Gold Crisis and Inflation Hedge Expected to Outperform Crude Oil

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:

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:

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:

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

Origin

October 8, 2008 | Filed Under Gold, Uranium, oil 

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