Gold As An Inflation and Market Indicator

Gold as an Inflation and Market Indicator: Where to Put Your Money When Prices Edge Higher

by Mark Skousen, Chairman, Investment U
Monday, December 12, 2005: Issue #494

For years, I had a fight with The Wall Street Journal editorial board over its front-page summary of market indexes, which highlights a dozen daily indicators, including stocks, bonds, oil, the dollar, etc.

Yet it deliberately omitted the single-most significant asset that each day measures the level of geo-political and monetary stability around the world: Gold!

Dan Henninger, deputy managing editor of The Journal, wrote me, “We do not believe gold is the best indicator of inflation.”

Since the Keynesian revolution of the 1930s, gold has been relegated to a “barbarous relic.” The establishment prefers flat money to the gold standard. It wants government rather than the market to maintain authority over money. It doesn’t want to legitimatize a “non-performing” asset that might be warning of trouble down the road.

As they say in the commodity trading pits, “Gold is just another commodity.”

Wrong! Gold is not just another commodity. Today, let’s look at gold as an inflation and market indicator and what we should be investing in right now.

The Best Inflation Forecaster: Gold, Oil or Interest Rates?

First, how many other commodities have served for centuries as money? Not oil, soybeans, or pork bellies. Moreover, unlike other commodities, gold is never used up in the production process. Annual production increases at a steady 1-2% a year and is added to the total stock of gold, creating a monetary Rock of Gibraltar in a sea of instability.

As a result, gold has always preserved its purchasing power over the long run. The following amazing chart demonstrates the steady purchasing power of gold over the centuries:

Note: The Changes in purchasing power shown in the chart were calculated from annual averages of the Wholesale Price Index (source Bureau of Labor Statistics, U.S. Department of Labor) and the annual averages of the exchange ratio of dollars for gold.

“Purchasing Power of Gold and of the U.S. Dollar, 1792-2005″
Courtesy: American Institute for Economic Research: www.aier.org.

As the chart demonstrates, gold always returns to its full purchasing power, although sometimes it may take several decades to do so.

Granted, the price of gold became more volatile as the world moved off the gold standard since the 1930s. But as Steve Forbes told me in a recent interview, “Gold is volatile because monetary policy is volatile. Gold is a constant, like the North Star.”

In my economics classes at Columbia University, I demonstrate the long-term value of gold by holding up a $20 Saint-Gaudens Double Eagle gold coin. Prior to 1933, our grandparents carried this coin in their pockets as money. Back then, they could buy a tailor-made suit for one double eagle, or $20. Today, the Saint Gaudens coin, which is worth between $600 and $1,000, depending on its rarity and condition, can buy the same tailor-made suit.

Gold also has the amazing ability to accurately forecast the direction of the general price level and interest rates. Recently, I ran an econometric model with the assistance of John List, a top economist now at the University of Chicago. We tested three commodity indexes (Dow Jones Commodity Spot Index, crude oil, and gold) to determine which one best anticipated changes in the Consumer Price Index (CPI) since 1970.

It turns out that gold proved to be the best indicator of future inflation, as measured by the CPI - even better than oil. The lag period is about one year.

And so it’s not surprising that last year, The Wall Street Journal started publishing the price of gold on the front page “Summary of Markets.” A Wall Street Journal editorial on December 1 stated, “We think this gold boom represents an investor bet on future price increase.” Victory achieved!

Oil: A Misleading Meter of the Economic Markets

Most of the media and the general public think oil is the premier indicator of economic performance. An energy crisis means a recession, right? Not always! Germany and Japan, for example, import most of their oil, but they avoided the 1979-82 recession. Today, energy prices have doubled, but there’s no sign of recession.

One reason is that the world economy has become more energy-efficient, and thus less dependent on oil and gas as the major source of energy. Douglas Bohi, director of the energy and natural resource division of Resources for the Future in Washington, D.C., claims that energy accounts for only 3-4% of the total cost of producing goods and services in the U.S.

Gold Predicts Interest Rates

Our econometric model also suggested that higher gold prices spell higher long-term interest rates. They tend to move together.

According to your gold forecast, will the price of gold stay above $500?

Ultimately, gold is an inflation hedge. When gold declines, it means less inflation down the road. When gold goes up, it means more inflation ahead.

What is gold predicting now? As the following chart shows, gold has been in a major bull market since 2001, when the terrorist attacks took place in New York and Washington.

What Does This Mean for the Future? Four things Regarding Inflation and the Markets:

1. War is inflationary. Since 2001, the Bush administration has dramatically increased government spending to fight terrorism and the war in Iraq. The Fed has been accommodating this increased spending with more money.

2. Expect more inflation ahead, as measured by the CPI and other price indexes.

3. Expect higher interest rates as inflation heats.

4. Higher inflation is bullish for hard assets in 2006. So, as far as the markets are concerned, I recommend buying gold and silver coins, mining stocks, oil and gas and real estate. Suggested fund: RS Global Natural Resources Fund (RSNRX), which has a five-star rating from Morningstar.

Good trading, AEIOU,

Mark

Today’s Investment U Crib Sheet

In my interview with Steve Forbes, we spent some time discussing oil prices, in addition to gold. Steve also comments on the stock market, the war in Iraq and his important life lessons. To catch up with Parts 1 and 2 of the interview with Steve, see Investment U # 477 and # 478.
I mentioned today that the Fed has been “accommodating” government spending by increasing the money supply For more on M3 - the broadest definition of the money supply - revisit Investment U # 493 - The Federal Reserve Discontinues the M3 Chart.
The Saint-Gaudens Double Eagle (from above) is a beautiful coin. If you’re interested in finding one, call Van Simmons at David Hall’s Rare Coins in Santa Ana, CA, at 800.759.7575, or email him at van @ davidhall.com. You can also visit his website at www.davidhall.com.