March 4, 2002 – The Fear Index is my most trusted model upon which I rely to establish gold’s relative value. I report the Fear Index in each letter, along with its 21-month moving average (see the data at the top of Page 4). But I haven’t looked at the Fear Index in detail since Letter No. 275 in November 2000, when it for the first time ever touched 1%.
In the months since then, the Fear Index has continued to work its way lower, touching an unbelievably low 0.91%. Recently, however, the Fear Index is showing signs of life, and is in the process of reversing its multiyear downtrend. Before I show how the Fear Index is calculated, I would like to provide some background information about it.
The Fear Index is a very useful tool because it measures exactly what its name says – fear, and specifically, fear about the monetary and banking system. Generally speaking, when the Fear Index is rising, uncertainty about the dollar is growing. From time to time because of events such as banking problems or inflation, people fear for the safety of their money, so they instinctively sell dollars and move into the safety offered by gold. Conversely, when the Fear Index is falling, any matters affecting thequality of the dollar are not seen to be worrying, so wealth moves back out of gold into the dollar.
Note that I use the term, ‘the quality of the dollar’. To explain this term, I refer to the ‘Monetary Balance Sheet of the US Dollar’, and I include below the MBS as of December 31, 2001, which I presented in the last letter.
Monetary Balance Sheet of the US Dollar as of October 31, 2001
(denominated in billions of units of account called dollars)
|Gold @ $278.40||$72.8||Federal Reserve Notes||$580.6|
|IOU’s Owed to Banks||7,959.8||Bank Deposits||7,452.0|
The liability side of the balance sheet shows M3, which everybody knows is a broad definition of the ‘quantity of dollars’. But it is the assets of the MBS upon which I want to focus, because it is these assets that determine the ‘quality of the dollar’. High-quality assets mean the dollar is of high quality. Conversely, low quality assets mean a dollar is of low quality.
Unfortunately, banks do not disclose much information about the quality of their loan portfolio, so to a large extent, we have to make some subjective value judgements about the quality of the assets upon which the value of the dollar is determined. Though these judgements are not a precise measurement, they are still useful.
The important point is that the dollar, just like any commodity or stock equity, can become overvalued or undervalued. And right now it is probably safe to assume that the quality of the dollar is on the whole being overvalued, given the mounting loan losses that the banks are taking as the recession deepens. Losses to Enron, K-Mart, Global Crossing, etc. are only the visible part of the loan-loss iceberg into which the banks have just recently crashed.
The Fear Index rises in response to these changing valuations of the portfolio of the banks. To explain why, it will be useful to show how the Fear Index is calculated.
I calculate the Fear Index at each month-end, using the information available from the MBS. For example, the calculation for December 2001 is as follows:
|(US Gold Reserve) * (Gold’s Market Price)|
|———————————————————————-||= Fear Index|
|(261.6 million ounces) * ($278.40 per ounce)|
Using the same formula, we can calculate the Fear Index for February 28, 2002, which is as follows:
|(261.6 million ounces) * ($296.80 per ounce)|
Why does the Fear Index rise and fall? What do these changes in the Fear Index reflect?
As the above calculations show, the Fear Index depends upon several components, of which the rate of exchange between dollars and gold (i.e., the so-called ‘gold price’) is perhaps the most important. The net result of the relative changes in these components used to calculate the Fear Index corrects any overvaluation and undervaluation of the dollar. In other words, changes in the quality of the loan portfolio of the banks are compensated by changes in the Fear Index.
If the quality of the loan portfolio of the banks deteriorates, or it is perceived by the market to be deteriorating, then the price of gold (and the Fear Index) rises. This rise in the gold component of the MBS keeps the MBS in balance.
Clearly, it is not the book-entry value of the assets of the MBS that is of importance, but rather, the market value of those assets. So even though the banks disclose little about the quality of their loan portfolio, the market in its infinite wisdom makes a subjective judgement of the quality of those loans, and these changes are reflected in a rising or falling Fear Index.
Recently, as the above calculations show, the Fear Index has been rising. So the market is saying that the quality of the loan portfolio of the banks is deteriorating.
This jump in the Fear Index from December 31st to February 28th can be seen in the chart below, which presents the month-end value of the Fear Index from December 1984 through February 2002. I particularly want to focus on the picture presented by this chart over the past several years.
The Fear Index fell below its 21-month moving average in November 1994, and it has not been back above its moving average ever since. However, look at what the Fear Index has been doing recently.
The Fear Index appears to have been putting in a base over the past year. What’s more, it is very close to moving back above its 21-month moving average, an event that has not occurred for more than seven years.
These are very significant developments. They suggest to me that the gold market is at an important turning point, and at the beginning of what is likely to develop into a multiyear bull market. The Fear Index is telling us that fear is indeed rising, and that increasingly people will be moving from dollars into gold. That describes of course the major trend already underway in Japan, which indicates that the Fear Index can be calculated for each national currency.
I have not provided here the Fear Index for the Japanese yen, but it is rising. It’s rising for the Argentine peso, and probably most other currencies of the world. And the Fear Index looks set to continue rising for the US dollar too as the problems of the US banks become increasingly apparent.
Lastly, long-time readers will recognize that the Fear Index has not yet given a ‘buy signal’, i.e., to buy gold. That will only happen when the Fear Index moves above its 21-month moving average AND the average itself is rising. This last condition is used to increase the reliability of the buy signal.
Looking ahead, my preliminary calculations show that the Fear Index will move back above its 21-month moving average at March 31st if gold closes that day above $298. However, to get an outright buy signal, with the 21-month moving average itself moving higher, my preliminary calculations show that gold will have to move above $325.
It is probably safe to assume that a buy signal in the Fear Index will probably be given within the next four months. In other words, it looks to me that gold will be above $325 within the next four months. This year could turn out to be a wonderful one for us gold bulls.