Rebuttal to Alex Dumortier, Gold Will Drop Below $500
April 21, 2011
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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
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