Gold Crisis and Inflation Hedge Expected to Outperform Crude Oil
Commodities / Gold & Silver Oct 07, 2008 - 02:58 PM
1. Introduction
Over the last 7-8 years, gold has consistently underperformed oil. Gold bulls are worried – after all, why invest in gold, when oil delivers a better performance, and so are apparently copper, uranium, and a number of agricultural commodities. The answer is simple – during the early stage of this commodity bull market (2000-2006), the fundamentals of oil were much better than gold. However, the relative fundamentals will reverse in later stages, when gold will dramatically outperform oil. This is simply the nature of the current commodity bull market.
The rest of this article attempts to explain the current commodity cycle. It provides a quick overview of previous bull markets in commodities and their typical stages. No attempt is made to explain commodity cycles in general, nor is attempted to provide a comparative analysis between the current cycle and the 1970s cycle. Either of these could be developed in the future. Our specific goal is to understand why gold has underperformed oil so far, and why it will outperform in the future.
2. Secular Bull Markets in Commodities
A historical review of secular bull markets in commodities by Jim Rogers establishes that commodity bull markets last from 15 to 22 years. Here are the actual cycles from the 20th century:
- 1906-1923 (16 years)
- 1933-1953 (21 years)
- 1968-1982 (15 years)
Some of the beginning or ending points might be disputed for a year or two, but the big picture is clear: these cycles can last for two decades.
Another very important property of secular markets is that typically a secular bull market for commodities (real assets) coincides with a secular bear market for stocks (financial assets) and vice versa. As an illustration, the period of 1968-1982 was a secular bull market for commodities and at the same time was a secular bear market for stocks. Naturally, secular bull and bear markets alternate. For example, the subsequent period, 1982-2000, was a secular bear market for commodities and a secular bull market for stocks.
It is generally accepted that commodities represent real assets, while stocks represent financial assets. Typically, a secular bull market for real assets is associated with a secular bear market for financial assets, and vice versa.
There are a number of explanations to this natural coupling of commodity bull markets with stock bear markets. The first reason is that commodity bull markets reflect a loss of purchasing power of the currency. Therefore, all financial assets denominated in that currency will also lose their purchasing power along with the currency, thus making them less attractive and lowering their demand. The second reason is that rising commodity prices reflect inflation and inflationary pressures in the economy, which increases the inflationary component of nominal interest rates. As a result, during commodity bull markets, nominal interest rates eventually rise, reflecting higher future inflationary expectations, thus increasing the nominal discount rate of the cash flows of stocks and bonds, and lowering their present value.
3. Stages of Secular Bull Markets
A typical secular bull market, whether for commodities or stocks, progresses naturally through three stages:
- Early Stage . This is the “Stealth” stage of the bull market, where the old mania from the late stage of the previous secular bull market still preoccupies the investor masses. The masses live in the past, and so does Wall Street. The shift is not recognized, widely regarded with skepticism, or even denied outright. It is also known as the “Stealth” stage, simply because the majority of investors are not even aware that the bull market is present – the asset class is not even on their radar screen. Instead, only a small minority of astute investors realize that a profound shift in the investment environment has occurred and begin to accumulate assets in the new investment class. This group of early investors is best known as “smart money”. Typically, at the end of the early stage, there is usually a major sell-off and poor returns for an extended period of time, may be as long as 1-2 years that shakes off many of the weak investors and most of the speculative momentum trend-followers. This period is typically long, lasting about 30-35% of the whole secular cycle, anywhere between 4-7 years.
- Mature Stage . This is the stage where the new investment trend gradually becomes recognized by institutional investors and investing in the new investment class becomes acceptable. Generally poor returns of the alternative asset class force institutional investors to look at alternatives. There is still a general disbelief in the new asset class.; there is plenty of skepticism. There is also the realization that the past returns have been so great, that prices cannot go much higher. Therefore everyone is “worried” that the bull market might soon be over. Every intermediate decline is declared the end of the bull market, During this stage, the market climbs the proverbial “Wall of Worry”. Nevertheless, the healthy returns from the early stage convince them that they should jump on board, albeit cautiously and with a relatively small percentage of their funds. In general, institutional investors are known as “Big Money”. They enter the markets slowly and steadily, typically herding tightly with their peers and trying not to deviate too far away from them. It is important to understand that even by the middle of this stage, a full decade may have passed since the beginning of the shift, while the masses (the average investor) have still not recognized it. This period is typically long, lasting about 35-40% of the whole secular cycle, may be anywhere between 5-8 years, even more.
- Late Stage . This is the “Mania” stage, the period when the masses enter the bull market in droves. They never saw the first stage, but they have watched the second stage develop for almost a decade. They are finally convinced that the trend is permanent and expect prices to rise forever. Caution is thrown out of the window and greed takes over. Use of leverage becomes the investment norm. Leveraged speculation is rampant; over time, greed turns into mania, with bursts of panicked buying. Throughout the stage, the buying conviction of the masses drives prices parabolically, which feeds back to reinforce their convictions. Asset-based lending becomes the norm, so rising asset prices begets more lending, which further fuels the boom. This stage is usually associated with a major bubble. It is also known as the “Blow-off” stage. It typically lasts 20-30% of the time, may be anywhere between 2-4 years.
4. The Current Bull Market in Commodities
The current bull market in commodities began in the period 1999-2001. For all practical purposes, the exact dating is irrelevant; Jim Rogers believes that it began in 1999. Others prefer 2000 because it marked the bottom of the Gold-Dow ratio. Still others prefer 2000, simply because 2000 marked the end of the secular bull market for stocks and the beginning of the secular stock bear market. Finally, some choose 2001 for the bottom as that year indicated the bottom for many commodities -- since 2001 all commodities were rising in terms of U.S. dollars. In the big schema of things, whether the secular bull market began in 2000, or a year earlier or, or a year later is irrelevant. For simplicity, let's use 2000.
2000-2006 was the first stage of the current commodity secular bull market. A protracted consolidation for all major commodities from the middle of 2006 till the middle of 2007 punctuated the end of the first phase. Oil corrected in 7 months from about $80 to $50, while gold consolidated in the range of $725 to $675 for about a year. During those 7-8 years, commodities were under the radar screen for the average investor. Wall Street was in denial – it confidently called for falling commodity prices. Institutional investors were largely not invested in commodities. Commodities were considered risky and unacceptable for conservative institutional investors. The primary demand for commodities during the first stage was consumption and industrial demand; the secondary demand came from the steady accumulation of smart money. Remarkably, the dollar was in a steady measured decline, yet the authorities and Wall Street were not overly concerned; on the contrary, dollar devaluation was considered benign, even a good thing, because it supposedly boosted U.S. exports. The length of this stage was about 6-7 years.
The beginning of the second stage of the commodity bull market should probably be best associated with the beginning of the Subprime Crisis – August 2007. The early Subprime tremors in January 2007 put a bottom in the six-month correction for crude oil. The crisis in August 2007 marked the bottom for gold. Since August, the second stage of the commodity bull market was in full motion. Characteristically of a second stage, about 6 months later, The Wall Street Journal reported on January 31 in the article “Investors Rush to Gold” that
“[t]oday, a different class entirely is powering gold's rise: mainstream investors and money managers who once shunned it… Gold's renewed luster shows the extent to which unease has replaced optimism since 2000… It is highly unusual for traditional investors such as mutual funds and trust companies to invest so much in a commodity they once viewed as a nonproductive asset… Until recent years, central banks around the world were selling their gold holdings, at prices far below today's prices. Now some central banks are buying.”
Plain and simple, the Wall Street Journal confirms that gold has finally become acceptable for investment institutions. It also confirms that we are now in the very beginning of the second stage of the commodity bull market. Also, characteristically of this stage is the remarkably weak and extremely volatile dollar with a multitude of daily mini-crashes. Its rapid decent since July 2007 speaks of an inherently new currency market; the falling dollar now raises concerns amongst mainstream economists. The dramatic decline of the major stock indexes since July–October of 2007 should also confirm a fundamental shift in the investment environment. Finally, since June the bond market has staged a major rally, associated with a flight to safety, which has resulted in a dramatic collapse in long-term interest rates. In early Fall the Fed began an aggressive rate-cutting cycle.
Thus, since the middle of 2007, there is a well-defined fundamental shift in the currency, commodity, stock, and bond markets, indicative of a qualitatively new stage in the development of the markets – the beginning of the second stage of the commodity bull market. If history is any guide, this stage should last another 6-8 years and end up with a major correction in all markets. In about 8-10 years from now, we should expect the commodity bull market to reach a mania of historic proportions.
It is important to emphasize that the above interpretations are entirely mine. I base it based entirely on my own decade-long studies of historical episodes of manias, bubbles, and more generally of cyclical analysis. In fact, it contradicts many world-renowned scholars in the field. For example, the highly regarded Frank Veneroso and Robert Prechter widely publicized their beliefs that during 2007 there was a commodity bubble; both of them called the collapse in commodity prices in mid March of 2008 to be the bursting of the bubble. I strongly disagree with them.
I also disagree with many highly sophisticated gold investors and with our own Doug Casey that the mania stage, if there is one, will be in 2-3 years, and possibly even sooner. In my opinion, we have a long way to go before we reach the mania – the psychology of the institutional investor will not mature in 2-3 years, and neither will the average investor; Wall Street still does not recognize a commodity bull market and is not geared for profiting from one; CNBC is not yet cheerleading; Mark Haines still pooh-poohs gold, and we have yet to see Money Honey in the gold pits of the COMEX. Thus, I obviously disagree with the idea that we will see a “mania” in a couple of years, although I expect healthy returns for gold. However, the intelligent investor should only benefit from a diversity of opinions by understanding the arguments behind each opinion.
5. The Current Cycle - Gold Underperforms Oil, so far
In the first stage of this commodity bull market, oil has outperformed gold. Indeed, since the beginning of the bull market, gold has risen roughly from $250 to $900 – less than 4 times, while crude has risen about 5 times. The chart below shows clearly that oil outperformed gold by approximately 50%, whether we consider mid 1999 or late 2001 as the beginning of the cycle.
However, gold bulls need not worry about this relative underperformance, because it was natural that oil should outperform gold in this first stage. Here is a summary of the fundamentals:
- Consumer Demand . Demand for crude oil was almost insatiable during the first stage of a commodity bull market. Investors and consumers alike have enjoyed the enormous wealth creation during the previous secular bull market in financial assets. Consumption for vacations, leisure, and all sorts of things is underpinned by the increased “paper” wealth of the previous period. Consumer demand for gold was relatively limited, except for possibly India and some oil-exporting countries. Consumer demand clearly favored oil over gold.
- Industrial Demand . The rise of India, China, and East Asia in general has powered similarly an insatiable demand for oil. Industrial demand for gold was relatively limited. Industrial demand also favored oil over gold.
- Investment Demand . During the first stage of the current commodity boom, Investors understood oil better than gold. Consumers, investors, fund managers, and the public in general understand intuitively the investment merits of crude oil. Gold is still poorly understood, even today; as the Wall Street Journal pointed out, gold is viewed as a “nonproductive” asset. Gold still puzzles the distinguished CFA – how do you value an asset that has no income stream? Even worse, gold is not part of the CFA curriculum, nor is there any meaningful discussion on gold in economics textbooks, where it is portrayed in mostly negative terms. Investors in gold are usually ridiculed as “Doomers” and “Gloomers”. So far, mostly “smart” money was buying gold. On the other hand, investment demand for oil was considerably stronger, thus favoring oil over gold.
- Inflation Hedge . Gold has always been a superb hedge against inflation. However, during the first stage of the bull market this was poorly understood by the public and the professionals alike. More importantly, during the first stage of the current commodity bull market, inflation was not considered to be a major problem. It is true that oil prices were seen rising, especially at the pump, but overall inflation was not seen as a problem, and inflationary expectations were “well anchored”. At the same time, crude oil was well understood as an inflation hedge. Ordinary people and investment managers observed indirectly its price at the pump; they understood the connection between rising oil prices and rising consumer prices. Therefore, oil was their instinctive choice as an inflation hedge. Such a rationale for buying oil has been discernible during the last 3-4 years; not yet for gold. However, I am not saying that gold is a poorer inflation hedge than oil. Quite on the contrary – gold has always been the better hedge, but people and investment managers could not recognize it as such during the first stage; the preferred inflation hedge so far was oil, rather than gold.
- Currency Hedge . The mainstream investment world, the government, and Wall Street did not recognize during the first stage the falling dollar as a persistent problem. In a sense, they did just the opposite – they cheerled its fall as stimulative for exports and for the macroeconomy. Therefore, there was no quest for a currency hedge against the weak dollar. With orderly currency markets during the first stage, the need to hedge the currency was minimal and did not drive demand for gold. Interestingly, media have reported in 2005-2006 that oil was occasionally purchased as a hedge against a falling dollar. Actually media portrayed oil as the anti-dollar.
- Portfolio Hedge . During the first stage of the bull market gold returns were well correlated with the returns of stocks and bonds. As such, gold has functioned poorly as a portfolio hedge. Recently, however, especially during the Subprime meltdown, gold has “decoupled“ from the stock market, and some managers are beginning to rediscover this magnificent property of gold. It is interesting to note that during the first stage oil was actually perceived as a portfolio hedge, while in reality it is not. Oil is an especially poor portfolio hedge in a recessionary economy, when both oil and stock prices underperform and re-establish positive correlation between them.
- Crisis Hedge . In times of crisis, gold is the ultimate safe haven. A severe and protracted financial and economic crisis would result in a global downturn and choke consumer and industrial demand for oil, while demand for gold increases dramatically. However, during the first stage no such crisis occurred. Gold shone during September 11, but this crisis subsided quickly, so gold gave back most of its gains. During the first stage, there were no other crises to fuel extra returns for gold. Thus, gold had little chance to shine where it shines best. Interestingly enough, if there was a perceived crisis, whether with Afghanistan, with Iraq, or with Iran, oil was propelled higher for fear of disrupting oil supplies and resulting oil shortages.
- Price Manipulation . Governments and central banks have attempted to keep the price of gold suppressed. This is currently considered highly controversial and is not accepted by the mainstream. It is also hard to prove, whether with official policy statements or with rigorous data analysis. As such, the argument is admittedly weak. Nevertheless, serious investors in gold should be aware of this possibility and should be familiar with GATA's work ( www.gata.org ) that documents in great details how and why the Establishment would be eager to suppress the price of gold and how exactly they seem to accomplish this. If this argument is accepted, then, gold had a clear disadvantage against oil. During the first stage, central banks have sold large stockpiles of gold that has reduced the return of gold relative to oil. However, as central banks have recently slowed down their gold sales, and some are reputedly buying gold on the open market, in coming years this should change the fundamentals in favor of gold.
6. Conclusion
To summarize the first stage of the current commodity bull market, the fundamentals for gold on all accounts are weaker than the fundamentals for oil. Therefore it was natural that during the first stage oil significantly outperformed gold.
However, during the second, and especially during the final stage of the commodity bull market, the above fundamentals will decisively turn in favor of gold. As such, in coming years we should expect gold to outperform oil. Moreover, the closer we get to the “mania” stage of the cycle, the better will gold perform relative to oil. Gold bulls have little to worry about.
By Dr Krassimir Petrov
Krassimir Petrov ( Krassimir_Petrov@hotmail.com ) has received his Ph. D. in economics from the Ohio State University and currently teaches Macroeconomics, International Finance, and Econometrics at the American University in Bulgaria. He is looking for a career in Dubai or the U. A. E.
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