gold:report

NOVEMBER 2005

Why gold, not oil, is the superior predictor of inflation

By David Ranson, H. C. Wainwright & Co. Economics1
We are now into a second year of extreme volatility in the price of oil. Although the economy so far is weathering it well, investors are scrambling to adjust their portfolios. Will prices stabilize, fall back, or escalate further? When the volatility ends, we expect them to decline, but only very slowly.
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ination must accelerate. Three limiting factors apply: changes in the dollar-price of oil, to a large extent, have historically been a reaction to changes in the dollars purchasing power; a rise in the price of one commodity (however important) relative to other commodities is not in itself sufcient to force a rise in the general cost of living; the number of episodes in which the price of oil changed substantially in a short period has been too few to serve as a basis for accurate forecasts. This paper demonstrates the extent to which the prices of commodities such as oil and gold serve as leading indicators of unanticipated ination and interest rates. The evidence presented covers producer prices, consumer prices and bond yields in the United States, but other work suggests that the relationships found are not greatly different in other currency zones, in some of which

central banks have adopted ination targets that are much more explicit than in the U.S. We believe it will be of substantial interest to investors to know that gold is a superior (perhaps the best available) early warning indicator of ination. Ways in which investment performance can benet from taking advantage of the properties of gold and other commodities will be presented in forthcoming papers.

But how much does the price of oil matter? Our research indicates that there is not much point in formulating broad investment strategy based on what oil is likely to do in the futureor even on what it has done in the recent past. Even if we knew for sure at what level oil prices will stabilize, the economic consequences would not be predictable. Far more signicant for the future of ination and the economy as a whole is the price of gold. A large increase in energy
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Gold versus oil as a leading indicator of inflation.

There are several ways in which the gold market provides more accurate information about future economic and capitalmarket performance than data from the oil market. Figure One shows, for example, that when the price of gold rises, producer-price ination tends to accelerate in the following year; when the price of gold falls, it tends to decelerate. Although the data presented in Figure One go back to 1951, there is a break in

prices

undoubtedly reshufes resources among sectors within the economy; but history refutes the oft-repeated claims that a recession necessarily follows or that
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For more information about the author, please see p. 6-7. Please read the disclaimer on p. 8 See Energy is too high-priced to be a good strategic bet, Strategic Asset Selector, H. C. Wainwright & Co., Economics Inc., March 2005, forthcoming. 3 This report updates earlier work by Wainwright in which we analyzed the powers of gold as an ination indicator. See Watch gold, not oil, Economic and Investment Observations, Wainwright, September 19, 1990; and Richard M. Salsman, What explains golds forecasting power, Wainwright, April 1994.

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behavior around 1968, prior to which the Bretton Woods monetary system was in force throughout the world, and the price of gold in terms of the dollar varied very little around its ofcial target of $35 per ounce. By the same test, oil is a relatively poor performer as a leading indicator of ination; in fact the oil price has been little better than random. As shown in Table 1, the correlation between movements in producer prices and oil prices in the prior year is almost zero.
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Table 1: Correlations between Inflation Rates and Oil and Gold From 1951
Commodity indicator Gold Oil Producer-price ination one year later .37 .01 Consumer-price ination one year later .50 .23

Data: Calendar-year averages of monthly indices for producer prices (all commodities) and consumer prices (all urban consumers) and of daily prices for gold bullion and Brent crude oil (Wall Street Journal).Data: Calendar-year averages of monthly indices for producer prices (all commodities) and consumer prices (all urban consumers) and of daily prices for gold bullion and Brent crude oil (Wall Street Journal).

that a rise in the cost of energy will tend to drive up the prices of goods in the production of which energy is required. But no single commodity can drive up the prices of all commodities. Only the federal government, by allowing the value of the currency to depreciate, can do that. To create a rise in the general price level requires more than an increase in the relative price of a particular group of commodities. Indeed, an energy-price

Gold versus oil as a leading indicator of the bond market.

Precisely because it anticipates ination so well, gold is also a powerful predictor of nominal interest rates, both long and short. This, in fact, is a more rigorous test of the relative powers of gold and oil, because bond market performance is an objective indicator, and is free from many of the errors of measurement that bedevil the ofcial indices of ination. In similar research on short-term interest rates we have obtained very similar results. Our calculations show that the time frame that yields the optimum correlation

The results in the table are reinforced when we combine price data for both gold and oil in a single least-squares equation to anticipate movements in either producer- or consumer-price ination. Only the gold variable is statistically signicant. Thus for purposes of anticipating ination one year in the future, there is no signicant information in the price of oil that is not already captured by the price of gold. Why do oil prices serve so poorly as a leading indicator of ination? It is true

increase is inherently deationary. By absorbing a larger slice of the incomes of energy users, it makes most other commodities less affordable.

Figure One: Gold: A Sensitive Leading Indicator of Inflation since 1951

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Figure Two: The Bond Market Follows Gold, Not Oil

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Data: Calendar-year averages of month-end gold prices (Metals Week/Wall Street Journal) and of monthly indices of producer and consumer prices (Bureau of Labor Statistics).

Data: As for Table 1, together with calendar-year averages of daily ten-year Treasury bond yields (Federal Reserve Board).

These correlation coefcients are obtained from regression equations (based on annual data) in which the dependent variable is the rate of ination one year in the future and the explanatory variable is the change in the price of the indicated commodity.

NOVEMBER 2005

(0.73) between changes in the price of gold and changes in 10-year T-bond yields is about twelve months. The optimum correlation (0.54) between oil-price changes and T-bond yields involves only one-month time difference. These results reveal two respects in which the information in the gold price is superior: gold provides a much earlier warning, and the correlation with interest rates is signicantly tighter regardless of the time frame. Figure Two illustrates how oil-price changes are not helpful in predicting changes in the bond market with any signicant lead time. The bars record the average response of the bond market to whether oil rose or fell in the previous year depending on whether the price of gold had risen signicantly, had merely risen, or had fallen. As the chart shows, in each category of gold-price movement, there is little difference in what bond yields do regardless of what happened to the price of oil. In all three categories bond yields moved in the same direction whether oil prices had risen or fallen. This result is conrmed by
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least-squares analysis in which we allow price changes in gold and oil to compete to predict the change in bond yields one year ahead. The oil-price variable is statistically insignicant in the presence of the gold price variable. The triangular relationship between oil, gold and bonds is illustrated in Figure Three. As the diagram shows, the relationship between bond-market movements and oil is roughly

ing where it has already been is far more fruitful. Despite growing recognition of golds forecasting power, investors,

schooled to believe that gold is a barbarous relic with no modern role to play or just another commodity, often resist using it in their investment strategy. Others are concerned that gold is buffeted by many bottom-up factors such as South African politics, Chinese demand, central-bank dumping and so forth, which can distort its price. But its forecasting power proves that such distortions do not last long.

contemporaneous. Gold is correlated with both oil and bonds, but moves in advance of both by about a year.

What makes gold different.

Because gold moves earlier than ofcial measures of ination, it works much better at anticipating monetary policy than Fed watching. the Gold distinguishes and absolute

Why gold is not just another commodity.

Gold has served as money over the centuries precisely because its properties were most conducive to playing that role. Its primary function throughout history has been as a liquid store of wealth, not as an industrial input. Even when gold is made into jewelry, it is still today a form of currency in large parts of the world. Unlike other commodities, which are produced for consumption, gold is produced

between

relative

strength of currencies and even helps forecast equity markets and style bets. The investment applications of gold are numerous, but not widely recognized. Analysts often try to anticipate where the price of gold is heading; however, know-

Figure Three: The Triangular Relationship Between Gold, Oil and the Bond Market

Figure Four: The Price of Gold is an Anchor for the Price of Oil since 1968

CONTEMPORANEOUS

Data: As for Figure Two.

Data: As for Table 1. Prior to 1984 crude oil prices are from Reuters Commodity Research Bureau.

5 These correlations are measured from 1974. See Economic Barometer, Wainwright, February 25, 2005. This publication updates the status of these and other ination indicators on a monthly basis.

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for accumulation. Virtually all the gold that has ever been mined still exists today. Gold is the chief member of an asset class of safe havens against the debasement of paper money. In this class are the other precious metals and collectibles generally, but gold is the most liquid. The purchasing power of gold what it will buy in terms of other goods and services is nearly constant over long periods of time. The late Roy Jastram, a Berkeley professor, in studying British and terms of other goods. For other commodities, short-term changes in supply or demand cannot be so easily cushioned. To build such enormous stockpiles of other commodities is an the reverse.

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dollar imparted value to gold, not

The implications of a gold-price change are far-reaching. It is partly because gold is so uninvolved in the economy that it can serve as a dependable barometer of the dollars purchasing power and therefore of pressures on ination and bond markets. The relative performance of gold and oil as ination indicators can therefore be traced back to one profound fact: in order to use gold for its main economic purpose (the preservation of wealth) it is necessary only to hold it. By contrast, in order to use oil for its main economic purpose (the production of energy) it is necessary to consume it literally to destroy it in the process of converting it to energy, water, and carbon dioxide. New supplies of oil must be found to replace all the oil that gets used, whereas the supply of gold is unaffected by its use. Thus the value of oil in terms of other goods is highly variable; the value of gold in terms of other goods is highly stable. When looking for yardsticks to assess prices and values, it is essential to adopt a sound unit of measurement. Oil is highly variable. The dollar can be highly variable too. But the purchasing power of gold is stable.

unthinkable task, nor would it make any economic sense. Because other commodities are major industry inputs, their relative prices change with the business cycle. Gold is not subject to these distortions since it is not a major input to industry. Changes in the gold price are thus a good barometer of changes in currency valuesand ultimately in the absolute level of prices. Since the real value of gold is roughly constant over time, changes in the gold price of a currency tend to reect changes in the markets evaluation of that currency. The currency, not gold itself, is variable. In effect, the gold price is the inverse of the price of money. In other words, the quoted price of gold is the price of paper money in terms of hard money. A rising price of gold reects inationary forces; a falling price of gold reects dis-inationary forces. Gold is the only money that cannot be debasedon the contrary, it is the measure of currency debasement. Whether the price of

American price indices over long time periods, concluded that gold exhibited relatively constant purchasing power.
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Even in the face of large gold discoveriesin Latin America in the 16th century, in California in the mid-19th century and in South Africa and Australia starting in the 1890s the world supply of gold increased only incrementally each year, and gold held its value. What about its future value? Since gold is a depletable resource, and large discoveries are becoming increasingly rare, the total stock of gold now tends to diminish each year. Thus golds purchasing power will remain stable, and its role as a measuring rod will become still more secure.

Why gold forecasts better than other commodities.

Gold is different because the reservoir of gold that is traded in world markets dwarfs any possible interruptions in the annual ow that result from either supply or demand. The annual ow of newly mined gold adds only about two percent a year to the gold supply, far less than for any other commodity, especially oil. This reservoir of gold stabilizes its value in
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gold is active or quiet, whether or not central banks ignore its movements, it is always measuring paper money. Those who misjudge or downplay the importance of gold have often been surprised. When the U.S. severed the dollars link to gold, monetarists

The co-movement of oil and gold prices.

The ratio between the prices of oil and gold, over the long haul, has been something like a natural constant.7 From the late 1950s to mid-1973 the dollar-price of oil hardly changed, while that of gold

predicted that the price would fall below $35 an ounce. They believed gold was just a commodity whose price happened to be xed by government and that the

Roy W. Jastram, The Golden Constant: the English and American Experience, 1560-1976, New York: John Wiley & Sons, 1977. For a recent estimate of the long-term norm for the oil-gold ratio, see Energy is too high-priced to be a good strategic bet, Strategic Asset Selector, Wainwright, March 10, 2005.

NOVEMBER 2005

escalated 250 percent from $35 under the Bretton Woods system to over $120 an ounce. Then late in 1973 came the Saudi oil embargo and a nearly 300 percent leap in the price of oil. While the Arabs were held responsible at the time for an arbitrary and destructive price action, from a more detached viewpoint they were mostly playing catch-up with the price of gold. During the Carter years, the U.S. initiated a second round of dollar depreciation. The gold price was allowed to rise another 300 percent, undermining OPECs pricing and precipitating the price increase that ensued during the second OPEC shock. By the end of 1980, oil had risen nearly 150 percent, momentarily restoring parity. In 1981,this upward spiral ended, but the

game of catch-up resumed in reverse. During Reagans rst term, the price of gold fell more than 50 percent from an all-time high of $800 in early 1980. The price of oil nally broke with a drop of more than 50 percent in the rst quarter of 1986. In the next phase both prices uctuated, but by 1990 the gold-oil price ratio had once again returned to its longterm norm, which we estimate of about 15.5. During the 1990s oil and gold prices declined together, only to leap up again in the new century. Figure Four charts the history of oil and gold prices since 1968. As Figure Four suggests, the dollar-price of oil has revolved around movements in gold. This behavior accords with the idea that the price of gold reects inationary

pressures in general, while that of oil contains information specic to the energy sector, a conclusion conrmed by statistical tests.

Conclusions
Ination is a monetary phenomenon, by which we mean it is governed by the purchasing power of a currency in terms of hard money benchmarks. How to tell whether government actions are combating or accommodating ination?

Watch gold, not oil. The price of gold is a reliable barometer of the value of the dollar; the price of oil is not. The effect on ofcial ination statistics and bonds alike is reliably indicated by how far policy actions have allowed the price of gold to rise.

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Approach and Investment Philosophy

Wainwright

Economics

conducts

and growth stocks; low-quality and highgrade bonds; foreign and domestic bonds; and for many other asset classes. Our work provides a much-needed challenge grounded in rigorous historical research to the clamor of seat-of-thepants rhetoric. Our conclusions often conict with the Wall Street consensus, and when they do, we turn out to be right the majority of the time. Our track record is unambiguous and monitored and published regularly. Our methods are very different from those of Wall Street. We do not base our assessments on data produced by the government but rely solely on nancialmarket prices whose superiority as leading indicators we have documented in detail. Our philosophy is to follow an investment discipline relying on facts rather than theory. Our work is not based on theoretical economics; in fact we often discover that academic theories are contradicted by

history. Our research is devoted solely to observation of the data. We test and retest our conclusions to insure that they are sound. We are specialists in identifying, testing and using statistical relationships to determine the implications of price movements in one market for other markets. We explore relationships that are either unknown or poorly understood on Wall Street. We do not use black boxes. All of our equations are made available to our clients, and we help with their own quantitative modeling in forecasting. Our clients have the benet of the longevity and depth of our experience in the investment arena. We are one of the oldest investment research rms in the world. Our current array of publications and services has evolved out of more than twenty years of pioneering work in the eld of investment science.

research on the performance of U.S. and international capital markets and their forecastability. We produce comprehensive quantitative analysis of top-down historical data. Comparable work is not available from any rm on Wall Street or in the City of London. We know all of our clients personally, visit them regularly and are available to answer their questions when they need an answer. Since we are not afliated with any brokerage rm, we have no vested interest in how our forecasts affect the trading habits of our clients. Out work is disciplined, quantitative, rigorous and totally impartial. Our output is practical and designed to facilitate real-life asset-allocation decisions. We publish monthly forecasts for the performance differential between stocks and bonds, stocks and cash, large-cap and small-cap stocks; value

NOVEMBER 2005

H.C. Wainwright & Co. Economics, Inc.

R. David Ranson President and Director of Research H.C. Wainwright & Co. Economics, Inc. South Hamilton, MA

R. DAVID RANSON is the president of H.C. Wainwright & Co. Economics, Inc., an investment research rm near Boston, Massachusetts. Prior to becoming a general partner of Wainwright in 1977, Mr. Ranson taught economics at the University of Chicago Graduate School of Business. He has been an assistant to then Treasury Secretary William E. Simon, and a member of George P Shultzs personal staff at the Ofce of Management and Budget. Prior to his service in Washington, he was a member of . the Boston Consulting Group. David Ranson has addressed audiences and published articles on a wide range of economic and investment topics, and has provided testimony to a number of Congressional committees. His work has also appeared in The Wall Street Journal, The New York Times, The Christian Science Monitor and other publications. He holds M.A. and B.Sc. degrees from Queens College, Oxford, and an M.B.A. in nance and a Ph.D. in business economics from the University of Chicago.

205 Willow Street, Suite B-300 South Hamilton, MA 01982, U.S.A. (978) 468-4575 (800) 655-4020 Fax (978) 468-9075 www.hcwe.com

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NOVEMBER 2005