Relationship Between Gold, Inflation, and Equities II

 

Introduction:

In part-1 of this study, we considered the question of whether monthly returns of gold were correlated with those of inflation or equities in the United States of America. We analyzed three decades of monthly returns using two statistical techniques, correlation and regression analysis. Were you surprised by the results?

Here in part-2 we will investigate whether there has been a relationship between the long term price trends of gold, inflation, and equities. But before we do, let us first clearly distinguish between “correlation of returns” and “price trends“.

 

Definition of Terms:

Sometimes, the words correlation and trend are loosely defined or used interchangeably. But each has a distinct meaning. Two assets may have a strong relationship between their long term price trends, while at the same time having little correlation between their monthly or weekly price returns.

As we discussed in detail in part-1, the statistical definition of the word correlation describes the degree to which the average variation of returns (deviation from the sample average return) between two assets are related. The mathematical formula once again is:

Trend analysis on the other hand examines the movement of an asset’s price, not returns, over a period time, typically months or years. This trend is often obvious by visible inspection on a chart whose x-axis represents time, and y-axis represents price.

Trend analysis seeks to uncover the historical direction and degree (slope) of price movement, and to detect if and when changes occur. Trend is related to the discount rate applied to an asset by market participants in the aggregate. For this reason, the vertical scale must be exponential and not linear so that rates of change become evident.

Prices seldom move in a straight line, preferring instead to ungulate in waves. An uptrend is defined by a series of waves having of higher highs and higher lows, while lower highs and lower lows define a downtrend. Trends can also exhibit serial correlation.

As explained in part-1, the S&P 500 index (SPX) monthly closing prices will act as the proxy for the equity market price. 1 And gold prices will be represented by the monthly closing US dollar price of one troy ounce. 2 Inflation will be defined as a general rise the price level of goods and services due to monetary causes, and will be represented by the U.S. Bureau of Labor Statistics’ Consumer Price Index for All Urban Consumers: All Items (CPI-U). 3

 

Comparing the Long Term Trend of Gold Prices and Inflation:

The following historical price chart will help determine whether the long term trends of gold, inflation and equity prices are related. The red line represents the inflation index, the green line represents gold prices, and the blue line represents equities, all end-of-month values from January 1979 to June 2011. Note that the vertical axis is plotted logarithmically, representing a proportional (percentage) rate of change in monthly values.

 

Note: horizontal axis markings represent the end and not the beginning of a year.

 

During the three decades after the U.S. became the last nation to abandon the gold standard, gold prices rose sharply at first and volatility was high. But by late 1999, gold had declined to a low of $254.80 as the wild price volatility also subsided.

Meanwhile, inflation rose sharply in the 1970’s before setting a slower pace in 1982, and slower still in 1990. The average annual rate of inflation from 1974 through 1979 was approximately 8.8% per year. From 1981 through 1989, the average annual rate dropped to 4.3%. And from 1991 through 1999, the average annual rate dropped to 2.6%.

Since the general price level rose in US dollar terms albeit at a declining rate, gold priced in dollars should have risen also. Therefore this chart does not indicate that the long term trend of gold since 1979 has been related to that of inflation in the United States as represented by the CPI-U.

Consider what happened next. Gold rose steadily at an average annual rate in excess of 16% per year from 2001 through 2009 while the rate of inflation declined to less than 2.5% per year during the same period.

If the uptrend in gold prices since 2001 has been indicative of monetary inflation, and the value of gold is assumed to be constant, then that which cost one dollar in 2000 should cost $5.22 today. This level of inflation should therefore be evidenced in the general price level of goods and services. Though some commodities like oil or cigarettes have risen sharply, the general price level of goods and services as defined by the CPI-U has risen at a much lower rate in U.S. dollars compared with gold.

 

Comparing the Long Term Trend of Gold and Equity Prices:

Let’s look at the first half of the price chart once again. While gold prices gold were declining to the low of $254.80 1999, equity prices as represented by the S&P 500 index were in a major secular bull market. From 1980 through 1999, the S&P 500 index rose at an average annual rate of 14%. In fact it is clearly evident that gold’s rate of decline steepened within a year after the S&P 500′s climb accelerated in 1995.

The new millennium ushered in a change in the secular trends 4 of both gold and equities. When gold began its clearly defined upward trend in 2001, the nearly two decade bull market in equities had already come to an end a year earlier, and a new secular bear market in equities had begun. While equities gyrated through several cyclical bear and bull markets, gold was climbing at an average rate of approximately 16% per year!

 

Conclusions:

The evidence in the U.S. for the past three decades indicates that the long term trend in gold prices has not been significantly related to inflation, but rather to the long term trend in equities. Gold prices may be affected at least to some degree by the same domestic and international factors which manifest themselves in equity prices, factors which are largely secular in nature.

Factors which encourage investor confidence in paper assets perhaps also make them indifferent to gold. Conversely, in times when acute levels of uncertainty and bear market volatility challenge investors’ confidence, they sell equities and seek to replace their fiat currencies for hard assets, such as gold.

 

Thank you for reading this article. Your comments are welcomed!

Read part-1 of this study

Related articles suggested for your reading:

A Technical Analysis of Gold’s Secular Uptrend

Adding Gold To An Equity Portfolio

Relationship Between Gold, Inflation, and Equities

Merging Fundamental and Technical Analysis


Footnotes:

  1. (Sep. 2011). In Yahoo! Finance. Retrieved from http://finance.yahoo.com/
  2. (Sep. 2011). In World Gold Council. Retrieved from http://www.gold.org/
  3. (Sep. 2011). In Federal Reserve Bank of St. Louis. Retrieved from http://stlouisfed.org/
  4. Secular trends last approximately 9-25 years. Several cyclical trends each approximately 1-3 years in duration can exist within one secular bull or bear trend. The cyclical bear from 2000 until early 2003, followed by the cyclical bull ending late 2007, and the second cyclical bear ending in early 2009 all comprise the same secular bear market which began in 2000 as measured by the S&P 500 index.

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  1. Relationship Between Gold, Inflation, and Equities | Sargon Y. Zia, merging fundamental analysis with technical analysis — October 16, 2011 @ 3:14 pm

  2. Adding Gold To An Equity Portfolio | Sargon Y. Zia, merging fundamental analysis with technical analysis — October 23, 2011 @ 11:28 pm

  3. A Technical Analysis of Gold’s Secular Uptrend | Sargon Y. Zia, merging fundamental analysis with technical analysis — November 2, 2011 @ 11:03 am

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