickel, aluminum and the rest has been nearly twice as great since the early '80s as gold's link with oil, it remains low below 0.2 on average. What's more, both the oil and base-metal correlations have varied massively over time. Going from 2006 into '07 they ranged well above the historic norm. But the correlation still says other factors are more important than oil.

With oil struggling this month as gold moves higher, the long-run correlation of just 0.10 suggesting a causal link of only 1% according to the principles of statistical analysis could be making a comeback. Pundits who tell you otherwise, claiming that gold's all about oil, make the classic mistake of confusing recent events for a law of nature.

Gold investment myth #3: gold is an 'inflation hedge'

It's not just recent history that creates misinformation in the gold market, however. The major newswires and leading newspapers cite gold as an 'inflation hedge' every time they mention the metal.

'Gold's allure as a hedge against inflation grew after [the] big rise in January consumer prices in the United States,' reported Reuters earlier this week. And it's easy to see why. For along with bad German wine and the Bay City Rollers, the 1970s cursed the industrialized world with soaring inflation in the cost of living.

Gold's stellar run up to $850 per ounce came that same decade, ending with the all-time high hit in January 1980. Therefore gold must deliver its strongest returns when the cost of living is shooting higher. Right?

Wrong. 'Those that think gold always acts as an inflation hedge are simply mistaken,' as Mike Shedlock of Global Economic Trend Analysis puts it. Just look at the last quarter century.

How gold dropped 15% of its value over 25 years

Consumer prices in the United States, even on the US government's own data, have doubled since 1982. Gold simply failed to keep pace. In fact, it's dropped 15% of its purchasing power over that time. At its lowest point, back in 2001, the loss of purchasing power for US investors reached over 75%.

How to square this fact with gold's huge returns in the '70s? Perhaps gold only responds to rapid inflation, you might think the nasty kind we got three decades ago, rather than the 'mild' case our money has suffered since then.

But you'd be wrong again. Between 1980 and '81, US inflation ate 17 cents of the Dollar's purchasing power. The gold price dropped 40% over the same period. And look further back even to when physical gold stored in government vaults helped support the Dollar, just as it did all other major currencies and you'll find that gold has always made a poor hedge against rising prices.

In the mid-70s, Professor Roy Jastram of the University of California at Berkeley found that gold had failed to keep pace with the cost of living during seven inflationary periods in Britain. His data ran across more than three centuries!

In the United States, Jastram identified six inflationary periods between 1808 and 1976. They saw the purchasing power of gold fall by more than one fifth on average. Only the final period in Jastram's study beginning in 1951 saw the metal gain value. It continued to gain purchasing power right up to that infamous top of $850. But from then on, it was downhill all the way until spring 2001.

Why gold investors should be watching Fed interest rates

What changed at the start of the 1980s? In two words, Paul Volcker. The key thing to watch isn't the rate of inflation, not by itself. You need to watch the gap between Fed interest rates and inflation instead.

Real interest rates paid on US Dollar accounts averaged just 0.01% between Jan.1970 and Dec.1979. That lack of decent returns made gold attractive on a relative basis. In truth, it only made gold less burdensome.

Gold pays no interest, remember. Indeed, gold costs you to hold it, either by rolling forward futures contracts to maintain a paper position, or through storage and insurance fees on physical bullion. Yes, these costs can be vanishingly small today, thanks to ground-breaking gold investment services such as BullionVault.com for instance. But gold still fails to pay investors any kind of dividend. And the gap between inflation and interest rates has to reach absurd levels to make gold worth holding.

That's just what happened in the '70s. It's what's happened in the 21st century so far as well. The real rate of interest, the gap between CPI inflation and the Fed's official interest rate, has averaged just 0.47% since the start of 2000. Real rates during the '90s stood almost four times as high and gold fell by one third. Measured against CPI inflation, in fact, its purchasing power dropped by one half.

So what to make of the upturn in real Dollar rates starting two years ago? By the end of 2006, US rates adjusted for inflation had shot up to 4%. We last saw that level just before the Federal Reserve first unleashed the flood of liquidity and cheap money still drowning the world's financial markets today. So the jump in CPI inflation reported this week really did drive that $23 jump in gold prices too but not because gold offers protection against higher consumer prices. Rather, the Labor Department's data set a challenge to the Bernanke Fed:

'Will you keep raising interest rates to defend the Dollar, pay a decent return to US savers, and crush the gold speculators like Paul Volcker did at the start of the '80s? Or will you freeze perhaps even cut real rates to prop up the housing market, bond prices and the Dow like Alan Greenspan would urge?'

It's clear that Bernanke's been dealt a bad hand by the Maestro. But will the gold market now fold, raise, or call his bluff?

City correspondent for The Daily Reckoning in London and a regular contributor to MoneyWeek magazine, Adrian Ash is head of research at www.BullionVault.com, giving you direct access to investment gold, vaulted in Zurich, on $3 spreads and 0.8% dealing fees.