The Great Commodity Pendulum of the 21st Century

Those of us in the older generation remember the 1970s. It was a wonderful time (for gold bugs). Gold went up. Almost all commodities went up. Bonds went down. Stocks went down. By 1980, most of the top mutual funds were gold funds. All of the establishment gurus lost their shirts. By 1981, they were believers in Dr. Doom. The (non-gold) mutual funds went to 12% cash.

If we wish to understand the 1970s (and subsequent American economic history), we must ask ourselves, what was the cause? Why did gold and oil advance so powerfully? Why did (consumer) prices go up faster than the money supply? Why did interest rates get into the mid-teens? (The prime rate in 1981 was reported as 20%; however, this was a false figure as the banks were trying to exaggerate. The actual high is best given by the T-bill rate, which hit 16% in May 1981.)

In the 1960s, Milton Friedman and his compatriot Anna Schwartz released a study which covered a century of American history. It showed that, when the money supply increased by 3%-4% per year (about equal to population growth at that time), the price level was stable. When the money supply increased by more than that, there followed, about 2 years later, a corresponding increase in prices. For example, if the money supply increased by 10%, then prices might increase by 6%-7%.

But in the 1970s, this theory, which had worked for a hundred years, went badly off. Toward the end of the decade, prices were rising at a double digit rate even though the money supply had never increased by more than 9% in a single year. In the 1980s and '90s, it was the reverse. Ronald Reagan came close to doubling the U.S. money supply during his Administration, but prices remained fairly tame. It seemed to be the best of all worlds, and Greenspan was called a miracle man by the media.

These strange events can be explained by the great commodity pendulum. If you look at nominal commodity prices from 1963-1971, you can see that they were flat. But this was the period when Keynesian economics became dominant in U.S. policy. The tax cut of 1963 was the start of this period, and through most of the 1960s the money supply grew by faster and faster rates. Thus the stability of commodity prices during this time meant that they were falling in real terms and were becoming unnaturally undervalued.

It should be noted that commodities show great long term stability of prices. One can research the price of wheat back into the early 19th century and find that in contractions wheat would hit a low of 50¢/bu. This low of 50¢ occurred again and again through the 19th century. And in the Great Depression the low established for wheat in the early 1930s was 50¢/bu.

But commodities are inelastic in price. For a commodity's price to rise there (usually) has to be a reduction in supply. This means that commodity producers have to go out of business. And commodity producers tend to hang on for a long time before they throw in the towel. Commodity prices are thus sluggish and take a long time to respond to the forces of supply and demand. Therefore, as the '60s progressed, the Fed issued more money, consumer prices rose, but nominal commodity prices remained the same. As noted, commodity prices thus became undervalued in real terms. Wheat at $1.40 in 1971 was the equivalent of 35¢ in 1932 dollars, its lowest price in U.S. history thus far. With commodity prices so undervalued, when Richard Nixon abolished the slender tie which remained to the gold standard on Aug. 15, 1971, it was the signal for a massive rise in prices. Commodity prices exploded to the upside. Crude oil multiplied by a factor of 20; gold multiplied by a factor of 25. These were the commodities which attracted the most attention, but virtually all commodities participated and made sustained price advances in the period 1971-1980.

These advances in commodity prices fed through to consumer prices. So consumer prices advanced for two reasons. First, the Fed (no longer restrained by the Bretton Woods system) was increasing the money supply; second, commodity prices were catching up for their sluggish behavior in the '60s. They were exploding to the upside, and they were increasing the prices of all consumer goods for which they served as raw materials. This is why the consumer price index started outpacing money supply growth in the final years of the decade.

I call this period (1971-1980, BC on the chart) the first upswing of the commodity pendulum. The Kennedy tax cut of 1963 started commodities swinging back and forth like a giant pendulum: first undervalued (points B and D), then overvalued (point C), then undervalued again, etc. In the down periods (AB and CD), commodity prices are declining; consequently consumer prices are relatively tame. The Fed feels free to ease credit and print money. Bonds go up, and stocks follow them up. In the up periods (BC and DE), commodity prices are rising rapidly; this feeds through to consumer prices; the Fed finds that a little bit of monetary stimulation causes a substantial rise in prices. So the Fed tightens. Bonds go down, and stocks follow them down.

The bullish stock market years of the '80s and '90s were made possible by the fact that by 1980 (point C) commodities were overvalued. This caused an increase in supply and set commodity prices (both nominal and real) on a downward slope. This moderated consumer prices, and the Fed was free to ease credit and create money. This was the second downswing of the commodity pendulum.

By 1999 (point D), commodity prices were again undervalued. But this time it was much worse. Greenspan, by his repeated easing, forced commodity prices below their levels of 1971. Wheat at $2.50/bu in 1999 was 15¢/bu in 1932 dollars. Today at $4.80 it is 30¢/bu in 1932 dollars, well below its Great Depression lows and even below its 1971 lows.

In short people, these are the 1970s. The double bottom in the CRB index in 1999-2001 is equivalent to the 1971 bottom. The 2000 peak in the stock averages corresponds to the 1966 peak, and the coming peak in the DJI (in the next few months) is the early 1973 peak. Gold and oil are once again leading the pack, but before this move of the pendulum is over every commodity will have its day.

The first upswing of the commodity pendulum (BC) lasted 9 years. But the downswing which preceded this second upswing was much more extreme. So the second upswing will probably last, order of magnitude, 15-20 years. And speaking conservatively it can easily carry to CRB 1200. (This is the actual CRB, dating back to 1956 and being called the CCI by some people. It should not be confused with the RJ-CRB newly invented by the modern Commodity Research Bureau.)

Once you realize that gold is in a 15-20 year up move very similar to its move of the '70s, it becomes possible to calculate reasonable price objectives. We know that gold hit a peak in 1980 of $875/oz. (This is often stated in the literature today as $850/oz., but $850 was the high on Jan. 18. If you research the New York Times for Jan. 22, 1980, you will find an interday high of $875, Jan. contract, NYCX reported for Jan. 21.)

Consumer prices doubled from 1980 to 1999. It is conservative to project that they will double again on this second upswing of the commodity pendulum (as they did in the first). That will mean a 4-fold increase in real prices from 1980 to the end of this second upswing (point E). So for gold to hit $875 in 1980 dollars once again (as a peak price), it will have to reach $3500 in nominal terms.

Pretty this will be.

Howard S. Katz was one of the early gold bugs of the late '60s and '70s, turning bullish on gold in 1965. His favorite gold stock, Lake Shore Mines, went from $3/share to $39/share over the course of the seventies (sold at $31). Katz turned increasingly skeptical about gold as it mounted its final rise in 1979, and he called the top after the close on Jan. 21, 1980 (with gold at $825.50/oz.). Katz traded gold in and out during the '80s and '90s and once again turned long term bullish in Dec. 2002. His thoughts on commodities, stocks, bonds and real estate are available in a letter entitled The One-handed Economist and published every two weeks giving specific advice on trades in stocks and futures. This letter is available (both electronic and paper copy) for $300/year with a 3-month trial for $100. Send to: The One-handed Economist, 614 Nashua St. #122, Milford, N.H. 03055. (Include both electronic and mailing address.)