What is the deal with gold?

Is it a ‘barbarous relic’ as Keynes claimed (mendaciously, as it turns out,

since when asked on the eve of Bretton Woods to design an international currency, he proposed
BANCOR: an international currency backed by... gold!) or are we assisting a titanic struggle between
corrupt central banks and the forces of sound money which will eventually triumph, sending gold to a
price of 8 squillion dollars and condemning everyone to economic hell except for the faithful few who
‘got gold’ in a kind of financial version of ‘the rapture’?

I suspect that the truth is rather more prosaic: gold is just a passive proxy for ‘stuff’ as opposed to fiat
money and hence it tracks the real inflation rate for ‘stuff’ since its price represents a kind of market’s
best guess as to the expansion of the broad money supply. Everyone complains that their true cost of
living increases by much more than a manipulated government inflation index which only tracks inflation
for things whose price goes down (like mass-produced high tech) or which don’t actually exist (like rent
which home owners pay themselves). Furthermore, as the price has risen and central banks have
dissipated their gold reserves to fill the gap between supply and demand, the purely monetary factors
controlling its price have come to the fore (as opposed to the technical mining factors). In this sense, the
most difficult thing to grasp about the GATA hypothesis of gold price suppression is why the authorities
could possibly believe that by manipulating the gold price they could ‘hide’ the true rate of inflation,
since it is immediately obvious to anyone who goes to buy groceries, services, etc.

Having experienced the Brazilian hyperinflation of the 1990s (which actually started as high inflation in
the 1960s, and one could even point to its origin in the massive overspending on Brasilia in the 1950s),
and as an assiduous student of economic history, I suspect that it will take many years for the US to get to
the kind of inflation rates of 20-100% per month which normally characterise a collapsing currency (and I
would add that the kind of hyperinflation a country gets depends on its political system – countries with
coalition governments where everyone passes the buck like Brazil, Turkey, Israel, found it politically
expedient to adopt some kind of indexation, while countries with governments with clear majorities tend
to adopt drastic economic shock plans – which usually ream the electorate much more – I’d put the US in
the latter category). Hence, it should be the most obvious thing in the world for the gold price to rise (and
carry on rising) by 15-20% per year and the only real conspiracy pushing the gold price is the universal
‘Hyperkeynesianism’ of governments which believe that they serve the greater good by creating money
out of thin air in excess of the underlying real rate of economic growth.

We thus find that the Compound Annual Growth Rate for the gold price since 2001 has been around 19%
(if we take a 3-period moving average of the average annual prices of gold to smooth out the swings, we
find gold went up by 10-14% per annum in 2003-2006 and has been rising by 17-21% per year over the
last 4 years. If you had to bet on the likely rate of gold appreciation over the next 4-5 years, the evidence
would thus lead you to say 25% rather than 50% or 100%.

The above may sound awfully boring to gold traders hoping to retire on the coming “moonshot” in
precious metals prices but a) having an accurate conceptual model of what drives the gold price will
protect your portfolio from the vicious downtrends that the ‘true believers’ have to endure and b) even if
the inflation rate accelerates by 3% per year (i.e. from 19% to 22% to 25%, etc.), taking an approximate
current price of $1100, we are still on track for $2600 gold by 2014.

These fib levels are given by successive half-roots of the golden number (φ = (1+√5)/2) (i.e. φ -3, φ-2.5, φ-2,
φ-1.5, φ-1, φ-0.5, φ0, φ0.5, φ1, φ1.5, φ2, etc.) which may be approximated by a familiar series of real numbers:
0.236, 0.382, 0.486, 0.618, 0.786, 1, 1.272, 1.618, 2.058, 2.618, 3.330, etc.)
If we calculate these ratios for the long-term downswing in the gold price from 850 to 253, we get a
sequence of prices (…, 321, 340, 364, 394, 432, 481, 543, 622, 722, 850, 1012, 1218, 1482, 1815, 2241,
2782, etc.) (i.e. 722 = 253+(0.786*(850-253))

I studied these Fib numbers about 10 years ago with Larry Pesavento, before they became fashionable.
One of Larry’s ‘big ideas’ was the particular significance of the 0.786 level, which marked the
transition from a simple retracement to a primary bull trend – furthermore, once breached, a price could
take out the 1.00 level and go straight to 1.272. The last major hurdle was to break through the 1.618 level
and then ‘the sky was the limit’. This applied to any financial instrument.

How does this apply to gold? (Unfortunately, I have to use London fix numbers as it’s the best price
series I can find, but they work quite well.)
On the gold retracement, the first major ratio we look at is the 0.238 ratio at $393. On 5/2/03 – the LF
(London fix) was $382.10 – Gold began a 2-month decline to $319.90 on 7/4/03, recovered to $371.40 on
27/5/03 (2-months), went down to $342.50 on 17/7/03 (close to a 61.8% retracement) before printing
$382.25 on 9/9/03 (it then meandered in a $20 range before breaking up definitively in November.

We then had 2 years of rather messy patterns, but note that there were oscillations around the .382 level
($483) in Sep-Oct 05, then another oscillation around the .486 level ($545) in Jan-Feb 2006 before gold
shot up to the .786 level ($725) on 12/5/06. We then started a major decline with 2 bottoms, $569.50 on
15/6/06 and $560.75 on 6/10/06.

At this point, we started to rally, reaching $685.75 on 26/2/07 and $691.40 on 20/4/07, followed by a long
and boring consolidation which went as low as $642.10 on 27/6/07, before finally taking out the old $725
high on 19/9/07. The C&H pattern played out over 16 months.

We then rallied for 2 months to the 100% target at $850 and spent 2 months oscillating between $790 and
$850, before moving higher to peak at $1011.25 on 17/3/08 (close to the 1.272 target at $1014). This is a
classic 0.786 breakout to the 1.272 level.

The rest is history, with a collapse in the market back to twin lows of $712.50 on 24/10/08 and $713.50
on 13/11/08 (London fix).

This was followed by a rally which again oscillated around $850 in Dec 08-Jan 09, before reaching
$989.00 on 20/2/09, followed by a 2-part handle formation which finally broke above the old high on
4/8/09. The C&H pattern played out over 18 months.

The last rally stopped at $1212.50, on 2/12/09 – close to the 1.618 target at $1218.

We can see from the above that when gold approaches an important fib level, it either oscillates for a
couple of months and goes through to the next fib level or starts a decline which turns into a C&H
formation which to date has taken around a year and a half to play out.

The recent move down from $1212 to $1058 (LF) is far too big for a $50-60 oscillation, so we can
surmise that gold is doing another C&H routine. Where is the low? Since $1014 was a real resistance
level, it appears to be more likely to be closer to the final low than the next fib number down at $850.

Interestingly, if we look at the microstructure of the initial sell-off from the Mar 08 high, we see that gold
initially bounced off $853 convincingly on 1/5/08 and then rallied back to $986 on 15/07/08. What came
next was the massive sell-off down to below $681 (spot), but if we had followed the above model, we
would have sold anyway at $986, since we would have expected an utterly dull 6 months of handle
formation.

The behaviour around $725 and $1014 suggests that when gold peaks and starts to form a C&H, it then
takes 5-7 months to reach the bottom of the cup.

Will gold repeat this relatively precise pattern in the future so in the future? Who knows? But if gold were
to take out $1215 tomorrow – this would still tell us something, namely that fiat money growth was out of
control and that inflation was accelerating. This is such an important point that it is worth repeating – the
point in time when gold bottoms relative to the model’s prediction (April/May) is giving you an insight
into where we stand in the deflation/inflation debate.

On the other hand, all other things being equal, the model tells you that during this initial 5-month
bottoming phase you can trade gold but should be wary of investing in it unless you’re relaxed about the
possibility of a 10-15% drawdown. Gold is just ‘doing its thing’ but from April/May onwards should
again be generously inclined towards longer-term investors and if it prints $1014, then it is a signal for a
great $200 trade, almost as good as the breakout above $1225 when it finally happens.

It also gives you a roadmap for the next 18 months: If history is to repeat itself, gold has to print $1014 on
the London fix as a bottom signal, but this is due no later than May 2010 (it may dip $20-30 below this
intraday, but it’s the London fix which counts). May-Sep will give a nice rally to around $1190, followed
by a retrace to around $1110 in December, with $1210 taken out in March 2011 and the fast run to $1490
around May 2011. I am merely projecting the previous time frame here and do not claim to have a crystal
ball, but would like to say that I would have done much better in my trading than was the case had I
listened to this model 6 months ago.