1. The Three Gold Bear and Bull Markets
2. Correlation of Gold with Selected Indices
1. Bear and Bull Markets
The recent history of the gold price can be divided into three periods: A bull market of the 1970s, followed by 20 years of mediocre performance, and again an increasing gold rate since 2001.
What are the reasons?
1.1 The 1970s Bull Market
At the beginning of the 1970s, the gold rate was at US$ 35. Ten years later the price stood at US$ 870 per ounce. This is a percentage gain of 2,485%. In contrast, during the same time the Dow Jones Industrial Average increased only from 809 to 839 points. This represents a total gain of 3.7%; not per year, but for the whole decade.
On a free market, the gold rate is determined by supply and demand. Major factors are the central banks who can sell and buy gold in large quantities as a monetary policy, the state of the national and world economy, international conflicts and crises, demand for jewellery, by the industry and investors.
The 1970s experienced a gold bull market, as his precious metal could now be nationally and internationally freely traded after the Bretton Woods collapse. Besides that, demand for gold also skyrocketed because of the dire economic times through which most western nations went in this decade.
In the 1970s, the US and European economies were characterized by low growth, high inflation and a high unemployment rat. Further, increasing national debt and an expansion of money supply made the currencies less valuable. All these factors let investors diversify their portfolios towards material assets, and gold in particular.
Other factors contributin towards an increase in the gold rate were the oil embargo, Vietnam War, Iranian revolution and Soviet Union’s invasion of Afghanistan.
Important Events in the 1970s for the Gold Rate
- 1971: Devaluation of US dollar
- 1st May 1972: One ounce of gold has a value of more than US$ 50. This threshold has been trespassed for the first time since Black Friday (1864)
- 19th May 1973: End of the Bretton Woods System. The post-war monetary order regulated currency exchange rates and setting a fixed gold-dollar conversion rate.
- 14th May 1973: Gold leaped for the first time in London to over US$ 100
- 14th November 1973: Limitations on gold trade were lifted
- October 1973 until March 1974: Oil crisis caused by members of the OPEC who declared an oil embargo. This led to a skyrocketing oil price and dramatic effects on national economies
- 1975: Trading in gold futures began at the New York Commodity Exchange (COMEX)
- 21th December 1974: US President Gerald Ford allowed the private possession of gold; other countries followed suit
- 7th/8th January 1976: Jamaica agreement, floating exchange rates
- 1979: Iran revolution to overthrow Iran’s monarchy
- 27th December 1979: Gold traded for more than US$ 500
- 4th November 1979: Iran held 52 US citizens hostage for 444 days
- 24th December 1979: Invasion of Afghanistan by the Soviet Union
- 21st January 1980: The London Bullion Market reported a gold price of $850, at the Commodity Exchange of New York gold was traded for US$ 873
1.2 The 1980 – 2001 Bear Market
The bull market for gold in the 1970s can be explained by the end of the gold standard, the begin of gold trade, economic stagnation in the West, the oil embargo and several wars and revolutions.
In the next twenty years, the gold price followed a completely different pattern. A gold investor could have made in the previous decade nearly 2,500 per cent profit by buying gold in 1970 for US$ 35 and selling it ten years later at US$ 850. If the same investor had bought gold in January 1980 for a rate of US$ 677 per ounce, he could have sold off his bullions a decade later for only US$ 409. A decade later, in December 2000 gold stood at only US$ 283. This constitutes a decrease of nearly 60%, not considering inflation.
What explains the gold bear market from 1980 until 2001? These two decades experienced first an end of the economic stagflation of the 1970s, with a stabilized economy and controlled inflation. In the 1990s Bill Clinton oversaw a long economic recovery, named New Economy. This was a transition from manufacture-heavy industry to a new technology- and services-based economy.
Interestingly, the fall of the Soviet Union which brought down communism in most countries, and ended a bi-polar world order after 45 years, seemingly had no impact on the development of the gold price.
Important Events During from 1980 until 2001 for the Gold Rate
- 1982: New gold deposits discovered in North America and Australia
- 1982: Private possession of gold allowed in the PR China. But only six years later it became feasible for private citizens to buy gold
- 1993: Germany lifts VAT requirements on financial gold
- 3. August 1994: Merger of the Commodity Exchange (COMEX) and the New York Mercantile Exchange (NYMEX) under the NYMEX name. This is to become the world’s largest commodity futures exchange, located in Manhattan, New York. The COMEX division trades in gold and other metals
- 1994: Russia formally established a domestic gold market
- 1997: US Taxpayers Relief Act, allowing individual retirement account holders to buy gold bullion coins and bars for their accounts, if the gold has a fineness of at least 99.5 per cent
- 20. August 1999: Gold was traded in London for as low as US$ 252.80 (US$ 324,95 inflation-adjusted)
- 26. September 1999: To regulate gold selling & its price, 15 European Central banks signed the Central Bank Gold Agreement (CBGA). The participating parties were the European Central Bank, the 11 Central Banks whose countries had introduced the Euro and the Central Banks of the United Kingdom, Switzerland and Sweden. CBGA set the annual limit of gold sales to 400 tons, or 2000 for the whole 5-year period of the agreement. CBGA was superseded by CBGA II and III
1.3 The Current Bull Market (2001 – )
The beginning of the 21th century is witness of a long and mostly continuous rise in the gold rate from US$ 265 per ounce at the beginning of 2001 until more than US$ 1400 ten years later. This translates into a gain of 528%, which is a stark contrast to the previous 20-year long bear market.
Which factors contribute towards the steady rise of the gold rate?
First, a reduction of gold supply: From 2001 the global gold production fell within a decade by 10%. Still, demand in jewelry and by industry continues to increase due to India’s and China’s steady economic growth. Additionally, at the end of the decade central banks began to step up their gold reserves.
Other important factors are the since 2001 increasing US national debt and the weakening of the US dollar relative to other currencies. Further, the financial crisis of 2008, during which the US government nationalized the two biggest US mortgage lenders and the biggest US insurer, drove up demand for physical gold and exchange traded funds. SPDR Gold Trust, the biggest ETF gold fund holds currently more gold reserves than the Chinese Central Bank. To stimulate the economy, the US Treasury reduced the federal funds rate to a mere 0.25 per cent. This low interest rate also made gold investments more attractive.
The Nine Eleven attacks had only a short-term direct effect on the gold rate. The London PM gold price experienced within this trading day an increase by more than 5%. Usually daily differences are 10 – 20 times lower. In the long-term, the September 11 terrorist attacks had no direct effect on the gold rate. However, it can be argued that the costs for the US war on terror led to an increase of US national debt which finally resulted in a weakening US dollar and a higher gold price.
Important Events from 2001 Onwards for the Gold Rate
- 11. September 2001: On this date, the gold price experienced a spike of 5% within one trading day. Usually, price differences are between ten and twenty times smaller
- 2004: Launch of SPDR Gold Shares (SPDR Gold Trust). This exchange traded fund tracks the price of a tenth of an ounce of gold. With approx. 1,299 tons (37.9m troy ounces) of gold held, SPDR Gold share is the sixth largest gold holder in the world, behind the central bank of France (2,435 tons) and ahead of China (1,054 tons)
- 2005: Gold price for the first time since 1987 more than US$ 500 per troy ounce
- 14. March 2008: At the New York Mercantile Exchange, gold was traded for more than US$ 1000 per ounce
- September 2008: The US government nationalized the two biggest US mortgage banks, Fannie Mae and Freddie Mac. This led to sharp declines at global stock markets. After the insolvency of the investment bank Lehman Brothers and the nationalization of AIG, the biggest US insurer, the gold rate reaches in New York its highest daily increase in history. This is 11.8 per cent, or a rise of US$ 92.40 to US$ 872
- 2009: For the first time in two decades, central banks become net purchaser of gold
- 2010: The London PM Fix reaches 35 successive heights
- 2010: Several central banks announced plans to increase their gold reserves. These include the central banks of China, India and Russia
- March 2011: Gold reached in New York an all-time record of US$ 1440 per fine ounce. Seen from another perspective, the US dollar (and the Euro) is compared to gold as weak as never before
2. Relationship between Gold and Selected Indices
Are there any correlations between gold and the oil price, stock indices, the US dollar and inflation? One would assume this is the case. But the data tells otherwise. Long-believed relationships either never existed, or disintegrated since the financial crisis of 2008.
2.1 The Gold-Oil Relationship: 3 Theories
Is there a correlation between oil and gold? The first idea suggests a direct causal gold oil relationship, the second argument proposes an impact of oil on shares of gold companies, and lastly a theory argues that the gold and oil prices are driven by a common factor.
First, Oil influences gold
First, one possible argument goes that a high oil price is bad for the economy, dampening growth and dragging down share prices. As a consequence, investors look for alternative assets, such gold. Thus, the oil price indirectly affects the price for gold. Such a scenario could be observed end of the 1970s when the oil cartel reduced the output of oil, so that its price surged. This sent shockwaves through the U.S. and global economy and resulted in the long recession of the 1970s.
Second, oil affects gold mines
Another line of thinking sees an inverse causation between the oil price and share prices of gold mining companies. Expensive oil makes gold extraction more expensive and therefore minimizes the profit margin of gold mines. This is because a big portion of mine expenses are related to energy, and the oil price.
Third, inflation impacts gold and oil
Third, both, gold and oil are traded in the U.S. dollar. Therefore, its price hinges on the strength of this currency. What is a sign of the strength (or weakness) of a currency? – It’s inflation rate. It can be argued that the prices of both commodities have a similar trend is not because one influences the other, but because their price is driven by a common factor. And this is the inflation rate.
This third theory is a reminder that correlation, meaning a similar pattern between two variables, does not necessarily imply causation. One explanation might be indeed causation: The oil price influences directly the gold rate. Another possibility is an indirect relationship, with another factor sitting in the middle. Or, as the third argument goes, a common factor that influences the rates of both commodities. It can even become more complicated, if the gold oil relationship is not stable over time. Say, in the 1970s the oil price might have had a much bigger influence on gold than it is now.
2.2 The Gold-Inflation Relationship: None
Conventional wisdom suggests that there is a strong correlation between gold and inflation. When inflation goes up, gold follows suit. Likewise, a drop in inflation would lead to a fall in the gold price. This is because in times of high inflation, gold becomes a better option for investors. But this reasoning is wrong.
Let’s look at three charts. They track the gold price in US$ per ounce and the monthly US Consumer Price Index, which is a gauge for inflation. The first chart goes from 1974 until 1980 which was a bull market for gold. The second chart shows the 21-year bear market from 1980 to 2001. On the last chart, the current bull market is seen, which stated in 2001. A visual inspection of both charts does not necessarily provide evidence of a positive relationship between gold and inflation.
What was the gold inflation relationship during these three major periods?
Fact 1: Bull Market, 1974 until January 1980, gold went up from US$ 129 (monthly averages) to US$ 675 per ounce at the end of the period. This is an increase of 353%. During the same time, the consumer price index, a measure of inflation increased by 67%. Here, gold strongly outpaces the inflation development.
Fact 2: Bear Market, between 1980 and April 2001, gold went down from US$ 675 to US$ 260 per ounce, which is a decrease of 67%. In contrast, the consumer price index increased during the same period by around 126%.
Fact 3: Bull Market, from 2001 to February 2011, the gold rate experienced huge gains of 527 per cent. The overall inflation rate was only 25 per cent.
Especially remarkable is the inflation decrease in the middle of 2008. If the theory of a positive correlation held true, the gold price would also go down. But the opposite was the case: inflation went down, and gold went up. This rather points to an inverse correlation between gold and inflation.
All of this points towards a weak or even non-existing relationship between the gold price and the inflation rate.
What do others say about a possible correlation?
First, the Wall Street Journal commissioned a study from the research firm Ibbotson Associates. According to their research, between 1978 and 2010 gold and the inflation rate have a correlation value of 0.08. This is nearly no correlation (on a scale ranging from -1 to 1, where 1 is perfect correlation, and -1 perfect negative correlation, and zero is the absence of a relationship).
Second, also Citibank comes in 2009 to the conclusion that “there is no obvious relationship between the gold price and inflation”. Sometimes the development of gold follows inflation, at other times there is an inverse trend or just on obvious pattern at all.
Therefore, it can be concluded that there is no, or only a weak, relationship between the gold rate and inflation levels.
2.3 The Unstable Gold-Stock Relationship
Is there a relationship between gold and the stock price? One might expect an inverse correlation: When stock goes up, investors make more money at the stock market and thus sell their gold. This drives then the gold price down. However, data tell us otherwise.
Now let’s look at three graphs. All three show the Gold Price (London Gold Fixing PM) and the Standard and Poor’s 500 Index.
The first graph goes from 1974 until 2011 and shows the growth of these two indices, starting with a base value of 1 at the beginning of the period. Gold outpaced the S&P 500 index in the gold bull market of the 1970s. From the middle of the 1990s the S&P 500 experienced huge gains and left the gold price behind. During this time gold was in a bear market. The dot com bubble of 2001 and the financial crisis of 2008 send the S&P 500 to the bottom. In contrast, during this time gold started to pick up and reached unknown heights. This first graph therefore indicates that the gold-stock relationship changed over the time, if it ever clearly existed.
The second graph shows monthly growth gains from 2008 until 2011. Here it seems that the gold-stock relationship is somewhat inverse.
The third graph shows the 12-month rollover correlation between the gold chart and the S&P 500 index. The correlation ranges from -1 to 1, were the first indicates a perfect negative correlation, and values close to one stand for a positive relationship. Zero would stand for the absence of correlation. This graph confirms the first assumption: The 12-month rollover correlation between gold and the S&P500 index changes its intensity over time. Also, the relationship becomes negative from time to time.
What to conclude from these graphs?
There is strong evidence AGAINST a stable gold-stock relationship over time.
2.4 The Gold-Dollar Correlation: A Mess Since 2009
Searching for a correlation between gold and the US dollar seems to be awkward at first, as gold is traded in this currency. Would it not be impossible to determine a relationship?
A relationship between gold and a currency can only be relative to a foreign exchange rate. Therefore, the US Dollar Index is used (USDX), which is a measure of the US dollar’s value relative to a basket of six currencies. These are the euro, British pound, Canadian dollar, Swedish krona, Swiss franc and Japanese Yen. When the US dollar increases in strength, the USDX goes up.
Fact 1: Between 2004 and 2006, the correlation between gold and the US Dollar Index was -0.44, between 1997 and 2006 it was -0.28, and between 1989 and 2006 the relationship was -0.28. Here, -1 means perfect inverse correlation (when the USDX goes up, gold goes down). Zero means no correlation at all.
Fact 2: Australia is the third largest producer of gold. Between 1999 and 2008 its correlation (AUD/USD) with gold stood at 0.84. That means, when gold rises, the value of the Australian dollar increases as well. A weaker correlation of 0.77 is between gold and the Swiss franc. This was true from beginning of 2006 until beginning of 2009.
Fact 3: From 2001 until 2009 gold and the US dollar had a nearly perfect negative correlation. When the dollar decreased, gold increased, and the other way around. However, since the end of 2009 this is no longer the case.