November 30, 2012

Gold – What to Expect During Cycles of Inflation or Deflation – Forecast 2013

Gold – What to Expect During Cycles of Inflation or Deflation – Forecast 2013

Discussions on gold usually center on its “bubble status.”  Is it in a bubble?  Has the bubble burst?  Is it reacting to inflationary pressures?  Deflationary pressures?  Is it really a trusted storehouse of value?  What do I get from owning gold?

Bitten by the gold bug back in 1979, I observed as a trader the rise to $850 in 1980 and have researched as an analyst, years of charted gold prices.  In 1990 the Central Banks of England, Germany, France, Ireland and several other countries sold their gold reserves at the lows ($253).   In preparation for and acceptance of, the European Rate Mechanism (ERM), a fiat currency based system, which was put into place to establish monetary equality amongst EU member states.  All in preparation for the arrival of the Euro as a unified currency.   The European Central Bank along with the central banks of each of the member states put in motion it’s own demise.  Following in the footsteps of the U.S. Federal Reserve Bank, the ECB continues to monetize its way to a protracted and eventual period of high inflation as the debt and currency bubbles burst on a global scale.

The Who, What, Where and When of Inflation and Deflation

A major sea change has been underway since the late twentieth century.  I am not attempting to stir the hornets’ nest or play devil’s advocate, but it is a plain and simple fact.

The deadly combination of financial bubbles that began in Thailand in 1997 and more recently in Iceland, Greece (on-going), Ireland, Spain (on-going), Portugal, and Italy (on-going), have punched holes into the economies of the countries involved.  Debt defaults, banking problems, a period of deflation (yes, really), and soon an extended period of high inflation have and will continue to scar and change the global economies.  It has been a major contributing factor to the rise in gold and I believe it will continue to support gold’s upward momentum.

What is true inflation or true deflation?  A friend and valued colleague, Dan Ascani, has written extensively on this subject.  To begin to understand these terms, acceptance that both are monetary phenomena is important and should be viewed within the context of a fiat currency system.

Dan explains:

Inflation is a monetary phenomenon and occurs….when too much money is created and prices rise.  Money can be created not only by an expansion of the monetary base by a central bank through its open market operations, but through an increase in bank lending.  In other words, every time a bank lends money, the total money in circulation in that country increases since, in the U.S., for example, Federal Reserve-dictated bank reserve requirements typically require a bank to have on deposit in its vaults only 10 to 15% of the amount of a loan that is created.  When long-term prosperity has been experienced, overly optimistic banks tend to lend too much money to customers.  Thus, inflation is not just a situation in which commodity prices rise, but a situation that occurs within the monetary base of a country. 

On the other hand, deflation occurs after too much money has been created by excess lending and borrowers cannot pay back their loans.  The resulting defaults are, therefore, deflationary because the money that the bank created through its loans was not paid back, and money circulating in the monetary base is destroyed.  Thus, bank loans and inflation create money, and debt defaults and deflation destroy money.  When money is destroyed, it is literally taken out of circulation – the opposite result from that of loan creation. 

Whatever the case, the definition, or the esoteric monetary conditions, one thing is true throughout the over four centuries of wholesale price and gold data:  gold is absolutely a long-term store of value that survives periods of inflation and deflation alike…the only item that has survived all of time, all governments, all types of economies, all economic conditions, all panics, collapses, and crashes, and all wars, while still maintaining its long-term purchasing power.” – Source: Gold In A Deflationary Economy, © 1999 by Dan Ascan

This is not to say that there haven’t been periods where gold has lost value, on the contrary history reveals long periods of sinking gold prices, but through each of them gold always returns to its relative value as expressed in terms of a basket of commodities.

Roy Jastram’s 1977 book ‘The Golden Constant ‘ has become the authoritative research book on gold. Spanning 438 years of economic up and down cycles this classic is now available in PDF format after being out of print for many years. Jastram’s influence in transforming many from speculative thought to factual information is undeniable and his work(s) are quoted and used to support various theses worldwide.

Jastram’s study is a masterwork demonstrating with clarity the behavior of the purchasing power of gold in periods of inflation and deflation and in a historical context judging as to what extent gold served as an inflation hedge or as a means to conserve wealth in periods of deflation. It covers the English experience from 1560 (the year of the Great Re-coinage in England) and the American experience from 1800 (the beginning of consistent data in America).

The entire 438-year study can be categorized into periods of inflation and deflation. Although Jastram’s study takes us through 1976 several respected analysts have updated Jastram’s work through current times.

Period 1: Deflation of 1814 – 1830

  • Lasting 16 years the purchasing power of gold increased 100% while commodity prices declined 50%. Imports flooded the domestic markets creating widespread unemployment. By 1818 credit had contracted to extreme levels forcing landowners to sell their properties. The gold standard was the monetary system in use.

Period 2: Deflation of 1864 -1897

  • Lasting 33 years the purchasing power of gold increased by 40% as commodity prices declined 65%. The U.S. Civil War not only divided the country but also sent prices sharply higher as severe inflation gripped both the north and south. The south saw a complete collapse of its currency and government financial system which brought the entire country into depression until 1879 when the Gold Standard was re-established after being abolished at the start of the war in favor of a fiat system.

Period 3: Inflation of 1897 – 1920

  • Lasting 23 years saw commodity prices increase by a staggering 232% while the purchasing power of gold dropped 70%. Within this period, from 1897 -1914, was a smaller period that many economists called “the classic gold standard.” During this time, institutions that issued money were required to hold sufficient gold reserves to meet any and all redemption demands. As with the Civil War, the beginning of World War I and increasing inflation proved that gold is not always the best inflation hedge.

Period 4: Deflation of 1920 – 1933

  • Lasting 14 years the purchasing power of gold increased 251% and commodity prices fell 69%. Global stock market crashed beginning with Europe in 1920. Although it took an additional 9 years to finally hit the United States, the devastating deflationary aftermath threw the world into the Great Depression. A careful study of this period reveals that while gold shares began to appreciate in 1930 it wasn’t until 1933 that gold and silver began their respective advances. The monetary system in place was the Gold Exchange Standard.

Period 5: Inflation of 1933 – 2007 (1976 – 2007 updated by Dan Ascani)

  • Lasting 75 years this period includes some unprecedented times for commodity prices as well as gold and silver prices. Overall commodity prices increased by 1456% and the purchasing power of gold increased by 147%. The monetary system in place was the Gold Exchange System until 1971 when the Bretton Woods Act ushered in government managed fiat currencies. Post Bretton Woods both inflation and gold moved substantially higher. Many feel that this period remains unresolved and its resolution depends on the depth and severity of the deflation to inflation cycle currently in force since 2009.  As the “bubbles” burst the pressure on global central banks to continue to inflate the remaining bubbles via non-stop monetary expansion will persist at least through 2015 as of this writing.  Are there “Black Swan” type situations brewing?  Yes, a resounding yes. On multiple levels yes. 

Period 6: Deflation to Inflation 2009 – ??

  • The chart below dates back to 1861 just prior to the start of the deflationary Period 2 and shows in graph form the purchasing power of gold during Periods 2 – 5. Interesting to note, when adjusted for inflation the current bull market (and record highs basis the U.S. dollar) has yet to exceed the highs seen in 1980 when the unadjusted high was $850.


If you were thinking it was safe to get back in the water – think again! It only gets more confusing from here as we move from bubble to bubble – from inflation to deflation and back to inflation again.

In 2008, the middle class was vilified and penalized for attempting to gentrify broken down inner city neighborhoods devastated by years of neglect. Many unsuspecting people paid inflated prices (real estate bubble) and then watched as the value of their homes went in reverse as the subprime debacle sent real estate prices into a downward spiral.

Foreclosures skyrocketed and corporate greed moved to unprecedented levels as C-level egos justified accepting and paying out multi-million dollar contracts as tens of thousands of lower level employees were laid off and the government (local, state, and federal) turned a blind eye and sank deeper into a dark cesspool of empty promises and corruption.

The global economic problems so long ignored and swept under the rug have come home to roost. I don’t believe there are any quick painless solutions. It took decades to arrive at this point – solving the problems and implementing solutions should not be expected to miraculously turn everything around in a year or two.  It will take many years.

The simple fact remains:  The Status Quo is changing.   Recognizing and preparing for the coming period of inflation should be a priority.   Being prepared removes fear from the equation. Making solid and fact based investment decisions has become paramount in creating and protecting wealth. The bottom line here: It’s YOUR money!  Who do you think is going to care more about it?

The Long to Near Term Picture for Gold

Long Term: (basis the Weekly March 2013 Gold Futures)

Off of the August 2011 high at 1926.80 gold continues to trace out what is best interpreted as a triangle pattern.  The chart below updated with the preferred Elliott Wave count shows gold prices having completed 4 out of 5 segments and the fifth now in its finishing stages.  The initial Fibonacci support zone begins at the 1635 area (=/- 10 points).

The momentum oscillators (stochastic and RSI) support the finishing decline underway with both turning lower from neutral readings.

Currently the most likely time frame to complete the triangle is lining up towards late December 2012 to January 2013.  Expectations would be for a strong thrust higher to announce the next rally phase is underway.  Longer term upside targets continue to a move above $2000/oz.  A high probability of this it occurring within 2013 also remains in place.


Near Term (basis GLD daily chart)

Off of the October 2012 high at 174.07, GLD is tracing out the last segment of the larger triangle pattern.  Wave E is two thirds complete with the last down leg in progress off of the mid November high at 170.01.

Initial calculations suggest a support zone between 158 and 154 being the likely area to complete the triangle pattern and set the stage for a kick off rally (thrust higher) to begin the next advance.

The momentum oscillators while pointing lower (stochastic) and more sideways (RSI) have not indicated a more severe slide lower is in the making.