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Indicator Warns of 78% Collapse in Gold's Purchasing Power


Here, an examination of whether gold is always a safe store of value during periods of currency depreciation.

There is an abundance of indicators giving extreme readings which indicate that the gold cycle is near a secular peak. However, any arguments dealing with gold's sky-high valuation or current overbought levels seem be dismissed with the gold bugs chanting their favorite mantra: "But the Fed is printing money!" It has become increasingly apparent that if this argument is not addressed head on, all warnings will fall on deaf ears. This article will perform the role of mythbuster in examining whether gold is always a safe store of value during periods of currency depreciation.

In reading articles on precious metals (and thousands of comments on those articles), it is quite clear why many people are buying gold. People believe the Fed is going to have to print a lot more money to pay for all the debt, and this will cause inflation. Then the gold bulls make the leap of buying a shiny metal as a way to hedge against the declining value of the dollar.

This is where their logic is somewhat flawed. There is nothing magical about gold relative to any other asset class. When the dollar goes down, gold can go up, sideways, or even down. "But gold is a CURRENCY" the gold bugs exclaim. This is irrelevant as you will soon see.
The indicator du jour is the Gold/CPI ratio. We will use year-end gold data from which starts from 1718, and CPI data from This will allow us to see how gold holds its purchasing power even during a gold standard.

As of the most recent CPI month (April 2011), the Gold/CPI indicator was at the sixth highest level out of 294 years. This is the 98% percentile. The all-time highest reading occurred in 1743. If gold would trade at the 1743 level, it would be at $1,653.

What about gold bugs' claims that the inflation adjusted price of gold is around $2,200? Well gold did indeed spend a number of days above that inflation adjusted level in 1980. However, by the end of the year it did not. This indicator is long term in nature and concerns itself with broad secular valuations over decades or centuries. Whatever happens during the year is just noise best left to other indicators.

Here are the 10 highest readings and what happened next to gold:

Let's take a look at 1760. Say somebody bought an ounce of gold for $20 in 1760 and passed it along through generations to his great, great, great, great, great, great granddaughter. By 1969 gold had managed to crawl all the way up to $35.4 for a gain of 81% in 209 years. Meanwhile, inflation went up 1,124% over the same time period!

The 2011 ratio is the third highest over the last quarter millennium. As for the top two, gold dropped 55% from December 31, 1979 to its nominal low about 19 years later while inflation went up 117% during that time. Gold dropped 59% from December 31, 1980 to its nominal low about 18 years later while inflation went up 93% during that time. So much for store of value.

Let's look at the top 10 lowest readings of this indicator:

As for the 2001 reading which got down to the 13th percentile:

Buy low. Sell high.

This indicator works during deflation, inflation, the gold standard and fiat currency environments. Both buy and sell signals were great.

The Gold/CPI indicator suggests the "Fair Value Average" of gold is $734 and the "Fair Value Median" to be $610. These figures are not far off from the $614 suggested by the gold/real estate ratio discussing in an earlier article (Why It's Extremely Risky to Hold Gold Now) or the $550/$536 suggested by another method (Gold's Average Price Is Second-Most Overvalued Since 1791).

While the dollar will depreciate, there is no guarantee whatsoever that the newly printed money will flow proportionately into gold. Gold's yield (0%) is considerably lower than stocks, bonds and real estate. Furthermore, gold is at the 98% percentile with respect to the valuation metric discussed in this article and 99% percentile by a couple of other techniques. The problem is the gold bugs assume gold will go from the 98%-99% percentile to the 100% percentile. NASDAQ still is down over 40% from its 2000 high and the United States has had inflation in every one of those years. Real estate has been going down five years in a row and look how much money the government has printed since then. Gold went down in the '80s and '90s and inflation back then was worse than the 2000s. So it is possible for a highly valued asset class to go down even during times of inflation. Gold now looks particularly vulnerable to such a phenomenon.
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