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Macro Economics
Gold Has Been the Waterloo of Many a Portfolio

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By FastMike
November 30, 2009

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[Edited for space; read the entire post here.]

It is late in the evening, Sunday, 18 June, 1815 and Napoleon Bonaparte's last assault on the British lines has just been repulsed concluding the battle of Waterloo and Napoleon's 'hundred days'.

But history has little noted, nor long remembered one particular 'material' casualty of Waterloo. You see, on the very next day, in markets and cities all over Europe the price of gold came crashing down.

End Sojourn.

The first general for whom history credits with solving the supply line problem was Gaius Julius Caesar. Supply lines can reach only so far. His solution was simple : carry gold (and silver) bullion, and purchase provisions on the go. So effective was the use of Roman gold against tribal loyalty, that Caesar's enemies would burn the crops of their own people to keep grain from reaching the hungry Roman legions. In the end gold proved a better ally than fire, and Western Europe became a province of Rome. Bullion it seemed, was a potent weapon.

It is said that the more things change, the more that they remain the same. So it was 18 centuries later. The English did not simply send an army to fight a great battle. A de facto state of war existed between France and Britain for more than a decade. The alliance army against Napoleon was planned months in advance (And legalized by declaring him an international outlaw). There were logistics to attend to. Armies, men and material, weapons, ammunition, transport, and provisions for both soldiers and livestock.

And, above all, an ample supply of gold bullion was to be deployed to strip the land clean, pacify the locals and provide for the alliance army in the field. But all that gold wasn't yet readily available.Bonds were issued. The money raised was then used to buy bullion, and massive amounts of it. But military planners make poor economists.

In spite of employing the most brilliant intercontinental financiers, who amassed tons of bullion for the Brits at the most efficient price possible, the price of gold rose to the sky. Let's face it, when a "government" starts to amass mountainous amounts gold, then as with the law of gravity, the laws of supply and demand are simply inescapable. In fact, by the time the alliance army deployed, the price of gold had nearly doubled.

And it came to pass, after all that planning and providing and storing and preparing for future years of turmoil, and after remembering and fearing and calculating and reasoning, and having an entire continent brace itself for a long war, after all that, Napoleon Bonaparte was defeated in just one decisive battle, in less than one day.

Which meant that all that stockpiled gold bullion wasn't needed, after all. Which then meant that the supply well exceeded the expected demand. Not to mention all that outstanding debt.

So the price of gold plummeted. In fact, the Brits couldn't even unload it when it offered to redeem paper notes for gold years after the war! When Parliament resumed specie payments for redeeming notes, at government fixed prices, that there was : "...little or no demand for cash... and their treasure... continued to increase to an amount far exceeding what it had ever reached... the directors issued a second notice [to redeem notes] ... for payment in cash ...". [Walpole]

Gold, it seems, can be abhorred as much as it can be coveted.

It would be four years before the market price of Gold would partially recover, and nearly forcibly, because of government restrictions, calling back notes and price fixing gold. It's a lesson that seems to go unnoticed throughout history :the price of gold is a two way street.

Now if Caesar and Napoleon are examples too distant in time to cause any concern there is a nearer example at hand. It's well within our lifetimes, and a textbook example at that.

During this current Bull Market in Gold, memories of the 1980 gold run has oft been mentioned : a record $850 an ounce in January of 1980. And today's Gold Bulls have been quick to mention that when adjusted for inflation Gold would have to rise to $2223 or thereabout in today's dollars to match the 1980 high.

Let's widen this inflation comparison a little further: let's observe that in the same month, January 1980 in which gold peaked, the Ten Year Treasury yield reached 13.27%. Yes, that's correct 13.27%.

But that proved to be the beginning of a divergence.

The Ten Year Note remained high and eventually neared 16% by 30 September, 1981. But by that same day gold had retreated to around $429 per ounce. Strange, but not without explanation.

Gold seems to have been more of a trade, than a hedge. Else, why should it have fallen with treasury yields still indicating inflation? Did Gold traders sense the defeat of inflation? Did that money flee gold and rush into bonds, as it did after the defeat of Napoleon? The more things change the more they remain the same, indeed!

That long decline in both 10 Year Note yield and gold prices continued until 15 December, 1997. On that day, the London close was at $283 per ounce. Today's gold bulls don't often boast about that! Now if you adjust for inflation, $850 in 1981 was $1445 in 1997 dollars, hence a shocking 80% decline from the high!

Oh! On that same day 15 December, 1997.... the Ten Year Note closed with a 5.766% yield.

That long decent in yield would still continue until 13 June, 2003 when it closed at 3.104% and gold closed at $353 that same day. Now very, very, very carefully observe that $353 in 2003 dollars would be $415 in 2009 dollars. And then very, very, very carefully observed that the 10 Year Treasury closed with a yield of 3.21% on Friday, this week past.

It's worth noting here that from January 1980 through December 1997, the S&P500 gained a whopping 750%; from 114.16 in January of 1980 to 970.43 in December of 1997. Hence, stocks and bonds gained value over that same period, while gold declined during those years of 'turbulence'.

Following this inflation calculus, the low of $283 in 1997 dollars would translate to $375.00 (or thereabouts) today. So hypothetically, should gold drop from say, $1175 to that low, $375 in today's dollars, it would be a decline of "only" 69%.

A little Holiday 'food for thought'.

So here we are, November 2009, with the Ten Year Note yielding 3.21%, gold at $1175 and the S&P500 60% off its' lows around 1100. And the only thing not taking part in this rally is the U.S. dollar. If the dollar is at the root of this strange phenomenon, it's a pretty shaky root as the dollar seems to spike and markets decline at the slightest hint of crises.

Lastly, when looking back at that 1980 gold rush, one must recall that there were few other places, if any, to trade into from dollars. Europe was at the end of the cold war. Germany would be 'saddled' with economics of piecing together two vastly different nations. South America's nations were experiencing wild inflation and near revolution and war. Britain was trying to turn itself about under the Thatcher government, and France was pretty much still dependent on Agricultural commodities.

The Japanese Yen was a safe haven, as was the Swiss Franc still on a gold standard in the 1980s. And lastly, global international markets connected with near-speed-of-light technology still seemed more like science fiction than science fact.

Hence, it's plausible,... it's reasonable to assume that the $850 per ounce ($2223, inflation adjusted) occurred mainly because there was little other choice. Hence, it's plausible,.... it's reasonable to assume that reaching $2223 per ounce today, from 1175 per ounce might require a global disaster or a bubble of 'biblical' proportions.

Gold is the stuff that dreams are made of. It has an erratic price history. Gold has a strange mystique. It's almost useless as a metal. It's just as useless as an essential mineral. It isn't a good indicator as at extremes it could signify both extreme confidence or extreme fear. At best, a rapid and extreme change in the direction of the price of gold seems to be a leading indicator of changes in other markets, soon to follow.

It'll be interesting to see whether or not history repeats itself. As with any commodity, demand usually leads to over supply. When demand slacks off, prices fall. And that a commodity that is being accumulated by governments, but has no essential strategic value should be viewed as 'the handwriting on the wall'. This belief that Gold is an all powerful universal safe haven currency, has been the Waterloo of many a portfolio for centuries.

But who knows for sure. Maybe this time is different.

Your 'en croute' Fool,
FM

Notes :
A related link on Bloomberg about gold demand and supply.

Really good stuff:

"The Ascent of Money", Niall Ferguson; excellent!

Terrific metals data.

Inflation Calculator

fm