Gold generates a lot of interest from the investment community lately – and with good reason. It is the world’s premier tangible asset and hard currency. It does not rust, corrode or oxidize. Its beauty is immutable, having been treasured by nearly every civilization on earth for the last 5,000 years. But there is one little known fact about investing in gold that must be understood in order to generate the best possible returns from this precious metal.
Gold is often seen as a hedge against inflation and the depreciation of fiat currencies. And while these things are absolutely true, they omit some important details. Specifically, gold does not tend to steadily appreciate, little by little over time. Instead, its price gains usually occur in a distinct, stairstep pattern.
The above chart shows the price of gold from 1900 through 2016 on a logarithmic scale. A logarithmic format has two advantages over a traditional price-axis chart. First, it allows the chart to clearly express very large changes in dollar value in a way that is easily comprehensible to the viewer. Second, it normalizes price changes, so that any given change in value – a doubling or halving, for instance – will always have the same scale at any point in the chart.
The value of using logarithmic scale becomes apparent when we examine the chart closely. It quickly becomes obvious just how closely the historical price of gold has followed the stairstep pattern during the 20th and early 21st centuries. The flat parts of the “stairs” in the accompanying chart are highlighted with red horizontal lines that depict the average gold price over that period. These flat areas are interspersed with step “risers”, which are the result of a sharply appreciating gold price, usually during a financial crisis.
From the late 19th century until 1933, the U.S. dollar was on a fixed gold standard. During this period, the dollar was officially defined as 0.0484 troy ounces (1.50 grams) of pure gold. This translated into a price of $20.67 per troy ounce of gold. This gold standard was rigorously maintained for many decades until the Great Depression forced a devaluation.
In 1933, President Franklin Delano Roosevelt officially devalued the dollar by 41%. Instead of each ounce of gold being exchangeable for $20.67, the government would now pay a full $35 for each troy ounce of the precious metal. This new, $35 an ounce standard underpinned the prosperity of the post World War II global economic system.
In 1971, after many years of mounting budgetary and inflationary pressure, President Richard Nixon allowed gold to float freely. This meant that the dollar was no longer exchangeable for gold at all. Gold, now officially untethered from the monetary system, immediately began to rise in dollar terms. This rapid appreciation persisted until 1980, when the gold bubble burst.
The yellow metal then spent the next 20 odd years experiencing a brutal bear market. Investing in gold during this phase of its cycle was a poor idea. But, in retrospect, this long period of persistently declining prices was really a two decade long price consolidation. By the early 2000s, gold rocketed skyward again.
The price of gold most recently peaked at more than $1800 an ounce in 2011. Since then, the price has gradually subsided to its current level of about $1,200 per troy ounce. We are once again in a trading range – the “flat” part of the stairs.
Why does this stairstep pattern exist in the gold price? The answer to that question in the first half of the 20th century is fairly easy. At that time, the dollar was defined as a certain weight of gold. As long as the U.S. Government was willing to exchange gold for dollars at a given weight, the price of gold was effectively fixed. This policy naturally resulted in long periods of stable gold prices.
But once a financial crisis of sufficient magnitude occurred, the government was forced to devalue. This created sudden spikes in the gold price that seemed to come out of nowhere. But the reality is that economic pressures had already been building for many years before the official devaluation happened.
Since the advent of the 1970s with its free-floating currency regimes, the stairstep price appreciation of gold has become more irregular, but is still there. I think that the stairstep pattern persists in the modern era because governments tend to use the gold price as an informal inflation barometer. If the price of gold rises out of its trading range, central banks will usually raise interest rates, thus suppressing the gold price.
But this is ultimately an unstable state of affairs. Even if the price of gold is contained, excessive debt and malinvestments still accumulate in the real economy. These eventually lead to financial crises that central banks address by lowering interest rates and printing money. This causes the price of gold to rise sharply and definitively break out of its trading range. These are the times you want to be investing in gold.
However, it is obvious that gold’s price movements are more nuanced than they were before its demonetization in 1971. Now gold tends to slightly overshoot in price at the end of its appreciation phase before settling back slightly. This happened most recently in 2011.
The “flat” portion of the gold price step has also transformed into a fairly broad trading range. This is where we are right now, with gold bouncing between about $1,000 and $1,400 per troy ounce. This consolidation will continue until the next financial crisis drives widespread, safe haven interest in investing in gold. The price will then spike violently upwards again, catching many investors off guard.
Gold is a great asset. But if you want to get the most out of investing in gold, it is imperative that you understand the stairstep pattern. Gold has been following this simple rule for the past century and now you can follow it too.
