Rising Fear Will Cause Gold to Soar

June 1, 2008 – In the early 1980s I began researching and experimenting to find a reliable and trustworthy guide to evaluate the precious metals. I came up with a working model in mid-1980s, which I call the Fear Index. It does two things.

First, it clearly illustrates gold’s relative valuation in terms of a constantly inflating dollar. Second, it is a road map showing us the major trends in gold. Over the years the Fear Index has accomplished both of these feats remarkably well.

I calculate the Fear Index at each month end. Here is the calculation for the Fear Index as of May 2008.

The logic underlying the Fear Index is quite straightforward, and relies on simple accounting. Banks have assets, and they have liabilities. Their liabilities are the dollars that we use as currency, of which there are two types.

The Federal Reserve creates ‘cash currency’, the green paper notes we carry around in our pockets. The commercial banks create ‘deposit currency’, which are the dollars that we keep with them on deposit in our bank accounts and use as currency in checks, bank wires, plastic cards and other type of transfers. The total quantity of these dollars circulating as cash currency and deposit currency is M3.

Given that dollars are liabilities, it is obvious that the dollar only has value because the banking system has assets of value. It is these assets that ‘back’ – i.e., give value to – the dollar. If the assets in the banking system had no value, the dollar would have no value and therefore would not circulate as currency. But there is more to this basic observation about currency. The Fear Index is based upon the fundamentally different nature of the assets in the banking system.

Banks hold two types of assets – these are tangible and intangible assets. Their intangible assets are the loans and other interest bearing paper they hold. The only tangible asset of relevance and importance within the banking system is the US Gold Reserve.

After the creation of the Federal Reserve in 1913, the commercial banks no longer held any gold assets. All gold was over time consolidated into one hoard held by the Department of Treasury as the US Gold Reserve. However, the Federal Reserve has a claim to this gold, and the US Gold Reserve is therefore reported as an asset on the Federal Reserve’s balance sheet. The Fear Index is a measure of this gold relative to the total quantity of dollars. The Fear Index is the percentage of gold that therefore provides ‘backing’ to the dollar.

I put backing in semi-quotes to show that I am using that term loosely. Under the gold standard, the dollar could be converted into gold upon demand of the holder. That redeemability ended when the dollar became unconvertible, fiat currency in August 1971. But even though redeemability ended, gold’s role in the monetary system did not end because it is an asset on central bank balance sheets. To this day, the US Gold Reserve imparts value to the dollar, the precise amount of which is measured by the Fear Index.

The Fear Index was 1.70% at the end of May 2008. It means that for every $100 circulating as currency, the value of $1.70 was based on gold and the balance of $98.30 was derived from the intangible assets within the banking system. This ratio fluctuates as confidence in the banking system ebbs and flows.

When confidence is high, people demand relatively little gold, so the Fear Index falls. But when confidence in the banking system erodes as is presently the case, people’s preferences change. They demand more gold because of the security and safety bullion provides.

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 chart below. 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 Federal Reserve chairman Paul Volcker that were aimed to save the dollar from collapse.

As we can see from the following chart, the Fear Index has been climbing this decade. And it’s not to hard to understand why. Confidence in the dollar began falling after the stock market bubble popped in 2000. People increasingly began opting to hold gold in preference to dollars because they became fearful of fiat currency, and rightly so. Look how much purchasing power the dollar has lost this decade. For example, crude oil began the decade around $25.50 per barrel. Reliable estimates show that inflation is presently rising about 11% p.a. Rising fear about the dollar is reflected by a rising Fear Index.

Recently, the Fear Index has been rising for another reason, namely, the unfolding banking crisis caused by sub-prime paper and other imprudent assets acquired by over-leveraged banks. The Fear Index reached 1.94% at the end of February, which is the highest level since 1996. Clearly, fear is rising, which brings me back to the above chart. There are a couple of noteworthy points to make as a result.

There are two solid red downtrend lines on the above 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 (green lines) to show that I expect the Fear Index to climb within a channel just like it did through the 1970s.

The second point to which I want to draw your attention on this chart is the upper 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%. 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.

Interestingly, we can use the Fear Index to forecast the price of gold. All we need to do is to make some basic assumptions and to adjust the formula to calculate for the gold price.

Let’s assume the US Gold Reserve remains unchanged, that M3 grows at 8% per annum over the next three years to $17,254 billion, and the Fear Index reaches 10%. Using the above formula, the gold price must therefore equal $6,598 per ounce. It’s just simple mathematics, but using the formula in this way shows how powerful and useful the Fear Index really is.