“All money is a matter of belief.”
– Adam Smith

Gold is taking a solid beating these days. It’s been slipping for a while, but when China revealed that it’s reserves were less than believed it really fell – quickly slipping below $1,100 per ounce when one mysterious trader dumped everything. It’s now more than a third off its 2010 peak and nearly everyone believes that it’s doomed to slip below $1,000 per ounce by the end of the year.

What happened? Isn’t gold the ultimate money in an unstable world? The short answer is no, and this has as much to do with the rise of the US Dollar as anything. But in the end gold is not as much a form of money as it is a barometer of fear – a commodity that appears to be in much shorter supply today than it was just a few years ago.

The value of gold as a store of value, one of the key characteristics of money, can be shown in this chart with the inflation adjusted value of one troy ounce over the last 100 years.

The price of a Troy Ounce of gold in constant 2009 dollars. From Kitco.

You can see quickly that there is a baseline price of about $350 in today’s money that gold hit as recently as 2000. It’s hardly a way to beat inflation over the long haul and shows an incredible amount of volatility. What is causing all of that? A few annotations to this chart showing key dates for the start of business cycles can explain nearly everything.

The price of a Troy Ounce of gold in constant 2009 dollars, with annotations for bear and bull markets.

During the Great Depression of 1929 gold soared, slowly retreating back after WWII. It then went on a long, slow slump until 1965 when it roared ahead again, reaching its greatest value against the US Dollar ever. The bull market of the 1980s saw another gradual slump, ending in 2000 as it started a long uphill jump that culminated in 2010.

This is a graph of fear, not value.

Gold. Lots of it.

Note that the inflection points don’t precisely line up. Gold hits a multiyear low before a bull market starts and comes off of its peak before a bear market ends. You can see clearly how the psychology that runs the stock market – and the whole economy – has to take shape before things really change.

It is also interesting to note that the Lehman Brothers crash and corresponding stock market bubble burst in 2008 does not register on this graph. Gold started rising in 2000 and didn’t stop until 2010, the year that everything bottomed out around the world. As an indicator of fear it shows that it was rising steadily, not coming to a head in any one event through the 2000s.

What should we make of today’s plunge? If you take gold as nothing more than a fear index, confidence is building for a new bull market in the next few years.

There are many reasons given as to why gold is down, of course. The Iran agreement is one, as is the latest agreement with Greece. But it really comes down to the fact that the US Dollar is very strong right now. All commodities are taking a terrible beating largely because they are all priced in US Dollars all around the world. Gold is simply leading the way because it has very little intrinsic value outside of its use in circuits and so on. Most of the market for gold is based on its value as a hedge against bad times.

What keeps the global economy keepin’ on.

International markets are telling us that the US economy is a better investment than gold right now. Can you hear the hoofbeats of a trampling herd behind that statement?

The only real net buyer of gold is Russia and that may be happening for internal (and corrupt) reasons given that they are mainly only buying their internal production. No other nations or banks are net buyers and none have been for a long time. There is no demand for gold as a reserve currency and the more paranoid “gold bugs” are not large enough in number to prop the stuff up. There is no real bottom to the market for gold at this time, although industrial uses may start consuming more as the price falls.

Where will it end? If the last bull market of the 1980s is any indicator we can see a price around $650 per ounce as a true “buy” signal for a new bull market and good economic times all around. That is unlikely to be reached before 2017 at this rate, but it could come that early. From that point, it’s likely to settle in to a slow steady decline.

An economy based on software is an economy with less need for capital and more need for brains.

No matter what, gold is a terrible investment right now. That means a net flow of money into more productive things which create jobs and generally get the economy going. This is a big step towards the Next Economy that is taking shape, one that is less focused on consumption and more geared towards “software” broadly defined – that is, intellectual property which boosts productivity and generally makes our lives more kewl.

Given this, commodity prices should continue to fall, inflation should remain tame, and outside of a small rise the Fed won’t have any reason to increase interest rates substantially. It’s part of a much longer term trend towards cheaper money and abundance.

The fall of gold is the first real sign that this world is taking shape and that investors are beginning to have faith in it. It will still take a few years for risk aversion to melt away and for good investments to become clear but the signs are all there.