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Rebuttal to Alex Dumortier, Gold Will Drop Below $500

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April 21, 2011 – Comments (26)

Rebuttal to Alex Dumortier, Gold Will Drop Below $500 

I had hoped that my recent post, $1,500 Gold, would inspire some criticisms. Once again, I am not disappointed. Now I have another opportunity to sharpen my blades. In this post, I examine Alex Dumortier’s (TMFMarathonMan) claim that gold is in a bubble.  I will pinpoint exactly why his reasoning is faulty.  I will not, however, prove that gold is not in a bubble.  I will only attempt to deal with Alex’s reasons.  It is possible that we are in a gold bubble, but that is not ascertainable from his analysis. 

In November, Alex published an article for Motley Fool titled: Warning! Gold Could Drop Below $500.  In the article, Alex makes it clear that he is not a gold bear.  He remains short term bullish.  It is important to note that Alex did not give a date for his price prediction, so we can infer that Alex is uncertain about how much further gold can run up.  This is a reasonable approach. 

The meat of Alex’s argument is that regression to the mean is a powerful force. Alex believes he has identified a mean price for gold in dollars. He posts two charts that back his claim that gold is far outside of the mean, in danger of a sharp decline.  We’ll set aside his assertion that “hucksters” are pushing gold on unsuspecting investors.   

I will show definitively how and why there is no mean price for gold to revert to. Hence, Alex’s argument that gold must revert to the mean is an absurdity.  

Let’s deal with the charts. 

1. Gold, 10 Year Trailing Returns, 1861-2010
2. Gold, Real Annual Average Price (in constant 2010 dollars), 1851-2010 

To keep this as clear as possible, to prevent any possibility of misconstruing my argument, I am going to focus on the second chart only. You will see that my analysis applies to the first as well.  So before we begin, take another look at Alex’s second chart

Two Distinct Periods 

The first thing I noticed when I viewed the chart is that there are two distinct periods. The first spans from 1851-1970 and is marked by very little volatility.  The second spans 1971-2010 and is marked by tremendous volatility. 

From 1851-1970, the price of gold in constant 2010 dollars fluctuates from $200 to $600 per ounce.  Price movements generally take a long time to complete.  Reversals behave similarly.   

By contrast, from 1971-2010, price movements are extreme.  In fact, gold peaked above $600/oz on 4 separate occasions: the early 1970s, the famous 1980 spike, the late 1980s, and the current run. 

This begs the question: how can 120 years go by with little volatility in the gold-dollar ratio, followed by a 40 year period in which gold shows 4 separate extremes that exceed any previous period? 

To answer that question, I’ll provide some background as we talk a short walk through American monetary history. 

1851-1913: The Classical Gold Standard 

For the period encompassing the first 80 years of the chart, America was on a classical gold standard. That is the price of the dollar was fixed to a certain weight in gold (1/20th of an ounce per $1). It was not impossible to increase the supply of dollars without a corresponding increase in the supply of gold, however. Usually this occurred in one of two ways. Either banks operating on a fractional reserve could extend the money supply by increasing their bank loans or the government could print issue additionally currency to pay for war (pretty much every war in modern history is financed this way.) 

As our economic history buffs know, too many dollars led to a flight of gold through the price-specie flow mechanism. If banks expanded their fractional reserve operation too far, customers attempting to redeem physical gold could cause a bank panic and a bankruptcy.  Powerful elements were in place, systemically, to maintain the gold-dollar ratio.  Hence, we observe the limited volatility of gold in the first 80 years of the chart.  The mean price of gold in that period, in reality, is not a mean. It is the fixed ratio of dollars to a weighted amount of gold.   

1913-1971: Mimicking the Gold Standard 

From a monetary historian’s perspective, the period from 1913-1971 offers ample interesting story lines. The Federal Reserve was chartered in 1913 (and I believe opened for business the following year.)  World War broke out, causing every belligerent to break from the gold standard in the first weeks of hostilities.  America briefly followed suit but returned to a Fed managed standard from 1918-1933. 

Please take a moment to inspect Alex’s chart again. Notice the sharp movement in price in the early 1930’s?  I suspect that is either the bank runs which resulted in a government forced bank holiday, FDR’s confiscation and outlawing of private gold holdings, or a combination of the two.  In 1933, FDR issued an executive order that “recommended” that all citizens turn over their private gold holdings.  The dollar was then devalued from $20/ounce to $35/ounce.  Dollars were no longer redeemable in gold.  In essence, America had declared bankruptcy. It wouldn’t be the last time. 

With the dollar no longer redeemable gold, what followed was a 38 year management of the price. The Bretton Woods agreement being the most obvious case of intervention.  A concerted political effort was put in place to keep the dollar gold ratio at $35/ounce. This is clearly not a mean.  This is a fixed price dictated by fiat.  Again, notice the lack of volatility in Alex’s chart from 1933-1971, as you would expect. 

For those with historically curiosity, there is a complete breakdown of all the crazy schemes and interventions pursued by the American government to keep the price fixed at $35 here (Part 1) and here (Part 2).  In the long run, they failed. The supply of dollars could not be checked (the Vietnam War and Great Society being the immediate culprits.) 

It’s Not The Price of Gold, It’s the Supply of Dollars 

The important point to consider, now that we see that there is no historical mean price of gold is that there was instead systemic reasons why gold reverted back to its fixed price, confusingly inferred as the long-run or correct price of gold by Alex Dumortier in his analysis, as obvious to him as a coin flip should be a 50/50 chance. 

The systemic reasons were important because they regulated the supply of dollars. In our 40 years since the end of the gold standard, the Federal Reserve has had the sole authority to regulate this supply with no mandate to maintain a fixed ratio of dollars to anything.   

This fact is overlooked by Alex. It supports my position that the gold-dollar ratio is going to continue to widen, that the price of gold will continue to rise, that gold is not in a bubble.  In fact, the entire monetary history  of the United States was overlooked by Alex,  There is not a single mention of the gold standard, the Federal Reserve, wars, or banking in his article. In other words, I find his analysis lacking.  Since his main argument is that gold will revert to a mean price that I have shown conclusively does not exist, what is left?   

Faith Based Argument 

All that is left is faith that the Federal Reserve chairman will make the right decision. Will he raise interest rates to regulate the supply of dollars?  Perhaps.  A significant rate hike would certainly change our outlook for gold prices.  A drastic hike would almost certainly cause a massive sell-off.  Obviously, this will not catch us by surprise.  Feel free to speculate on this possibility. In the meantime, I repost my thoughts on our current predicament, copied from the “$1,500 gold” blog:

“I would love to see America adopt a sound policy of border defense, a reduction in confiscation+redistribution in the welfare/warfare state, interest rates that come close to the reality of the nation's available savings and time preference, and a stable money supply.  These things would be disasters for the price of gold. And if they ever happen, I will be happy to dump all but the tiniest portion of my metals (the tiniest portion would remain simply because we are dealing with politicians after all...)

Nor would I ever advocate 100% exposure to metals with no other stocks (if you can afford to be investing in the first place) to anyone. But if you're just getting started and you have no "insurance" against the exponential growth of the warfare/welfare machine (considering its historic role in destroying national currencies), I would advise anyone to start building a safety nest in PMs.  Once you feel comfortable, then diversify with stocks. If the country ever decides to choose sanity over perpetual war, and sound fiscal policies over perpetual raising of the debt ceiling to meet the promises of previous generation's "leaders", stable money over inflating/crashing/re-inflating/latherrinserepeat, that would be the time to stop worrying about that stupid yellow metal.”

Quantitative Rebuttal 

Alex’s threw down the gauntlet: 

“However, I have yet to see any of them offer a convincing rebuttal of the quantitative argument I made that gold is in bubble territory.”   

Here is my quantitative rebuttal: Alex’s superficial survey of gold prices garnered him 205 recs!  That’s excellent evidence that gold is not in a bubble.  

David in Qatar

26 Comments – Post Your Own

#1) On April 21, 2011 at 6:36 PM, TMFAleph1 (94.91) wrote:

Now this is an interesting rebuttal. I don't think I buy it, but it will force me to think about my argument more deeply.

Alex Dumortier

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#2) On April 21, 2011 at 6:40 PM, XMFSinchiruna (27.70) wrote:

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#3) On April 21, 2011 at 6:50 PM, whereaminow (21.10) wrote:

Alex,

Appreciate it. I know we can get under each other's skin, but I didn't approach this with that in mind. Thanks for the nice reply and I look forward to hearing your expanded thoughts.

David in Qatar

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#4) On April 21, 2011 at 11:21 PM, buffalonate (94.16) wrote:

I wouldn't touch gold.  As you can see from the above chart what goes up really quickly goes down really quickly.  I have heard that the hedge funds have taken their money out of gold which just leaves dumb money left holding the bag when it crashes.  After congress comes up with some type of budget deal for 2012 that brings deficits more under control a lot of the fear will dissipate.  When the fear is gone the price of gold will crash.  

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#5) On April 22, 2011 at 4:46 AM, FleaBagger (29.31) wrote:

buffalonate - "After congress comes up with some type of budget deal for 2012 that brings deficits more under control a lot of the fear will dissipate." 

That's hilarious! Thanks for the laugh. 

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#6) On April 22, 2011 at 5:18 AM, dbjella (< 20) wrote:

buffalonate

I got to admit it too, that made me laugh.  Not at you, but just the thought of it is very funny.  Congresses idea of cuts amount to nothing more than a drop in the bucket.  When push comes to shove and people think their entitlements will be cut, then we go back to increases. 

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#7) On April 22, 2011 at 5:33 AM, ryanalexanderson (< 20) wrote:

Personally, I've decided that I'll exit 75% of my PM's when the Fed raises rates by 1%. I don't anticipate this happening anytime soon.

But I personally am not too interested in historical data too much. Unless anyone happens to have alternate-universe data of how gold fared under extended periods of ZIRP in the past.

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#8) On April 22, 2011 at 8:24 AM, Condaan (21.12) wrote:

I think it would be more interesting to see how gold relates to a bag of goods like those of the CPI over the last X years.  I know the CPI has it's own issues, but wouldn't a 'stuff' for 'stuff' analysis eliminate the machinations of currency?

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#9) On April 22, 2011 at 8:25 AM, Condaan (21.12) wrote:

Oh, and David, thanks ... you're one of the Fools that I enjoy reading whether I agree or disagree.

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#10) On April 22, 2011 at 8:41 AM, FreeMarkets (92.16) wrote:

This begs the question: how can 120 years go by with little volatility in the gold-dollar ratio, followed by a 40 year period in which gold shows 4 separate extremes that exceed any previous period?

If you look closer at the chart, 1860-1864 had volatility due to the Civil War and the fact that we temporarily left the gold standard.

Again in 1890 gold had a run, because the U.S. dropped silver from the coinage act.

Then again there was volatility with the creation of the FED.

Eliminate the political actions above, and gold would be a near comple flat line in the time period.

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#11) On April 22, 2011 at 11:08 AM, TMFAleph1 (94.91) wrote:

@Condaan

That is exactly what the chart depicts: Real prices are derived by adjusting nominal prices for changes in the CPI.

Alex Dumortier

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#12) On April 22, 2011 at 11:44 AM, FreeMarkets (92.16) wrote:

My issue with the CPI is I don't trust it, as I think many others do not either.  60 years ago a can of tuna fish was in the CPI (it was 8 oz) and it cost 30¢.  Today a can of tuna fish costs $1.50, but it is 62% smaller (3 oz).

The CPI will only tell you that tuna fish costs 5x what it did 60 yrs ago, ignoring the size difference.  Considering there was 166% MORE tuna in the 1950 can, the current price today should be $3.68 or 12x as much.

Using inflation as a measure is a bad way to measure the price of something like gold.  For example, you may say gold was $34/oz in 1950, tuna costs 12x as much so gold should be worth $34 x 12 =  $408 (OMG! that's exactly what Alex's chart says).

But direct comparison of prices to gold is ALSO wrong.  As I wrote about here (The Theft of Productivity), inflation does NOT take into account productive advances.  Our boats are faster,our netting technology is better, we have more efficient ways of finding tuna using under water sonar, and better understanding of their migration patterns.  All of these things should be pushing the price of the product down.

According to this source, the average Amercican farmer is 12x more productive than in 1950 compared to 2000.  Because I can't find a source for tuna fishing/fisheries, we'll have to make up a number.  I'll use 5x (assuming fishing has issues with weather conditions, and possibly over fishing issues).  You can make any assumption you want.  That productivity increase is  going to drive prices LOWER, and if one assumes 5x productivity growth then you can assume that, if we were still at a fixed $34/oz dollar standard, the price of tuna would be around 6¢ per can.

Now, if we divide that $3.68 for todays can of tuna by 6¢, you get monetary inflation (for tuna) of 61x.  Multiply gold at $34 in 1950 by 61x and you get $2,085 oz.

So the REAL question is what is the productivity multiplier?  If you assume 5x for the entire economy since 1950, gold is about 20% undervalued.  If you assume 10x, it should be trading over $4,000/oz.

ONLY if you assume that their has been ZERO productivity gains since 1950 can you assume gold should be priced at $400/oz (based on tuna!).

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#13) On April 22, 2011 at 1:52 PM, FleaBagger (29.31) wrote:

FreeMarkets - Don't forget that productivity increases also affect gold miners!

But then again, more than 99% of the gold being sold on the market today was mined decades or centuries ago. If 5% of the people holding gold decided to sell it for some reason, it would slash the price more than if global mining production doubled. Conversely, no amount of mining can affect the price if everybody decides they want more gold and no gold investors/speculators are willing to sell it at current spot.

So increases in gold mining productivity are likely to have only the slightest fraction of the effect on prices that productivity increases have on consumable items.

To bolster your point still further, gold was probably undervalued in 1950, because of a combination of Bretton Woods and U.S. citizens not being allowed to buy it. 

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#14) On April 22, 2011 at 2:06 PM, ESPNcrzy03 (< 20) wrote:

DinQ +1, FreeMarkets +1, and FleaBagger +1

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#15) On April 22, 2011 at 3:24 PM, FreeMarkets (92.16) wrote:

#15 So the only think that can kill the recovery is inflation?  Do you see the irony in the statement?

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#16) On April 22, 2011 at 3:25 PM, FreeMarkets (92.16) wrote:

#15 So the only thing that can kill the recovery is inflation?  Do you see the irony in your statement?

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#17) On April 22, 2011 at 5:15 PM, leohaas (32.07) wrote:

Nice work again, David!

The gold price expressed in dollars was affected significantly by the US decision to abandon the gold standard. Therefore, looking at a gold price trend that was in effect prior to 1971 and drawing conclusion for the time frame past 1971 is a useless excercise.

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#18) On April 27, 2011 at 7:04 PM, ETFsRule (99.94) wrote:

I can't believe people are still having this debate.

The work of Paul van Eeden proves, conclusively, that gold is currently in a bubble. He shows us that the price of gold (or more accurately, the "value of all mined gold"), has far outpaced the growth of the US money supply. This is the only correct way to analyze whether or not gold is overpriced.

It's all explained here:

http://www.paulvaneeden.com/Actual.Money.Supply

http://www.paulvaneeden.com/The.Actual.Money.Supply

http://www.paulvaneeden.com/the.gold.model.updated

http://www.paulvaneeden.com/Gold

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#19) On April 30, 2011 at 10:20 AM, fuzzywzhe (< 20) wrote:

This site has wasted my time in that it won't allow me to post pictures or links.

I can easily prove that there is no current gold bubble, there is a dollar bubble and a debt bubble.  But screw it.  I detest sites that allow you write out 10 pages of stuff, only to censor out any data you provide.

Hey Alex, go ahead and short silver and gold.

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#20) On April 30, 2011 at 3:43 PM, TMFAleph1 (94.91) wrote:

This site has wasted my time in that it won't allow me to post pictures or links.

You can post both pictures and links here -- knock yourself out! Nobody is "censoring out" any data.

Alex Dumortier

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#21) On April 30, 2011 at 4:18 PM, whereaminow (21.10) wrote:

ETFsRule,

I had never heard of Paul van Eeden, but I will research your links and include them in my next post.

David in Qatar

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#22) On April 30, 2011 at 6:09 PM, fuzzywzhe (< 20) wrote:

Fine.  Let's see if works this time.

This is a graph of the National Debt and the US Federal yearly tax revenue:

The same data represented of the Federal tax revenue as a percentage of the national debt.  2010 isn't shown but it's 15%:

See a 40 year trend there?

Heres the national debt shown as actual (blue) and projected (red).  Projected growth of the national debt assumes an average of 9.4% increase of our national debt.  If this is correct, we can expect a national debt of 33 trillion dollars by 2020.

And finally, our national debt expressed in terms of troy ounces of gold instead of dollars:

See anything?

If not, forget it. I really don't really feel like putting a whole lot of effort into this at this point.

The point is, Alex, is that in your "analysis" you ignore the intrinsic value of this:

 

Is the same as this:

and this:

Are you thinking this is the 1980s - you can see it's not.  Our debt is radically different as is our revenue and our ability to pay off the debt, or even service it.

Do you think "this time it's different" because we've been on a fiat system for all of 40 years?

We have a real bubble on our hands, but it's not gold and silver.  It's not oil.  It's not sugar, or copper.

It's debt.

If we wouldn't pay back the national debt all through the 1970s when the national debt was only 2 times the federal tax revenue, who thinks we're even going to bother to service it when the national debt is 15% of federal revenue?

It's pretty simple to see that the US will either inflate its way out of it's debt, or simply default.  It started in 1980, with a moron of a Republican as president who doubled the national debt at the shocking rate of just 8 years.  After he was done, there was no fiscally conservative party.  It was just a bunch of hooligans that tell different lies to get elected and spend outrageous sums of money that can never be paid back.

You think that the government is going to allow interest rates go to 10% or 20%?  How is that going to happen?  At 20%, the government will be paying more for interest on the debt than the government brings in from tax revenue.

That's what stopped the last gold "bubble".  What will stop it this time, is the collapse of the US currency.  I figure 2014-2017.

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#23) On May 07, 2011 at 10:25 AM, belcherjb (< 20) wrote:

This is all very elucidating, but I always come back to two things. 

The first is very obvious: never mind the "price of gold", what the price of gold really tells us is the value of the dollar.  But, of course, we knew that.

The second is the one that really persuades me: at the time of the American revolution, an ounce of gold would buy a good man's suit; at the time of the War of Northern Aggression (feel free to substitute your favorite name for that war), an ounce of gold would buy a good man's suit; at the time of the second world war, an ounce of gold would buy a good man's suit; today it is still true that an ounce of gold will buy a good man's suit.

 You get the point.  I have never considered gold to be an investment at all.  Gold, to me, is plain and simple "insurance", insurance against a failing monetary system.

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#24) On May 07, 2011 at 11:23 AM, ETFsRule (99.94) wrote:

"The second is the one that really persuades me: at the time of the American revolution, an ounce of gold would buy a good man's suit; at the time of the War of Northern Aggression (feel free to substitute your favorite name for that war), an ounce of gold would buy a good man's suit; at the time of the second world war, an ounce of gold would buy a good man's suit; today it is still true that an ounce of gold will buy a good man's suit."

It's good to see someone who actually gets it. Yes, the purchasing power of gold has been very stable over time.

And that's the most obvious proof that gold is currently in a bubble: because the purchasing power of gold has greatly increased over the past few years, by outpacing the price increases of pretty much any other asset class, and by not showing any connection at all to the monetary inflation rate. I could go into more detail, but there's no point (gold bugs won't listen anyway).

And I agree that gold can be a good hedge against inflation... just not right now. So much future inflation has already been priced in, that you would have to drastically overpay for that "insurance". Stocks are a better choice right now.

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#25) On May 07, 2011 at 3:53 PM, TMFAleph1 (94.91) wrote:

@ETFsRule

We are in complete agreement.

Alex Dumortier

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#26) On May 07, 2011 at 4:00 PM, truthisntstupid (82.69) wrote:

ETFs rule

No fair!   To be able to sum up in a few words what I wrote a whole blog trying to say!  You rule, man!

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