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Gold at $1,700 an ounce?

You'd better believe it!

(Published, April 2001; updated, April 2007)

By Dana Samuelson and Dr. Bill Musgrave

Gold is enjoying its most sustained and aggressive bull market in a generation. Economic cycles and market fundamentals indicate that gold has the potential to reach as high as $1,700 per ounce, double its record high of $850 in 1980, or even higher. In this special report we detail the compelling historical and economic factors that are driving gold to such amazing heights, and explain how you can preserve your wealth--and therefore your freedom--in an increasingly unstable world. We cover the following topics as they pertain to the gold market:

  • It's all about freedom -- James U. Blanchard III
  • Inflated money supply (M3)
  • U.S. family income, debt, and savings
  • The precarious dollar
  • Mega-cycles and the Dow-to-Gold Ratio (DJ/R)
  • Back to the 1970s

This report is admittedly long and detailed. But if you take the time to digest it, we think you'll agree that gold at $1,700 an ounce is looking more likely all the time!

It's all about freedom -- James U. Blanchard III

Before we get into the details of our research, we'd like to take a few moments to talk about our friend, mentor, and inspiration, one of the true giants of the gold industry, James U. Blanchard III. For those who don't know, Jim Blanchard was the man who almost single-handedly pioneered the re-legalization of private gold ownership in the United States back in 1974. During our long friendship and professional relationahsip, Jim taught us that gold is not simply the most trusted long-term preserve of wealth, but it's also the source and symbol of real financial freedom. Were he alive today, we know Jim would be absolutely ecstatic about the present prospects for gold.

Like his colleagues Ayn Rand, Milton Friedman, and Alan Greenspan, Jim Blanchard's driving philosophy was all about freedom. To Jim and his circle, gold represented true financial freedom because it is the world's oldest and most universally accepted form of money, beholden for its value to no government, no corporation, and no individual. As Jim liked to say, "gold is the only financial asset you can own that isn't simultaneously someone else's liability."

Perhaps Jim was so adamant in his support of gold-as-freedom because he truly knew what it meant to be shackled. When he was eighteen years old an automobile accident left him confined to a wheelchair for life. But to his undying credit, he turned this personal tragedy into the drive for public good. As a high school teacher in New Orleans in the early 1960s, Jim Blanchard thought it completely absurd that private gold ownership in America, the land of the free, was against the law. So in the late 1960s he flew to the Bahamas, bought a gold bar, and smuggled it back home. As an act of protest, he then appeared on local New Orleans television, waving his gold bar and daring the authorities to arrest him! In 1972, continuing his one-man campaign to re-legalize gold, he hired a bi-plane to buzz Richard Nixon's second inauguration toting a banner that read, "Legalize Gold!" Although fighter planes drove his daring protest from the scene, Jimmy ultimately won the war. In 1974, thanks to his relentless public and private lobbying, gold ownership by U.S. citizens became legal for the first time since 1933.

Once gold was re-legalized, many of Jim's friends and followers came to him with the natural question, "Now that we can own gold again, where can we buy it?" So quite by accident Jimmy found himself in the business of buying and selling gold. By the late 1970s, what began as a kitchen table business to help out friends grew into one of the largest precious metals and rare coin firms in the country. Jimmy and his wife Jackie went on to found the National Committee for Monetary Reform, a spearhead organization whose annual conferences in New Orleans attracted hundreds of internationally renowned speakers like Ayn Rand, Milton Friedman, and Margaret Thatcher, along with thousands of attendees. Following Jimmy's passionate belief in freedom, the purpose of these think-tank gatherings was to promote contrarian investment strategies and the ideals of personal liberty.

At the start of the 21st century, personal freedom remains a crucial issue. While the threat of totalitarian communism has been overcome, our individual liberty remains at risk nonetheless from the threats of terrorism, corporate hegemony, and governmental control. At the same time, gold has been largely overlooked as an investment, displaced by wild paper chases and stock market roulette. The breathtaking U.S. economic boom of the late 1990s, with its strong dollar, easy equity profits, and apparently low inflation, resulted in the lowest gold price in a generation. But millions of Americans are finding that, tied up in stocks and beholden to shrinking corporate profits, their personal wealth is rapidly evaporating. As goes our wealth, so goes our freedom.

And even worse, more Americans than ever before are finding themselves trapped by debt. If you examine the facts surrounding today's new economic reality, I think you'll see for yourself that, yes, the great stock market bubble gave us a wonderful ride, but its prosperity was something of an illusion, financed to a large degree with borrowed money and an extremely inflated money supply. Paper wealth fluctuates wildly. Gold, however, has no historic peer as a long-term store of value. The time for gold -- solid, trustworthy, and independent -- has come again!

Inflated money supply (M3)

At its simplest level, the dismal prospects for the dollar (and the shining prospects for gold) may be summed up by the phrase, too much of a good thing. There are simply too many dollars flooding the world. U.S. money supply (M3) has exploded after years of accommodative Fed policies, and the result has been astronomical household debt, a crashing housing market (which is only beginning to reveal its full impact), and burgeoning inflation that will be difficult to control regardless of Fed vigilance. All of these consequences spell bad news for the dollar and good news for gold.

But the problems of easy money don't end with the excessive supply of dollars. A rising sea of liquidity in most nations is inflating asset prices, encouraging risky investments, and creating scenarios like month's 'Shanghai Surprise,' in which a 9% drop in the Shanghai stock market triggered an asset sell-off around the world. In the past year, global central bankers have fostered money supply growth rates that are truly stunning. Brazil's M3 grew by 18.2% last year, India's by 19.5%, China's by 17.8%, England's by 14%, and the Eurozone's by 9.7% (source, to name a few of the most important. Most of the major industrialized nations have made cheap and plentiful money a fundamental aspect of their economic policy, mainly to support inexpensive exports, reduce trade deficits, build asset valuations, and stimulate consumer spending.

All of this excess cash has been slopping around world markets seeking after high returns and quick profits, much in hedge funds and other huge institutional investment vehicles. Valuations have been pumped to the bursting point by so much easy cash that virtually any perturbation (like a quarter-point increase in the cost of the yen) brings the whole system to its knees, as we saw last month in the Shanghai stock market and yen carry trade.

We've been saying for quite a while that the explosion of the U.S. money supply is reaching epidemic proportions that are likely to have a devastating long-term effect on the economy. According to many experts, the U.S. is already plagued by inflation far greater than the reported CPI and PPI numbers suggest, precisely because of the money supply. The inflation rate of the dollar as measured by M3 is actually about 10%, far higher than the CPI rate of 3.3% for 2006. Inflation, as we've said before, is simply a reduction in purchasing power, which is a reflection of the amount of money available to spend.

So despite all the noise about the Fed's vigilance against inflation, the government is sewing the seeds of huge inflation problems down the road by running the dollar printing presses overtime. As David Ricardo, one of the founding fathers of modern economic theory said in 1817, "experience shows that neither a state nor a bank ever had the unrestricted power of issuing paper money without abusing that power." Truer words were never spoken.

The unsettling prospects for inflation and M3 are underscored by Michael Hodges in his superb Grandfather Economic Report series, which we highly recommend to all of our readers.

As you can see in the chart above, the purchasing power of the dollar has eroded profoundly over the last 50 years, and in almost perfect symmetry with the unprecedented explosion of the U.S. money supply. Since 1950, according to the data analyzed by Hodges, the dollar has lost 88% of its purchasing power while the money supply has increased by 3,000%.

The issue is not money and credit in themselves, but money and credit that are created out of thin air. The accommodative policies of the Fed have combined with our fractional reserve banking to create an excessive money supply, with nothing to back it up but guarantees. Because of the inflation it encourages, both in prices and asset values, an excessive money supply sets in motion a speculative exchange of 'nothing for something,' which ultimately undermines the creation of real wealth.

The current subprime crisis is a perfect example of this 'nothing for something' conundrum. Rather than real wealth creation, these mortgages, and the easy money policies that make them possible, provide the illusion of wealth based upon the unrealistic promise of supercharged asset growth, itself fueled by yet more easy money and easier credit. But when this growth stalls out, as it has in the housing market, borrowers find themselves worse off than they began, unable meet their payments or keep their homes.

In general, financial markets are the first to benefit from an expanding money supply. As the prices of financial assets swell, in order to maintain growth momentum, the money supply must grow at a like or faster pace. If growth in money supply slows, so does the price growth of financial assets. A big slowdown, like we've seen in the housing and mortgage markets, can knock the props right out from under these 'false wealth' assets, which, in turn, could knock the props right out from under our economy.

U.S. family income, debt, and savings

While the illusion of wealth via cheap mortgages and easy credit has made many Americans feel more prosperous, the reality is that family incomes and savings have decreased substantially during the era of easy money. From 1999 to 2005, according to Hodges, the median family income in the U.S. declined by 6 percent. What's more (or less), household savings has dwindled into the negative while household debt as a measure of income is now at an all-time high!

This chart shows a 46-year trend of the U.S personal savings rate, or that part of disposable income that has been saved. Prior to 1970, the rate of personal savings was rising consistently, along with family incomes. As inflation-adjusted family incomes continued to stagnate, the saving ratio started falling rapidly, plummeting since 1992.

As of last summer, the U.S. savings rate dropped to negative 1.6 percent — an all-time record low, not only for the U.S. but for any leading global economic power in modern history, according to Morgan Stanley economist Steven Roach. Americans have not saved so little since the depression of the 1930s. Rather, we have been on a spending binge well beyond our growth of income, and it shows in soaring household debt ratios during the past two decades.

As savings have dwindled, debt has exploded, creating a double-whammy for U.S. households. The chart shows household debt increasing twice as fast as economic growth. The debt ratio started slowly and then exploded to today's historic record high debt ratios, which are currently 110% of national income, or $11.5 trillion in 2006, an increase of 11.7% over the prior year. Household debt ratios increased 90% faster than the growth of the economy since the late 1960s, when real median family incomes stopped rising. In other words, debt rather than savings has been the driving force of our so-called economic growth in recent years.

The precarious U.S. dollar

In defiance of almost every economic law, the U.S. dollar has remained relatively strong despite the astronomical U.S. money supply expansion, our huge trade deficit, growing inflation, and a slowing economy. Why? The only answer seems to be that the dollar is the only game in town, despite the increasingly poor odds it offers to foreign investors. For the time being, that is.

The U.S. dollar index chart above shows the big picture since 1983. Two major points must be emphasized. First, dollar is rapidly approaching its most critical and fundamental support level of just under 80 on the index chart. Since 1983, the dollar has fallen below this level just once, in 1993, when it briefly touched an all-time low of 78.3. Should the dollar break below this critical support level, it has the potential to go into a very step decline. This event would be extremely bullish for gold.

Second, as the call-out boxes show, when the U.S. has been fiscally irresponsible, the dollar has fallen in value against other currencies. Conversely, when the U.S. has been fiscally responsible, the dollar has risen in relative value. The bad news is, our government has seldom been more fiscally irresponsible than it's been since 2001, running up the largest budget and trade deficits the world has ever seen. This unfortunate reality is another reason why further declines for the dollar are likely, and why we remain so bullish on gold.

During the 1980s, the yen was the world’s currency of choice. During the late 1990s, the dollar took its place. Today, almost by default, the dollar remains the dominant currency, but for how much longer? Clearly, the world is beginning to lose its taste for dollars, and no other paper currency is well-positioned to take its place. So it's no surprise that gold is coming back into favor as the international currency of choice. Last year's major gold rally in all major foreign currencies confirmed the world's growing taste for gold as an insurance policy against governmental irresponsibility and the dollar's demotion. Indeed, against this fiscal backdrop, the current bull market for gold is far from over. In fact, it may just be getting started!

The dollar has recently begun its much-anticipated decline, falling to a 14-year low against the British pound, a 20-month low against the euro, and a 10-week low against the yen. With economic growth slowing considerably in the U.S and prices rising in eurozone nations, it seems likely that the Federal Reserve may lower interest rates earlier than expected, while the European Central Bank is likely to continue raising rates to curb inflation. The prospect of this interest rate differential is one reason traders and central bankers are increasingly bailing out of dollars.

The U.S. currency has lost about 12% against the euro in the past year and almost 50% over the past five years. Against the yen, the greenback has declined about 3% in the past year and 6% in the last five years. And the losses are likely to continue. Jim Swanson, chief investment strategist at MFS Investment Management, expects the dollar to drop 15% against the euro and 15% against the yen in the next 12 months.

A growing list of nations apparently agrees with this dim prognosis for the dollar. Zhou Xiaochuan, governor of the People's Bank of China, stated recently that China has very clear plans to diversify its reserves, which now stand at more than $1 trillion, away from dollars. Officials in Beijing have also repeatedly indicated that China might gradually reduce its purchases of dollar-denominated assets. China's reserves increased by a massive $850 billion in the past five years, and about 72% of China's reserve assets were denominated in U.S. dollars.

A number of other countries including Sweden, the United Arab Emirates, Qatar, and Russia also announced intentions this year to diversify their reserves away from dollars. Central banks worldwide have been diversifying their reserves since 2001. Since then, they have reduced their holdings of the U.S. dollar from 70% of reserve assets to 66% at the end of March 2006.

This accelerating shift in global asset allocation bodes extremely well for gold. Immediately following China's announcement the gold price reached a two-month high, and that's just the beginning. For months we’ve been anticipating a large downturn in the dollar and a concomitant upturn in the gold price, and now it's happening. Whether this is the start of the massive dollar plunge many experts have predicted, it's too early to tell; but based on the monstrous U.S. trade and budget deficits, and the darkening sentiments toward the dollar worldwide, we don't see how the currency can maintain its strength in coming years.

Mega-cycles and the Dow-to-Gold Ratio (D/GR)

Most analysts agree that valuations for U.S. stock markets have been over-inflated for several years. Even the recent corrections are just signs of things to come. When you consider the fundamentals we've been discussing -- the huge U.S. credit bubble, hyper-inflated money supply, and the precarious strength of the dollar, you'd have to be an ostrich to believe that the stock markets will do anything but further from here. As the chart below shows, thirteen times in the last 100 years the Dow dropped 30% or more from previous highs. Seven times in the last century it has plummeted more than 45%! Amazing and scary!

If past performance is any indication of future expectations, the Dow is on track to fall to 30% from its recent peak to around 8,800 or lower. Couldn't happen, you say? Given the outrageous heights to which the equities markets have been driven, this figure is actually conservative. Who would have thought the NASDAQ would have given up over half of its peak value so quickly after the tech bust?

By focusing on the larger cycles, one can clearly see that we are on the verge of a historic, once-in-a-generation economic turning point. Over a 100-year period, the Dow has consistently followed 18-year cycles of over-performance with similar periods of under-performance, relative to its long-term average. The latest bull market in equities, which began in 1982 and reached far higher than ever before, is now coming to a halt. After an extraordinary boom period in which both the Dow strongly out performed its long-term historical averages, we are now likely to be entering a period when equities markets will under-perform. That is, if history serves. It is during these downswings of stock market under-performance that other investment vehicles, like gold, have historically taken over and performed well above their long-term averages.

If the Dow were to follow tradition and correct Down 30% from its peak of 12,780, it would come to rest at about 8,800.

Now let's look at the Dow-to-Gold Ratio (D/GR), a crucial tool for tracking the gold price relative to the performance of the equities markets. The D/GR is the number of ounces of gold needed to equal the Dow Jones Industrial Average. Historically, whenever the Dow is extremely high, gold is extremely low, and the D/GR is high. But when the Dow "corrects" off these historic highs, gold would gain in value relative to the Dow, bringing the Dow-to-Gold Ratio (D/GR) back into line.

Here are some examples. Just before the great Crash of 1929, when the Dow had reached an unheard of peak of 381.17, the Dow-to-Gold Ratio was just over 18:1, also a record high. In other words, just before the Crash, slightly more than 18 ounces of gold were required to equal the Dow Jones Industrial Average. After the crash, when stocks fell by some 82.9%, the D/GR narrowed to just 2:1. Similarly, in 1966 the Dow reached another historical peak at 995.01; the Dow-to-Gold Ratio was over 28:1. Within eight years the Dow lost more than 36% to a bottom of 631. Gold, however, rose to from $35 an ounce to a little over $200 and the D/GR came back into line at 3:1. Even as stocks moved up, however, gold continued to surge dramatically due to rampant inflation, and by 1980 the D/GR had reached 1:1.

Now let's return to the present. With gold currently around $650 and the Dow around 12,400, the D/GR stands at around 19:1, higher than it was just before the Great Depression. Using conservative calculations, let's speculate that the Dow corrects down 30% from its recent all-time high, as it has done thirteen times in the past after a major peak. This downturn would place the Dow at around 8,800.

As you can clearly see from Dow-to-Gold Ratio chart above, the next bottom is projected to result in a D/GR of no more than 5:1. The Dow-to-Gold Ratio chart clearly indicates a projected bottom range to occur somewhere between 1:1 and 5:1, with 5:1 being the conservative estimate. With the Dow at 8,800, the conservative estimate would place the gold price at $1,760 per ounce. Obviously, past history is no guarantee of future performance, but the indications are dramatic.

In order to achieve the levels projected by the Dow-to-Gold Ratio, gold needs to reach a price level of six or seven times its recent bottom of $252. This kind of growth is not at all unreasonable, based on what this market has done in the past. The last major bull market in gold saw the price multiply by 24 times between the bottom in 1968 (at $35 an ounce, concurrent with a top in stocks) and the peak in 1980 (at $850 an ounce, almost concurrent with a bottom in stocks). Also keep in mind that the recent stock market up-cycle saw the Dow multiply in value by more than twelve times from its beginning in 1982, something that was hardly thought to be possible. When you examine the larger cycles of the Dow-to-Gold Ratio, a six- or seven-fold increase from gold's cyclical bottom of $252 is quite reasonable, especially in light of the present U.S. and world economic conditions.

Back to the 1970s

Today, gold is in a consolidation phase that looks strikingly similar to one it went through in 1975 and 1976, and which set the stage for its historic climb from $105 in 1976 to $850 in 1980.

From 1971 through 1973, gold gained by more than 100%, rising from around $40 to $105 an ounce. In 1974, it gathered even more momentum, climbing above $180 on the back of burgeoning inflation for a one-year gain of 80%. In other words, gold more than doubled in price between 1971 and 1973, and then nearly doubled again in 1974. In 1975 and 1976, things settled down. Gerald Ford took over the presidency with his famous WIN (Whip Inflation Now) buttons. Watergate and Vietnam had ground to their ugly finishes, and gold fell sharply on profit-taking before consolidating with most of its gains intact.

Under Jimmy Carter, inflation reasserted itself with a vengeance. Iran dethroned the Shah, seized our embassy in Tehran, and pulled the U.S. into a Middle East quagmire that weakened our reputation abroad and our economy at home. All the while, oil prices and interest rates escalated.

The gold market really caught fire in the 1970s for three main reasons. First, Richard Nixon took the nation off the gold standard, which allowed the government to print far more dollars than there were ounces of gold in the treasury and laid the groundwork for the horrible inflation that plagued the decade. Second, the Arab oil embargo created supply problems (remember those long lines at the gas pump?) that drove up prices around the world, and helped to plunge the U.S. into recession. And third, the combined effects of the Watergate scandal, the dismal end to the war in Viet Nam, and, especially, the Iranian hostage crisis, created a crisis of confidence in U.S. leadership that forced investors to look beyond the U.S. dollar and equities markets to financial safe-havens like gold.

So let's review: record oil prices, rising inflation, runaway money supply, Middle East quagmire, and crisis of confidence in U.S leadership. Do any of these conditions sound familiar today? We’ve all heard history tends to repeat itself. The last time all these factors were so forcefully present in the market, the gold price multiplied 20-fold, skyrocketing to its all-time high of $850. And, as you can see below, the gold chart that's been developing since 2002 is almost identical in shape to the one in the 1970s that led to record prices.

If our 1970s analogy holds, and we think it will, gold has a second, explosive rise in store for us. Based on the important factors such as a weakening dollar, enormous national debts and deficits, growing inflation, rising global conflict, and exploding international demand for commodities, we believe gold will climb above $850, above $1,000, and ultimately set a new high somewhere between $1,200 and $1,800 an ounce. Will it be a steady, measured climb to those prices? Not likely, in today's world of hedge funds, ETFs, and web-driven instant speculation. In the immortal words of Bette Davis in All About Eve, “fasten your seat belts, it’s going to be a bumpy ride!”

Again, it's all about freedom

As we enter into the next phase of our economic life, one that is not nearly so rosy as the past decade, it is important to keep our freedom in mind. With our wealth in paper, we're beholden to corporations and governments. But with our wealth in gold, we are beholden to know one. Remember, as goes our wealth, so goes our freedom.

Our old friend Jim Blanchard taught us that during times like these, fortunes are made or lost. Perhaps more important, he also taught us to have the courage of our convictions and not waver in the face of daunting odds. The economic problems we face today as a nation are among our most challenging ever and won’t be solved quickly. The U.S. has gone from being the largest creditor to the largest debtor nation. We consume more oil than any other country, and we are more dependent on imported oil today than we were in the 1970s. Inflation is on the rise and will get worse as the money supply expands further to pay our enormous debts. Our currency is in a major decline and the only reason it has not crashed further is there's no clear worldwide alternative--yet. Indeed, the dollar is fast becoming the old alpha male, barely leading the pack. Will the euro usurp its status as the world’s currency of choice, or will the yuan? Or will it be gold itself, as it was for so many centuries?

In any event, gold will benefit immensely from a global transition away from the dollar by becoming a repository for huge amounts of wealth as investors seek safe-haven alternatives. So once again, we urge you to take advantage of today's inexpensive gold market while you still can.

Gold at $1,700 an ounce? Perhaps it seems unlikely until you know the facts. The dangerous U.S debt trap, the bloated U.S. money supply, the precarious dollar, and the startling realities of the Dow-to-Gold Ratio: when you consider all these factors together, gold priced at $1,700 seems not only reasonable but even conservative. Truly, we ignore the lessons of the past only at the peril of our wealth and freedom. Please do not make this mistake. The time for gold has come again. You'd better believe it!

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