Thursday, October 22, 2009

The Relationship Between Gold and Interest Rates

Former economics professor John Doody argues that $1,000 is the new floor for gold based on a simple historical relationship between gold and interest rates. As interest rates remain low and inflation rises, this information can help you profit from gold. See the explanation in the following post from Daily Wealth.

Using basic economic principles (the gold to interest rate ratio), a former economics professor explains why gold is not a safe investment but rather the only safe investment.

"$1,000 an ounce is thought by some to be gold's ceiling..." John Doody wrote last week to his subscribers. "We see it as now the FLOOR."

When John Doody talks about gold, I listen...

This year, his Top Ten List of gold stocks is up over 100%. John says his Top Ten list has averaged a 30% annual return since the start of his newsletter, Gold Stock Analyst. John has been writing Gold Stock Analyst for about 15 years.

One thing I like about this former economics professor is that it's all about the numbers to him... It's not about conspiracy theories like it is with so many gold bugs. For example, John will actually tell you when gold stocks are overpriced according to his model – imagine that with dyed-in-the-wool gold bugs!

So why does John think gold will keep going up now, when many others say it's bumping up against its ceiling? I asked John that yesterday...

It's simple, he said, if you just compare the price of gold to interest rates.

In short, when interest rates are high, then gold (which pays no interest) falls. And when interest rates are low (like they are now), gold rises. To keep it apples to apples over time, John subtracts inflation from interest rates.

In the 1980s and 1990s, you earned high rates of interest on your cash. So gold was flat for those two decades. Plain as day.

But for much of this decade and the decade of the 1970s, you typically earned NEGATIVE interest on your cash (after you subtracted inflation). So gold has soared.

John sees those negative real interest rates continuing. So gold will keep rising. Simple as that.

For the specifics, currently, the consensus inflation rate forecast for the first half of 2010 is around 2%. But banks basically pay you no interest. So you have a choice: Own gold, which pays no interest. Or hold cash, which pays you NEGATIVE interest, when you take inflation into account.

Yesterday, John explained that since the Federal Reserve will likely keep interest rates very low for a very long period of time, gold can keep going higher.

I asked John if gold had become too popular these days. He said absolutely not...

"Look, hedge funds are just starting to get into gold. Retail investors haven't bought. CNBC calls gold a bad inflation hedge. Central banks haven't bought. If gold was popular, I'd have a hundred thousand subscribers, not a couple thousand. We've got a long way to go. $1,000 isn't the ceiling... it's the new floor."

John ran the numbers, and in a sneak preview of his upcoming issue, he proves how the price of gold has "beaten" inflation fivefold since it first started freely trading 40 years ago.

"CNBC says that gold has only gone from a peak of $850 in 1980 to $1,050 today – for a $200 gain," he said. "So CNBC's conclusion is that gold is not a good inflation hedge... That's just plain wrong, but the people believe it."

To be brutally honest, if you plan to be a serious investor in gold stocks – and you're willing to do your homework – you're foolish if you don't read John's newsletter. John updates his unique valuation numbers every month for the 75 precious metals companies he follows. Plus, he writes up a detailed analysis about once a quarter on each company.

It is the best starting point in the business. It's the first place I go to find out how much gold each company has in the ground and what its cash flows are.

If you agree with John – that $1,000 gold is the new floor, not the ceiling – chances are, you're buying gold stocks. And if you're buying gold stocks in size, you ought to do it with John's help.

This post has been republished from Daily Wealth.

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