Here’s Number 5

June 10, 2002 – The Fear Index has given a buy signal. It is only the fifth buy signal since the US government abandoned the Gold Standard in August 1971. This buy signal is bullish for gold.

The Fear Index is my own invention, and I find it to be a very useful tool. In absolute terms, it is a good measure of gold’s relative value. So when the Fear Index is low, gold should be bought/accumulated. Conversely, a high Fear Index may be a good signal to move out of gold.

Additionally, the Fear Index is also very useful as a trend indicator. Trends in the Fear Index are a good guide of trends in the price of gold itself. And it is the periodic changes in trend that I measure in order to determine whether or not a ‘buy signal’ is generated.

I calculate the Fear Index monthly, based on the latest available data at the end of the month. The calculation for May 2002 is as follows:

Given the above formula, one can see that the Fear Index measures the dollar’s reliance upon gold. We often forget that the dollar is a creation of accounting. In contrast to gold, the dollar is not a tangible asset. The dollar has value only because there is value in the assets on the balance sheet of the nation’s money issuing institutions. These are the Federal Reserve and this country’s commercial banks, which together are the only issuers of dollar currency.

Cash currency is issued by the Fed, and deposit currency is created by the banking system. Taken together, cash currency and deposit currency equal the total dollars in circulation, which is measured by M3.

Thus, we know from the Fear Index that for every one hundred dollars circulating as M3, there is $1.05 worth of gold held in the Federal Reserve. In effect, this gold gives to the dollar 1.05% of its value, with the other 98.95% arising from the other assets of the Fed and the nation’s banks.

There are two criteria to generate a buy signal. First, the Fear Index must move above its 21-month moving average, which is a condition that usually presages in any market a change in trend. Second, the 21-month moving average must be higher than the previous month. In other words, the moving average itself must be rising. This second condition is used as a filtering device in order to avoid whip-saws in which the Fear Index moves above and then back below its moving average.

Based on these two criteria, a buy signal was given at the end of May. And the significance of this buy signal can be seen from the accompanying chart, which illustrates the five buy signals that have been given by the Fear Index since 1971. Each of the first four buy signals initiated a prolonged rising trend in the Fear Index.

By staying above its 21-month average for an extended period of time, the Fear Index gives rise to distinct cycles marking these prolonged trends. The cycle begins when the Fear Index crosses above its 21-month moving average and triggers a buy cycle. The cycle then ends when the Fear Index crosses back below its 21-day moving average.

The first cycle began after President Nixon ended the dollar’s convertibility into gold, thereby defaulting on the US government’s promise to redeem thirty-five dollars for one ounce of gold. After that event, confidence in the monetary and banking system began to fall, and the Fear Index began rising.

Confidence continued to erode while fear grew during the Herstatt crisis and the failure of Franklin National Bank in 1974, up to that time, the largest banking collapse in the U.S. Soon thereafter the cycle peaked with President Nixon’s resignation, and a sell signal was generated in June 1975 when the gold price was $162.40. Confidence in the monetary and banking system was being restored, and people’s fear for the safety of their money began to recede. But not for long.

A second cycle began in 1977. Confidence in the monetary and banking system was again being shaken, but not because of banking crises and political turmoil. There was a new culprit causing this rise in fear, namely, the rapidly rising inflation unleashed by the Carter administration.

Confidence was not restored until the inauguration of President Reagan, and the cycle ended when the Fear Index crossed back below its 21-month moving average in January 1981. The gold price ended that month at $507

The Fear Index then began a protracted decline. It briefly crossed above its 21-month moving average in 1982 with the Penn Square Bank crisis and Mexican debt default in that year. But a buy signal was not generated because the second criterion was not met. The third cycle did not begin until 1986 when another banking crisis started brewing.

In March the previous year the Ohio and Maryland ‘banking holidays’ were an early warning sign that not all was well with the nation’s savings and loans (S&L’s). But the real damage began to appear in Texas and the Southwest as a collapsing oil price eventually knocked the props out from under countless banks and S&L’s riddled with imprudent loans. The Fear Index began to rise.

Then there was the swoon in the dollar’s exchange rate against the Deutschemark and other major currencies as well as the October 1987 stock market crash. By that time S&L’s nationwide were going belly-up at death rates not seen since the Great Depression. But when it became apparent that these events were not going to crash the banks and the monetary system, in time fear began to subside and confidence began to return.

The Fear Index crossed back below its 21-month moving average in February 1988. Gold stood at $425, and then both gold and the Fear Index began to decline.

That decline stopped toward the end of 1992. The European Exchange Rate Mechanism had just fallen apart after George Soros ‘broke’ the Bank of England. And central banks everywhere were reflating national currencies. The Federal Reserve was not an exception to these reflationary actions, and the fourth cycle began.

In contrast to the three previous cycles, this fourth cycle was mild and short-lived. The Fear Index crossed below its 21-month moving average with gold at $383 in November 1994, and it has been below its moving average ever since – until now. A new cycle has begun.

How long will this new cycle last? How high will the price of gold rise in this new cycle? Why is fear rising?

At the moment there are more questions than answers, and no doubt these answers will be revealed in time. But for now there is only one thing upon which to focus.

A buy signal in the Fear Index has been triggered, marking 91 months of decline in the Fear Index. And while past experience does not necessarily mean that history will repeat and that the gold price is guaranteed to soar, past experience is nonetheless a useful guide. And those who ignore this fifth buy signal in the Fear Index do so at their own peril.