Excerpted from the October 1999 issue of Hussman Econometrics
All rights reserved and actively enforced.

One of the notable market events in recent weeks has been the surge in gold prices above $320 an ounce. The advance came after 16 central banks announced that they would be trimming their gold sales, which had been weighing on the gold market for months. The question now is whether this bounce was a one-time pop, or whether it is the start of a sustained uptrend.

As you know, our approach focuses on the marriage of two factors: valuation, and trend strength. The key issue is always how those are defined in practical terms. Do we have a bull market in gold? We can't completely rule it out, but the highest probability is that gold will continue strongly higher only after a significant stock market decline and indications of economic weakness emerge. Here's why.

The price of an ounce of gold in U.S. dollars is measured as $/ounce of gold. In foreign countries, the price of an ounce of gold is measured as FC/ounce of gold (where FC denotes "foreign currency"). The exchange rate between the U.S. and foreign countries can be written as $/FC. That's the price (in dollars) for 1 unit of foreign currency. Now, since gold is easily transportable, it obeys the "law of one price". That is, the price in dollars is the same as the price in foreign currency, after currency translation:

$/ounce of gold = $/FC x FC/ounce of gold.

Stare at that equation for a minute. Any time you see the price of gold rise, one of two things must be true. Either the foreign price of gold (FC/ounce of gold) has increased, or the value of the dollar must have declined (i.e. foreign currencies have become more expensive, and $/FC has increased).

As a result, huge and sustained moves in the price of gold require either 1) worldwide inflation, or 2) a plunging U.S. dollar. Unquestionably, rising inflation - particularly worldwide inflation, is a plus for gold prices, but the real action comes when inflation rates are rising worldwide and the dollar is under pressure.

Hands down, the main factor that moves the dollar is not the action of inflation itself, but the action of long-term real interest rates (long term interest rates minus long term inflation expectations, which can be very roughly proxied by the current inflation rate, since inflation is "serially correlated"). When long-term real interest rates are trending down (relative to long-term real interest rates in other countries), the dollar typically declines. When long-term real interest rates are trending up, the dollar typically rallies.

The reason is simple. There are two objectives to holding a dollar: one is to buy goods and services, and the other is to earn interest. Higher interest rates are good for the value of the dollar, since they make holding dollars more profitable. But higher inflation is bad for the value of the dollar, since it deteriorates the purchasing power in terms of real goods and services. The bottom line: the dollar does best when interest rates are rising, or when inflation is declining, or preferably both. That's another way of saying that the dollar does best when real interest rates are on the rise. The longer the term over which these trends are expected to persist, the stronger the action of the dollar. The dollar does worst when real interest rates are trending lower.

So if we're looking for a rally in gold, we're really looking for 1) World inflation, particularly in the U.S., and 2) falling long term Treasury bond yields. This combination is most frequently seen early in a recession. Remember, unless demand is actually falling, slower economic growth is correlated with faster inflation. That means that inflation is generally rising at the time the economy enters a recession. At the same time, it turns out that long term interest rates stagnate or fall as the economy enters a recession. The net result is that as the economy softens, long-term real interest rates tend to decline, and the value of the dollar typically plunges. That's the time you want to own gold.

That's the trend part. Now the valuation part. Gold stocks tend to be more volatile than the bullion. One simple measure of valuation is the ratio of gold prices divided by the Philadelphia Gold and Silver Index (the XAU). If you think of gold prices as influencing the earnings of these companies, the Gold/XAU ratio is a very crude "earnings yield". In practice, we use more sophisticated measures, but for expositional purposes, the Gold/XAU ratio is sufficient. The higher the ratio of Gold/XAU, the more attractive the gold stocks are relative to the metal itself.

Let's get some numbers. Over the past 25 years, gold stock prices have gone nowhere overall, rising at less than 1% annually. From an efficient markets standpoint, this actually makes sense. Since gold typically does well in recessions, when other stocks are doing badly, it turns out that gold stocks have what's called a "negative beta". Over the long term, finance theory says that such stocks should theoretically earn less than the risk-free interest rate, and sell at above-average price/earnings multiples because they provide "insurance benefits" for a portfolio. And in the long-term data, this theory turns out to be true.

If you want to define a useful "trend" in gold stocks, you just don't get much useful information by looking at gold stock prices themselves. Since 1975, when the XAU has been above its level of 6 months earlier, it has continued to advance at an annual rate of 0.65%. When the XAU has been below its level of 6 months earlier, it has advanced at an annual rate of 0.73%. That's as close as you can get to an indicator being perfectly uninformative.

Gold bullion prices have somewhat better information. When the price of gold is higher than 6 months earlier, the XAU has followed by advancing at a 6.87% annual rate, on average. When the price of gold is lower than 6 months earlier, the XAU has declined at a -4.31% annual rate. While that seems like a big performance difference, it is statistically insignificant because gold stock prices are wildly volatile. These average performances are just overwhelmed by that volatility to be of any practical use.

Ditto for inflation trends. When the rate of inflation has been higher than 6 months earlier, the XAU has advanced at an 8.18% annualized rate, compared to a -5.02% annualized loss when the rate of inflation has been lower than 6 months earlier. As a "tendency" this information is useful, but as a guide to investing, the volatility still overwhelms this predictable component of price movements.

The trend of long term interest rates is actually more important than the trend of inflation. When the 30 year Treasury yield has been below its level of 6 months earlier, the XAU has advanced at an annualized rate of 19.17%, compared to an annualized loss of -17.51% when Treasury yields have been rising. Since economic weakness tends to produce falling real interest rates, we also get a strong difference in performance based on whether the economy is expanding or contracting. When the NAPM Purchasing Managers Index has been below 50, indicating a contracting economy, the XAU has surged at an annualized rate of 23.48%, compared to an annualized loss of -9.66% when the PMI has been above 50. On the valuation front, when the ratio of gold prices ($/ounce) to the XAU has been above 4.0, the XAU has advanced at an average annualized rate of 24.82%, compared to a -13.34% annualized loss when the Gold/XAU ratio has been below 4.0. That means that you generally want to buy gold stocks when they are lagging the price of the metal. And given the fact that trends in the XAU itself are uninformative about future returns, it also means that you are better off buying gold stocks on dips than to buy upside "breakouts".

Not surprisingly, the combination of all of these is rare but extremely powerful. In the rare instances when 1) The rate of inflation has been higher than 6 months earlier, 2) Treasury bond yields have been lower than 6 months earlier, 3) the NAPM Purchasing Managers Index has been below 50, and 4) the Gold/XAU ratio has been above 4.0, the XAU has soared at an astounding rate of 123.63% annualized. In contrast, when none of these have been true, the XAU has plunged at -53.21% annualized. That's a gaping difference.

In short, gold prices have surged in recent weeks, based on an announced slowdown in gold sales by central banks. While it is tempting to chase prices higher, particularly since gold has been in the doldrums for so long, it is important to impose discipline on that impulse at this point, because not enough factors are in place to expect a strong and predictable continuation. That's not to say prices can't go higher, particularly since gold stocks are so volatile, and the sheer random error can be very wide. But when you have a lot of volatility, it's even more important from a return/risk standpoint to have very high forecasts, and those are still missing at the present.

We expect to have a strong buy signal on gold stocks in the months ahead, but that signal will almost certainly require a softening of economic growth. It may be close, but we don't have that signal yet. Most probably, the buy signal on gold will follow a strong stock market decline, even if the decline in the overall stock market has further to go. For now, we're watching, but are not inclined to chase gold stocks here.

Editors note: By September 2000, all four of the market factors noted in this report had become favorable. The price of gold at this point was $275 per ounce, and the Philadelphia XAU Index stood below 50. As the market conditions for precious metals shares change over time, investors are encouraged to review our weekly market commentary on a regular basis.

The Hussman Strategic Total Return Fund has the flexibility to invest up to 30% of assets in securities outside of the U.S. fixed income market, including foreign government bonds rated A or higher, utility stocks, and precious metals shares, when market conditions suggest that such diversification is appropriate.

---

The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.

Prospectuses for the Hussman Strategic Growth Fund, the Hussman Strategic Total Return Fund, the Hussman Strategic International Fund, and the Hussman Strategic Dividend Value Fund, as well as Fund reports and other information, are available by clicking "The Funds" menu button from any page of this website.

Estimates of prospective return and risk for equities, bonds, and other financial markets are forward-looking statements based the analysis and reasonable beliefs of Hussman Strategic Advisors. They are not a guarantee of future performance, and are not indicative of the prospective returns of any of the Hussman Funds. Actual returns may differ substantially from the estimates provided. Estimates of prospective long-term returns for the S&P 500 reflect our standard valuation methodology, focusing on the relationship between current market prices and earnings, dividends and other fundamentals, adjusted for variability over the economic cycle (see for example Investment, Speculation, Valuation, and Tinker Bell, The Likely Range of Market Returns in the Coming Decade and Valuing the S&P 500 Using Forward Operating Earnings ).