Gold & Oil, hand-in-hand

October 6th, 2006

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We love to observe the market. One of the observations we made is that oil and gold seems to rise and fall together, with oil leading the way. What is the unsound thinking of the market that results in this kind of behaviour?

This is how the market thinks: inflation is good for gold price. Rising oil prices result in inflation. Therefore rising oil prices is good for gold price.

In the short term, this unsound thinking will be a self-fulfilling prophecy. But in the long run, it will be exposed as no more than a passing fade. Regretfully, we shouldn?t even call it ?thinking? in the first place- the market?s ?thinking? is often pseudo-thinking that frequently change drastically along with the tide of unreliable human emotions. Today, the market finds it fashionable to ?think? this way. Tomorrow, it will be fashionable to ?think? another way.

So, what is the real deal with gold anyway?

Now, let?s go to the fundamentals. For much of human history, gold was often used as a store of value. That is, gold was money. Initially, with the introduction of paper currency, gold was still used as a backing for paper currency. Therefore, a gold-backed currency instills as much confidence (in its use as a store of value) as gold itself.

In 1971, something happened that shook the foundations of the financial world. The relationship between the US dollar and gold was severed. That is, the US dollar was no longer a gold-backed currency. Since the US dollar is the world?s reserve currency, the money that most of us hold today is no longer backed by gold.

Therefore, fundamentally, the value of gold relative to a currency is an expression of confidence of that currency in its utility as a store of value. This fundamental reason is based on the assumption that gold is trusted as a store of value. Based on the fact that gold had always served this function for most of human history (except from 1971 to today), we doubt its use will significantly change for the rest of human history.

What will result in a loss of confidence of a currency that is not backed by gold? In truth, an un-backed currency is nothing more than a piece of paper (or in this age, digital information). Therefore, monetary inflation (printing of money) will result in a currency losing its value. The effect of monetary inflation will be general price inflation, which is the general trend towards higher prices across all goods and services.

As we said before (see The story of gold), gold was rising quietly (though not so quiet for the past 12 months) for the past several years. What does this tell us?

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