My Fear Index Is Back

October 22, 2007 – On September 18^th former Federal Reserve chairman Alan Greenspan appeared on the Jon Stewart Daily Show, where he made the following comment: “I was telling my colleagues the other day… I’d been dealing with these big mathematical models for forecasting the economy, and I’m looking at what’s going on the last few weeks and I say, “Y’know, if I could figure out a way to determine whether or not people are more fearful, or changing to euphoric… I don’t need any of this other stuff. I could forecast the economy better than any way I know. The trouble is, we can’t figure that out.” He’s wrong; we can figure it out with my Fear Index.

I invented the Fear Index over twenty years ago. But because M3, the total quantity of dollars in circulation is needed to calculate the Fear Index, I had to put the Fear Index in limbo back in 2006 when the Federal Reserve stopped reporting M3. Fortunately, as I noted in my article ‘M3 Resurrected’, published on September 3^rd, John Williams of www.shadowstats.com is again making M3 available. My Fear Index has therefore been resurrected.

Of all the indicators and models that I use, it is the one that I rely upon the most. It is by far my most trustworthy indicator, with a well established track record. Not only is it invaluable in determining gold’s relative value, it also holds the key that Alan Greenspan is looking for to understand the broad economy.

It all comes down to money, and in particular, the demand for two alternatives. When people are “euphoric”, to use Alan Greenspan’s term, they willingly hold dollars, but when they turn “fearful”, they instead opt for the safety and security of gold.

The Fear Index captures people’s changing preferences for money (i.e., gold) or the money-substitute we call ‘dollars’. Their changing preferences provide a good indication of what is happening to the overall economy – it tends to be good when people opt for dollars, and bad when they opt for gold.

The Monetary Balance Sheet of the US Dollar – another one of my creations – is useful to explaining the Fear Index. The following table presents the MBS for September 30, 2007.

The Fear Index measures how much gold is backing the US dollar. For every $100 in circulation as measured by M3, presently the value of $1.58 is based on the US gold reserve. The remaining $98.42 is based upon the value of the other assets in the Federal Reserve and the US banking system.

Therefore, the Fear Index measures what portion of the dollar derives its value from gold, and what portion is derived from paper. Because paper promises can be – and often are – broken, the quality of that paper at times becomes uncertain. Because balance sheets must always ‘balance’, the dollar value of gold rises to fill the ‘black hole’ created by the declining value of the debts backing the dollar.

I calculate the Fear Index at the end of each month. Here is the Fear Index formula and its input values as of September 30, 2007.

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

Here’s how I explained this chart in my article, ‘Farewell Faithful Friend – The End of the Fear Index’ back in March 27, 2006:

“These changes in demand for the relatively fixed amount of gold that exists in the world’s aboveground stock cause the Fear Index to rise or fall, as is clear from the above chart. This chart presents the Fear Index at each month-end since the creation of the Federal Reserve in 1913.

During the Great Depression the Fear Index reached 30%. In other words, for every $100 in M3, the value of $30 was derived from the gold in the US Gold Reserve. Since then the Fear Index has been in a protracted decline that was interrupted only by a huge rally in the 1970s.

Regardless whether you lived through the 1970s or just heard about it, you know that people back then increasingly demanded gold because their confidence in the dollar was badly shaken. The Fear Index rose as a consequence. It only resumed its long-term decline in 1980 after confidence in the dollar began slowly being restored by actions taken by Paul Volcker, the Fed chairman, that were aimed to save the dollar from collapse.

In fact, it is my expectation that within several years, the Fear Index will climb toward the peak reached during the Great Depression. It will do this as the problems with dollar fiat currency become more apparent, causing a flight from the dollar into the safety and security of gold. The flight out of the dollar is already underway. It’s only a matter of time before the rush for the exits turns into a torrent.”

As we can see from the page-1 chart, the Fear Index has been climbing for several years. There are a couple of noteworthy points to make as a result.

There are two solid red downtrend lines on the page-1 chart. Look at what happened after the first downtrend line was broken. The Fear Index soared. Now look at what is happening. The Fear Index is again soaring, and I expect it to continue climbing higher, repeating the experience of the 1970s. I’ve drawn two uptrend channels to show that I expect the Fear Index to climb within an uptrend channel just like it did through the 1970s.

The second point to which I want to draw your attention on the page-1 chart is the dotted, red downtrend line. I expect the Fear Index in time to reach and eventually break through that downtrend line. In other words, the Fear Index over the next several years is heading back to – and probably above – 10%. If I am right, the price of gold is destined to rise much higher.