Why gold could hit $8,500 an ounce

Inflation is rampant and bonds and gilts are worthless. And while there may be a bubble, it's not in commodities. John Stepek looks back to the 1970s, and discovers how the price of gold could rocket.

The next bubble to burst won't be commodities

From the late 80s until now, that sleazy operator inflation barely got a mention, though we were living through two decades of never-before-seen money supply growth. Who cared? He was serenading stocks and houses and we were getting richer. "That's nice," we said, "but ssshh".

But now the old cad has dumped poor, dear housing and stocks for a new lover: commodities food, metals and energy and polite society is outraged. "How could he?" we are all saying. And that's part of the problem the fact that we are all suddenly talking about inflation. The genie is out of the bag and it's going to be impossible to get him back in.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

That hasn't prevented the world's top central bankers from going on a concerted genie-suppressing effort. Bernanke, King and Trichet have all spoke out on the subject this week. But it is too late for that. Pandora's Box has been opened.

In the long-term it does not matter what central bankers say. What matters is what they have done. Gold and oil are going to go a lot higher. But how high? I'll tell you. Perhaps $8,500 for gold and $400 for oil.

Here's why

The first thing to note is that Federal Reserve chief Ben Bernanke's words last week and again this week did send the gold price down. We must thank him for that he's given us another buying opportunity. As I said before, I still see $850 an ounce, or just below, as an obvious floor, and that is where I and probably half the world's hedge-funds have placed my buy-orders.

Central bankers can't talk down inflation

But despite all the rhetoric, nobody has actually done anything yet. Is Bernanke really going to raise rates by anything significant, just as we head into a derivatives crisis? Even my granny's budgie knows you can't raise rates when a business downturn is accelerating. Trichet's hands are similarly tied. Despite the German terror of inflation, the problems in Spain, Ireland and Italy are just too pronounced. Mervyn King also seems to understand the inflationary danger we are in, but can you see him embarking on a major rate-raising cycle with the spectre of Gordon Brown breathing down his neck like some ghoulish character out of Lord Of The Rings?

So instead they are concentrating on inflation expectations' the perception of the problem. But if your house is going down in value, if your salary is not rising, (indeed if your job is under threat), if your pension pot has emptied and your earnings are buying you less and less each year, it does not matter how loudly the central bankers shout about it - everything around you, from the wind in the trees to the traffic, will be screaming inflation.

How typical of today's authorities to be more worried the perception of inflation than inflation itself. It is like being more concerned about the employment numbers or what people think of the employment numbers than with the serious problem of unemployment. It shows the shallow world of soundbite and lazy policy in which we now live. Sooner or later it will come back and bite us all, but by then it will be too late.

Mark my words, inflation is about to accelerate as the authorities attempt to deal with this now-inevitable derivatives crisis. I would advise you to keep your eyes on the inflation train coming down the track, rather than the butterflies on the buddleia on the sidings that the central bankers would have you look at.

The next big bubble and it ain't commodities

Why, oh why would anyone buy a bond or a gilt? You might get yields of 3%, 4% or 5%, but the cost of living is patently rising by so much more than that. Virtually guaranteed to lose purchasing power, it just doesn't make any sense.

So why are people buying them? It's because bonds are perceived as safe. But I can't help but think now that the inflation genie is out, more and more people will come to realise the truth about the declining purchasing power of their money and move their funds elsewhere.

There's been endless talk of commodities being in a bubble. Oil is in a bubble, we hear. But supply has to exceed demand in a bubble. It does not. Last February for the first time in the history of the world demand for oil exceeded production that situation has remained the case for 90 days. But there is no supply shortage of bonds. And you have to question the real value and use of the underlying asset.

The bubble, if it's anywhere, is in bonds and they, in my humble opinion, will be the next one to pop.

How high will gold and oil go?

Well, history shows us what is possible.

The most obvious time to look to for parallels is the 1970s. Then the gold price went from the artificially suppressed price of $35 an ounce to $850. That is a rise of, give or take, 2,500%. A similar 2,500% rise from the artificially suppressed 1999 low of $250 would take us to $6,250. That is what happened before.

However, there are lots of differences between then and now: in those days interest rates were higher, the threat from derivatives was not as pronounced, debt was lower, there was not such a global crisis in banks, money supply growth was not so out of control, and crucially, Gordon Brown and Ben Bernanke were not in charge. So perhaps $6,250 is a little conservative.

Michael Hampton, who is the best trader I know, uses all sorts of cycles and technical indicators in his work and is continually looking for fractal (repeating) patterns. Among other things, he has what he calls his simple ten for' rule. Let me explain.

He argues that a 1970s dollar had about ten times the value of a 2000 vintage dollar. For example, the S&P averaged around 100 in the 1970s. It is over 1,000 this decade. Similarly the Dow averaged around 800-1,000, while for the Noughties that figure is around 10,000. Gold began the 70s at $35, it began the 00s at almost $300.

By the same reckoning, he argues that if gold went to $850 last time, it could spike to $8,500 this time.

He uses the same argument for oil. It went from low single-digits to $13 by the end of the 1974 oil crisis. Now oil has gone from $10 to over $130. By the end of the decade oil went from $13 to almost $40. So Mr Hampton, not unreasonably in my view, has a possible eventual target of $400 for oil (which he sees by 2012-13, by the way).

Some food for thought.

Just before I go - if you're a MoneyWeek subscriber, we'd like to get your feedback about the magazine. An email from MoneyWeek editor Merryn Somerset Webb will be arriving in your inbox later today. We'd really appreciate your response, so please look out for it.

Turning to the wider markets

Enjoying this article? Why not sign up to receive Money Morning FREE every weekday? Just click here: FREE daily Money Morning email.

The FTSE 100 index fell 50 points to close at 5,827. A weak quarterly update from supermarket giant Tesco hung over the retail sector, while housebuilder Persimmon was the main faller as the RICS survey warned of falling prices and a slump in sales.

European markets fell back, with the German Xetra Dax losing 44 points to close at 6,771 and the French CAC 40 fell 38 points to 4,761.

US stocks were volatile. The blue-chip index ended the day in the black as oil prices fell as the US Energy Department cut consumption forecasts. The Dow Jones Industrial Average climbed 9 points to close at 12,289. However, the wider S&P 500 fell 3 points to close at 1,358 while the tech-heavy Nasdaq Composite fell 10 to 2,448,.

Overnight the Japanese market made gains after two days of losses, as the weakening yen boosted shares in car manufacturers. The Nikkei 225 rose 162 points to end at 14,183.

Brent spot was trading this morning at $133.12, while crude traded at $132.58 in New York. Spot gold was at $873. Silver was trading at $16.56 and Platinum was at $2,016.

In the forex markets, sterling was trading at 1.9543 against the dollar, and 1.2618 on the euro. The dollar was trading at 0.646 against the euro and 107.5 against the Japanese yen.

This morning, Royal Bank of Scotland has said that first-half profit will be "satisfactory" as it said that writedowns will remain in line with the £5.9bn it indicated in April.

The hi-tech kiosk promising vintage returns

Big retailers are turning to electronic 'information kiosks' to prise more money from customers choosing, for example, which wine to buy. Which could bring stock market success for one pioneering firm.

Buy this emerging oil giant now

The economics of oil extraction have changed lately and previously unprofitable reserves are now being exploited. And for the adventurous investor, there's money to be made from the oil sands of Canada.