The Big Picture & The Fear Index

August 1, 2005 – The Fear Index is my most important analytical tool for evaluating gold. It’s like a trusty compass that one might take on a hike. The Fear Index points the direction gold is taking, and therefore alerts us as to how we should be structuring our portfolios.

When the Fear Index is rising, we should be maximizing our gold holdings, and minimizing them when the Fear Index is falling. But the Fear Index does even more than provide direction. It also measures gold’s value.

Many analysts try to value gold by looking at annual supply and demand. This approach is seriously flawed because gold is not like other commodities.

The fundamental difference to other commodities is that gold is not consumed – it is accumulated. Therefore, gold’s annual supply is essentially irrelevant. Compared to the existing aboveground stock of gold, annual supply is too small to make a difference in determining gold’s price. As far as supply is concerned, it’s the aboveground stock of gold that is important.

Consequently, gold cannot be analyzed in the same way one would try to evaluate the price of soybeans, crude oil or any other commodity. These commodities all have a relatively small aboveground stock, so their price therefore depends almost entirely on how much is produced in any given year.

Supply, however, is only one-half of the equation. Demand must also be considered, and here again many analysts miss the important point. It is not only the demand for gold that rises or falls, but the demand for dollars also rises and falls. Economists assume that the demand for dollars is constant, but that is an error. Demand for any money fluctuates, and these fluctuations can be very volatile.

For example, during the peso crisis in Argentina a few years ago, the quantity of pesos in circulation declined by 30%. Normally, a decrease in the quantity of money like this would result in a massive deflation. However, while the supply of pesos was falling, counter intuitively prices in peso terms rose by 50%. Why did this happen?

Simple. The demand for pesos declined even more rapidly than the supply of pesos. As a consequence, the price of pesos fell, which in money terms means the purchasing power of the peso declined. Importantly, the Fear Index very effectively measures the demand for gold relative to the demand for the dollar.

When the Fear Index is rising, the demand for gold is rising faster than the demand for the dollar. The reason for this phenomenon is what gives the Fear Index its name.

People move into gold because they become fearful about the dollar. The demand for gold rises as people fear that the purchasing power of their dollars will be inflated away, their dollars will be lost in a bank collapse, government imposed capital controls will limit their ability to use their dollars, or they fear any one of a number of other monetary disorders that cause people to worry about the safety of their dollars.

As this fear grows, the demand for gold grows because gold is the only money that is not someone’s liability. In other words, with gold one does not have any counterparty risk. This attribute makes gold a very formibable competitor to the dollar and all other national currencies.

The formula for the Fear Index and its value as of July 31^st are as follows:

The Fear Index measures how much gold is backing the US dollar. For every $100 in circulation, presently the value of $1.15 is based on the US gold reserve. The remaining $98.85 is based upon the value of the other assets in the Federal Reserve and the US banking system.

This relationship is explained in my book, The Coming Collapse of the Dollar, so I won’t get into a more detailed explanation of the mechanics of the Fear Index here. I want to instead focus upon the important points being conveyed by the following chart.

This chart presents the month-end value of the Fear Index from 1913 to the present. We can see that the Fear Index fluctuates, and more to the point, it moves in discernable trends. Here are several key observations about the above chart:

Until the Great Depression, the Fear Index hovered around 8%, meaning that 8% of the value of the dollar was derived from the gold backing it.

With the growing concern in the Great Depression about the safety of one’s dollars, the Fear Index began climbing. At its height, nearly $40 of every $100 in circulation was backed by gold.

As confidence in the dollar was restored after the Great Depression and World War II, the Fear Index began a long decline. People were in effect happy to hold dollars (which back then were considered to be ‘as good as gold’), that is until the early 1970 s.

· The trend of the Fear Index rose in the 1970’s as people increasingly demanded gold. During the worst days of the Carter administration, the Fear Index reached nearly 10%.

· When President Reagan took office, the Fear Index began a protracted decline. However, that decline ended a few years ago, with the Fear Index making a rounded bottom.

· Recently, the Fear Index has broken its long-term downtrend line. The last time it broke a similar downtrend line was in the early 1970’s, after which the Fear Index soared, as can be seen on the above chart.

· My expectation is that the Fear Index will continue to climb from here. It is headed up to the long-term downtrend line going back to the 1930’s (the dotted line on the page-1 chart).

· Finally, I expect the Fear Index will in time break above this long-term downtrend line. When it does, monetary turmoil will prevail by then, which will usher in the inevitable collapse of the US dollar.

What will be the price of gold when the Fear Index reaches 5%, 10% or even higher levels? We can calculate the price of gold by using the Fear Index, as follows:

Let’s assume that the US Gold Reserve remains unchanged at 261.5 million ounces, and further, that M3 climbs 20% from today’s $9,740 billion to $11,688 billion. Solving for the gold price, under these assumptions with the Fear Index at 5%, we get $2,235 per ounce ($71.86/gg). At a 12% Fear Index, gold would be $5,364 ($172.46/gg).

Let’s assume, however, you are a dollar-deflationist, and therefore, instead of M3 growing by 20%, you expect it to decline by 20% to $7,792 billion. Using the above formula to solve for the gold price, and again assuming a 5% Fear Index and the gold reserve remains the same, we get $1,490 per ounce ($47.90/gg).

So regardless whether there is inflation or deflation in our future, the point is that gold wins. It always wins when the Fear Index is climbing – which is what it has been doing relentlessly for nearly four years now. When the Fear Index is climbing, gold wins because its purchasing power is increasing compared to the dollar, regardless whether there is dollar inflation or deflation