At the beginning of December, gold touched $1,140 an ounce. It ended last week $140 higher at $1,280.
It has risen by 20% against the euro, and 15% against the pound over the same time period.
Gold miners, meanwhile, have risen by more than 25%.
Gold has been on tear. Is there anything to worried about?
There might be. And that’s why I’d advise caution ahead of this week’s big events.
Both inflation and deflation can be good for gold
Let’s start with some positives.
First, the economic environment. Gold likes outright inflation – when prices, as well as the supply of money and credit, rise apparently uncontrollably, such as in the 1970s.
But contrary to popular belief, gold can also do well during periods of deflation – when prices are falling and the supply of money and credit is contracting. We saw this in the 1930s.
Whether we get inflation or deflation, both are forms of monetary stress, and gold’s role as money of last resort becomes important.
However, periods of disinflation (such as the 1980s and 1990s) are different. This happens when the economy is buoyant, the rate of inflation is benign or falling, yet money and credit are expanding.
During these periods, gold can be a rotten asset to own. You might argue that we experienced such a period between 2011 and 2014.
But now, with oil, iron ore and copper prices tanking, quantitative easing (QE) ending in the US, no sign of interest rates rising anywhere, and some stockmarkets outside the US turning negative, ‘disinflation’ seems to have morphed into ‘deflation’.
There is not the same sense of economic expansion that there was a year or two ago. Deflation tends to lead to monetary stress – at which point people turn to gold.
The Swiss National Bank’s decision last week to stop preventing its currency from strengthening against the euro created all sorts of turmoil, with various FX firms suffering serious losses.
Again, this benefits gold. In an environment of volatility and potential bankruptcy, the fact that gold carries no counterparty risk suddenly becomes very important.
Something else to consider along these lines is the many countries that have pegged their currency to the US dollar. Hong Kong is one, of course. But I’m also thinking of Venezuela and seven nations across the Middle East that have suddenly had their oil revenues slashed. As the dollar gets stronger, how many will consider decoupling?
In short, the currency wars are hotting up and gold should benefit.
Another positive is that the gold bugs have been quieter than normal.
Usually, when gold has a run like the one it has just had, gold bugs become quite vocal. This time, I would say they have been quite restrained. Perhaps it’s because most of them own silver, which hasn’t done so well.
In any case, the lack of noise coming from that quarter is a good thing. Gold is very volatile. The less euphoria coming from the gold bugs, the more space there is for gold to carry on rising.
Gold is expensive relative to other commodities
So now let’s turn to what has me worried.
I’m going to show you some charts, courtesy of Nick Laird over at Sharelynx, which show the long-term ratios of gold versus oil and copper. In other words, how expensive gold is relative to copper and how expensive it is relative to oil.
We’ll start with oil. This chart shows the ratio since 1970.
The blue line shows how many ounces of gold it takes to buy a barrel of oil – when the line is rising, oil is becoming more expensive relative to gold.
With oil at about $48 and gold at $1,280, it currently takes 0.0375 ounces of gold to buy a barrel of crude oil.
As you can see from the chart, that makes oil very cheap relative to gold. We’re at around the same point as we were in the midst of the financial crisis in early 2009 (after the oil price collapse) and in 1999, when oil hit $10 a barrel.
In 1973-74 (just before the oil price shock), 1980 (when gold went to $850), in 1986 (another oil price crash) and in 1989, the ratio went briefly – at the point of maximum extremity – below 0.03. (For example, oil hit $10 in 1986, while gold was above $300.)
If we were to reach such a point of extremity now, and oil stayed at $50, gold would be over $1,700. But we are talking historical extremes here.
The other point to note is that the ratio has not tended to stay below 0.04 for long. Instead, it reverts to the mean – around 0.06 to 0.08. For that to happen, either the oil price has to rise, or gold has to fall – or a bit of both.
I’d suggest an oil price rise is the most likely outcome, but this ratio does make good look a little over-valued and thus vulnerable.
My next chart shows the copper-gold ratio since 1980. Again, as the black line rises, copper is becoming more expensive relative to gold.
Copper is cheap on a relative basis (at 0.002 ounces of gold per pound of copper), but that’s not to say it can’t get a lot cheaper. 0.00136 is the post-1980 extreme.
But say copper were to plunge further from its current level of $2.50 down to, say, $1.50 a pound. If that ratio hits its previous extreme of 0.00136, then gold would be $1,100.
Now I don’t view gold as being ‘just another commodity’ for reasons I’ve explained many times before. But it’s certainly worth keeping an eye on its relative over-valuation.
Are investors getting too excited about European QE?
There’s one other thing worrying me about gold.
There two big items on the European news agenda over the next few days. First, the announcement by the European Central Bank about QE. Then the Greek elections. All of this potential news is getting investors excited.
But here’s something worth noting. The Swiss franc’s ‘ceiling’ against the euro was announced on 6 September, 2011. That same day, gold peaked at $1,920 an ounce, amid fears of a Greek exit from the eurozone.
And the day that gold bottomed in November last year, was the first trading day after the failure of the Swiss gold referendum.
My point is that time and time again, we’ve had a build up to a big event – and then gold has done the reverse of what’s expected. As the market maxim goes:
“Buy the rumour, sell the news”.
There’s been so much hype and expectation over ECB QE. The euro has been a disaster. But what if the ECB announces less QE than expected? Perhaps the euro rallies and the dollar falls – maybe even taking gold and gold miners down with it?
I’m not saying it will happen – I don’t know and nor does anybody else – I’m just saying it’s possible.
“If in doubt, do nowt.” I’m staying long physical gold, and long gold stocks (with my risk well managed). But I’m keeping plenty of cash on the sidelines, at least until this Thursday’s big event is over.
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