Hope Still Springs Eternal

In the hardcore goldbug world, anyway. Jeff Nichols is forecasting gold to reach US$1,500 sometime this year, and sees the metal's price reaching at least $2000 when it reaches its cyclical high. $3000 is becoming more likely in his eyes.

His argument is the standard one, the kind of fundamental analysis used in the gold world. Expansionary monetary policy will bring back a resurgence of inflation, making gold more valuable as a wealth protector. In the case of the U.S., monetary inflation will erode the greenback's value. The U.S. economy will endure a long spell of stagflation. On the production side, the decline will continue for another five years or so.

However, one demand factor he points to is a lot like the "New Era story" I fingered in the late-November Enter Stage Right article that started off this blog. In it, I said:

A full-fledged bubble, however, needs a "New Era" story to make those historical relationships look misleading. It has to explain why those old pros were fooled. The New-Era story for the 1920s U.S. stock market fell into place in 1924.... Edgar Lawrence Smith... showed that a carefully-selected basket of common stocks not only held up over the long term, but also tended to outperform a similar basket of corporate bonds. The subsequent "New Era" pronouncements, right up to 1929 and even beyond, were elaborations, extensions, and exaggerations of Smith's point. What characterizes a New Era story is its rationale for treating a historically overvalued investment as undervalued; the disjoint is ascribed to an essentially permanent sea-change, or previous veil of ignorance being lifted....

...[A]s the gold price continues to climb, a New-Era rationale is taking form.

This rationale starts off with two solid observations: gold also serves as a crisis hedge, and it tends to move in opposition to the U.S. dollar. Recent central-bank gold purchases, particularly India's, and recent Chinese complaints about the dollar are factored in. All of these put together gives a real New-Era story, which we'll hear more frequently if gold keeps rising: The U.S dollar is losing its reserve currency status, and gold will be (at least part of) its replacement.

Like any good New-Era story, it plausibly explains why an asset class is out of whack. In this case, it explains why gold is ratcheting up despite little to no inflation on the immediate horizon. It also ties in gold's rise with the U.S. dollar's drop, and recent international dissatisfaction with the U.S. government's debt and deficit levels. It's also subject to extension, should inflation reappear, and exaggeration. If gold enters into a full-blown bubble, the above New-Era story will be warped into excited proclamations of the "imminent" demise of the greenback.

As the above snippet makes clear, I use the term "bubble" and "New Era story" in a more nuanced way than is usual. Admittedly, some New Era stories come true. Someone saying, in 1910, "The American economy shall replace that of the British Empire as the largest in the world; American stocks ought to be bought to participate in that growth" would have been telling a New-Era story. Despite the wreckage of the 1930s, that story has come true.

But a lot of them don't. The "New Era of Home Ownership" in the U.S., to put it gently, hasn't quite come to pass. Nor did the "New Internet Era" as was forecast in the late '90s. It might be worthwhile to review predictions from that era to see the difference between 1998's future and our real present.

Regarding the New-Era story for gold, which I myself am skeptical about, Nichols has this to say:

The other factors which Nichols feels will help lead to the big price increases in gold over the next few years are what he describes as "a rising secular expansion of investor participation", together with continuing reserve diversification by Central Banks due to what he feels is an "irreversible erosion of the U.S. dollar as the single dominant reserve asset and denominator of much world trade."

"As a result of these secular developments, over the next decade and beyond, the long-run average price of gold (stripping away the major cyclical bull and bear market swings) will be considerably higher than past experience would suggest . . . and considerably higher than many analysts and investors would dare imagine" says Nichols.

That's pretty close to what I imagined it to be. (I should note that Nichols firmly says that gold is not in a bubble, and that gold bull market is amply justified by the fundamentals.)


The Mineweb reporter does a good job of summarizing Nichols' points of optimism in the report:

He feels gold's strength is built on solid fundamentals - fundamentals that gold bears, among them a number of eminent economists, fail to recognise. These include: Continuing expansionary U.S. monetary and fiscal policies; strong continuing Central Bank demand for gold as a reserve diversifier; continuing expansion of investor interest; a continuing decline in world gold mine production which he reckons will continue for at least another five years before high gold prices have been sufficient to stimulate new production. Finally he looks to expanding and evolving geographic markets for gold, particularly in the East where the combination of a traditional cultural interest in gold is boosted by rising incomes and wealth....

If these fundamentals play out, it's more than likely that Nichols' predictions will be upped - perhaps by him, almost certainly by others.


As a closing side point, $3,000 gold is fairly crucial for today's gold investors. The last secular gold bull market ended in 1980, when gold touched $850. The ensuing bear market pummeled gold down to $300. Someone buying gold at the 1974 high of $200 was still sitting on a profit after the '80-'82 bear market wreaked its carnage.

Using the '80-82 bear as a gauge, a post-bubble gold bear will slice two-thirds off the metal's price. If gold's ultimate top is above about $3,500, then someone buying now will still have a slight profit even at the bottom of the next bear market. If only $2000, though...