Perspectives - September 2011

The chart reveals that the S&P 500 lost 95% of its value relative to gold between 1967 and 1982, before bouncing back by an astonishing 4,008% up to 2000, and since then reversing to a loss of 89%. As the long-running bull trend on gold enters its twelfth year, a superficial reading of these statistics might tempt investors to conclude that they should sell gold. But that would be premature. First, statistics can be misleading. If we now look at the data from the reverse angle, the 4,008% rise in the value of shares as measured in gold from 1982 to 2000 translates into a relative fall in the price of gold at 97.5%. If the crisis of confidence in the global currency system were now to cause equities to give up all their gains during their bull run, gold would need to quadruple in value from today’s levels relative to the S&P 500, taking it to a price of USD7,500 for a constant value against the US stock market. Even if it only matched the relative underperformance of -95% seen in the 1967-1982 period, the bullion price would climb to USD4,000 at constant equity market value.

The annualised returns that underpin this historical price series are equally illuminating. The gold price averaged a 16.2% rise annually from 1967 to 1982, whereas the return on shares was restricted to just 1% a year. In the subsequent period from 1982 to 2000, share prices rose at an annual average of 16.5%, whereas the price of gold declined by 1% a year. Moving to the final period from 2000 on, gold has been increasing at a rate of 17% a year while the S&P 500 has been sliding by 1.9% a year. The rate of advance registered by an asset class enjoying a long-term bull run would, therefore, appear to be around 16%-17% a year with the comparative asset class stagnating around the zero mark. On these grounds, if gold were to continue rising in value for five more years, its price would reach the USD4,000 mark.

However, our positive view of gold is not founded on this mildly intriguing exercise in mental gymnastics and compound interest. We believe gold will sustain its uptrend relative to paper assets until a viable solution is found to the debt crisis. While we cannot say how long it will take for the crisis to be resolved, but we do know there are three ways of solving it: printing money; transferring
wealth from creditors to debtors; restructuring debt. Depending on the policy decisions taken, the implications for gold are likely to be radically different. Restructuring the debt and making creditors bear the full burden of the losses would plunge the US into Japanese-style deflation, and the gold price would probably not go above the USD2,000 threshold. Printing money and buying back US T-bonds to anchor long-bond yields below 3% could easily see the bullion price climbing to around USD4,000. We do not subscribe to the deflation scenario for the US. Ultimately, the crisis will be resolved through a combination of printing money, debt reduction and debt restructuring.

In these circumstances, raising our projection for the price of an ounce of gold to USD3,000 is not unreasonable, although we are acutely aware that any temporary rise in deflationary risks, as seen in the last few weeks, will force the price of gold downwards until the markets begin to factor in the likelihood of the authorities reacting by pushing through reflationary measures again. The bull run on gold does, therefore, appear to have entered the final straight during which speculation and volatility will undoubtedly mount. But gold’s core position in portfolios is still amply justified until the risk of deflation has become a distant and painful memory.