Money: Gold Theories Devalued

Despite the repeated efforts of gold bugs and anti-gold bugs—"worms," as Nicholas Deak used to call them—it's very difficult to read great meaning into fluctuations of the gold price. That's true even of the rather wide price swings gold has become prone to in recent years.

For instance, take the sudden and dramatic fall in the price of the yellow metal that occurred in late February—a slide of over $100 per ounce in little more than a week's time. This "collapse" was the occasion for the eleventy-fifth declaration that "gold is dead"—or had "turned to lead" or "lost its luster." You can choose your own cliché.

As usual, the Cassandras were wrong, possibly because their market perspective is blinded by moral outrage. One financial writer recently suggested to me that it's evil for people to invest in a nonproductive asset like gold at a time of high unemployment.

True, it looked pretty grim for a couple of days as gold, which had been trading in excess of $500, briefly traded under the $400 mark. In a single day, gold dropped by $42.50 per ounce. Its cousin, silver, also took a plunge of $4.30 per ounce from its 1983 high of $14.66.

But, after testing the $400 level, gold bobbed right back up—"just like Ivory Soap," as Wray Kunkle, a futures trader for Voss & Co., likes to say. As this was written in mid-March, gold was trading at around $426. Silver was back up to $11.28 per ounce.

There was a point last summer when it really did look like the precious metals were breathing their last. In August, silver had, almost unimaginably, traded briefly below $5 per ounce—compared to an equally unimaginable high of $50 per ounce back in January 1980. Gold had gone down in August to $289 per ounce. Here's hoping you bought at the lower prices, but the tendency for all too many investors is to get the buying fever near the peak and to avoid the metals like a plague when they seem to be going down for the count.

Asked to explain why gold and silver bounced back from those August lows to over $500 and $14 per ounce respectively, precious metals expert Glen Kirsch of International Financial Consultants joked, "More buyers than sellers." That's actually probably as good a reason as any, given the wildness and unpredictability of the markets these past few years.

Seriously, Kirsch said it is "very natural to expect it to buoy after such a drop." Ordinarily, commodities make a 50 percent retracing of both up and down moves. In coming back from its low last year, he said, the metals overshot that measuring stick and were therefore due for a correction. But then, of course, the March rally from February lows could be explained in the same technical fashion.

For the more fundamentally inclined, gold and silver reached their depths last summer as interest rates had peaked and inflation rates were beginning to scrape bottom. Then, about the time, oddly enough, that the stock market began its historic rally, the precious metals began rising.

The Federal Reserve was pushing down interest rates, making nonearning metals relatively more attractive to finance and hold. Rapid monetary growth and expectations of recovery also increased demand for precious metals. It doesn't take many people worrying about renewed inflation or dollar weakness to get gold moving.

Silver moved along with gold, but with an added impetus. For one thing, it was undervalued relative to gold, in terms of traditional price ratios. For another, being a widely used industrial metal, hope of recovery spurred demand for silver more than for the monetary metal, gold. Finally, depressed copper production constrained supplies of silver, a byproduct. The net result was that, while gold rose 75 percent through January, silver nearly tripled.

As for the subsequent price "collapse," there have been all kinds of explanations and speculations in addition to the strictly technical ones. One has the Soviets and Saudis dumping gold, out of opportunism in the first instance and financial need in the second. Some of both is probably true.

The most popular explanation attributes the price weakness in precious metals to that in oil. That certainly can't be ignored. It is undeniable that a gold-oil price relationship has developed since OPEC started manipulating the price of oil. But, as Kirsch notes, "That's old news. Oil prices have been declining for some time." Only if oil prices decline much further than expected, leading to lower expectations for commodity prices in general, is gold likely to fall out of bed.

Michael Checkan, assistant manager of Deak-Perera in Washington, notes that the latest OPEC flare-up caused "a lot of people to get burned and driven out of the market" as the news of oil price cuts precipitated a panicky sell-off that forced traders to sell out of their long futures positions. Whatever the reasons, both Checkan and Kirsch agree that silver at around $10 and gold at around $400 are excellent long-term buys. But Checkan advises investors to "stay away from the futures market."

Regardless of the oil price, there are growing signs suggesting that we are not, as the conventional wisdom now has it, in a "disinflationary" period. Somehow the federal budget deficit (en route to $250 billion or more in coming years) must be financed, since it is unlikely that Congress will do the right thing and cut spending. Overtly raising taxes or borrowing every available penny of private savings would create a stagnant economy. That isn't politically expedient.

Interest-rate pressures resulting from the collision of recovery and federal borrowing will tempt the Federal Reserve irresistably to accommodate the government and the private sector with inflationary monetary policies. It also looks increasingly likely that Congress will repeal tax indexation, which only makes sense if the government expects inflation to provide a windfall of revenues from bracket creep. It will be a while before reflation fully asserts itself, but it may not be long before the gold market begins anticipating it.

Steve Beckner is a financial reporter and columnist for the Washington Times and the author of The Hard Money Book.