A 33-Year-Old Lesson on Gold

After a third consecutive week of stock market gains, the Dow (DJINDICES: ^DJI  ) and the broader S&P 500 Index (SNPINDEX: ^GSPC  ) both closed at five-year highs on Friday. Conversely, the VIX index (VOLATILITYINDICES: ^VIX  ) registered its lowest closing value in over five-and-a-half years. The VIX, which is derived from option prices on the S&P 500, is a measure of investors' expectations for stock market volatility over the next 30 days.

A golden bubble bursts
Thirty-three years ago today, on Jan. 21, 1980, gold reached $850 per ounce, its all-time high on an inflation-adjusted basis. The momentum of the final spike in prices was tremendous: During the first 11 1/2 months of 1979, the price of gold had doubled to $457; over the next 36 days, it came close to doubling again (+88%). The next day, however, the price gold fell 13%; over the following years, the loss amounted to nearly two-thirds.

The causes of the bubble are clear, in hindsight. Advanced economies had suffered the ravages of inflation during the 1970s and political tensions were at a high at the beginning of the 1980s: The Soviet army had just invaded Afghanistan the previous month and the hostage crisis at the U.S. embassy in Iran had erupted one month prior to that.

Finally, there was an important financial condition that fueled the gold bubble: Negative real interest rates. The following graph shows the yield on the 10-year U.S. Treasury minus the rate of inflation over the prior year:

Source: Federal Reserve Bank of St. Louis.

Today, real interest rates are also negative. On Thursday, the real yield on the 10-year TIPS (Treasury Inflation-Protected Securities) closed at -0.64%, up from their all-time low of -0.86% achieved in October (TIPS were introduced in 1997.) The world is not devoid of political risks today, nor have all fiscal and structural challenges been addressed. However, gold and silver owners, via products such as the SPDR Gold Shares (NYSEMKT: GLD  ) and the iShares Silver Trust (NYSEMKT: SLV  ) ought to consider that if rates continue to normalize and anything other than a disaster scenario occurs, their losses could be horrific as the precious metals revert to prices nearer their historical inflation-adjusted averages. My best guess is that gold's all-time nominal high above $1,900 from Sept. 2011 will remain unchallenged for some years -- and longer once you account for inflation.

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Read/Post Comments (5) | Recommend This Article (15)

Comments from our Foolish Readers

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  • Report this Comment On January 21, 2013, at 6:31 PM, MDApache6 wrote:

    You have missed one critically important point. The U.S. government did not owe the world the massive sum of dollars that it does now. There is no possible way that the U.S. debt will be repaid. It will either be defaulted on (unlikely) or inflated away (very likely). The world is on the edge of a massive currency war - a true race to the bottom where corrupt governments attempt to inflate away their unmanageable debts by printing money.

  • Report this Comment On January 21, 2013, at 6:37 PM, innovator1 wrote:

    I have to disagree with the writers analysis.

    using Tips isnt consistant through out.

    Also it doesnt seem that the writer calculated inflation the same way in both key periods.

    if inflaation was calculated the same as the late 70's im guessing this chart looks way different and therefore these conclusions are moot.

  • Report this Comment On January 22, 2013, at 7:56 AM, menelyik wrote:

    "The Motley Fool" has shown itself very consistently to be a propaganda outlet for "TPTB", including the large banks and the central banks. While 33 years of trading gold may seem like a long time, it is perhaps worthy of mention that gold has actually been valued as a storehouse of real value for over 5,000 years .... and no paper currency can ever hope to come close to that before it gets swept up in the trash .....

  • Report this Comment On January 22, 2013, at 11:20 AM, ryanalexanderson wrote:

    Building on the above comments: The fed entered 1980 with a prime rate at 15%, and it peaked at 20%.

    The Fed had the latitude to broadcast rate increases, and be believed.

    Whereas nowadays, raising the interest rates to the long term average of 5% would cripple the economy. Hell, they can't even stop the acceleration of money printing at the moment, let alone slowing down money printing. Let alone hint at an interest rate increase.

    The people who say "debt doesn't matter" terrify me (I'm not accusing you, Alex, of saying that). With any luck, the US will have a 'dry run' they can observe with Japan on this matter before things get much worse.

  • Report this Comment On January 22, 2013, at 7:30 PM, rd80 wrote:
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