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Busting Some More Myths about Gold

By Louis G. Navllier April 18, 2017

In the last few months, we have written several times about how you don’t need to fear the Fed’s rate-raising decisions. Gold will likely perform fine if the Fed continues to raise rates. In fact, we made the point more than once that gold will likely decline to a fairly-attractive price before any expected Fed rate increase, but then gold will rise fairly strongly after the rate increase is announced. That has happened the last three rate increases – December 2015, December 2016 and March 2017. Going back to the previous rate-raising cycle, gold rose from under $400 to over $600 when the Fed raised rates 17 times, 2004-06.

The pundits uniformly predict that gold will fall when rates are increased since gold “offers no interest income” to compete with cash or bonds, but we pointed out that interest rates are still ultra-low in Europe, Japan and America, and that interest rates are still negative in “real” (after-inflation) terms. We have also argued that gold doesn’t compete with long-term bonds or stocks. Its primary role is as a cash alternative.

Now, it’s time to examine another long-standing myth about what pushes gold prices up and down – price inflation. Is gold really an “inflation hedge” that rises the most when inflation is rising the fastest?

Let’s look at the evidence – first, the short-term inflation indicators, then the long-term inflation trends.

Last week, the Labor Department reported that the Producer Price Index (PPI) declined 0.1% in March and the Consumer Price Index (CPI) fell 0.3% in March. But gold rose strongly on that news! After the three leading inflation indicators were announced last week, gold rose from $1,252 to $1,288, up $36.

Gold Increased Despite Inflation

Last week’s inflation reports were crowded out of the headlines by the dropping of the Mother of All Bombs (MOAB) in Afghanistan, combined with a massive parade of long-range missiles in North Korea. On the financial pages, the inflation news was overtaken by news of declining long-term U.S. Treasury bond rates, making a Fed increase in key short-term rates less likely at their next two FOMC meetings.

In other words, the 44,000-pound gorilla in the room (MOAB) and a coming showdown in North Korea likely helped to push the price of gold up $36 last week – not any short-term change in inflation rates.

Longer-Term (Since 1980), Inflation and Gold Moved in Opposite Directions

Longer-term, inflation seems non-correlated with gold. Inflation was much higher (on an annual basis) from 1980 to 2000 – when gold fell and stayed low – than from 2000 to 2010, when gold soared.

Long Term Inflation and Gold

In the 1980s, gold fell 29% when inflation rose 64%, then gold fell another 27% when inflation rose 33% in the 1990s, but then gold soared while inflation was lower. Despite 35+ years of evidence, we still hear that gold is primarily an inflation hedge. The cause of this anomaly is that most investors are prisoners of their past. During the 1970s, stocks and bonds were in bad shape but gold soared. At the same time, price inflation reached double digits, so the myth was born that gold is primarily an “inflation hedge.”

The problem with that explanation is that gold was a controlled market for 41 years, trading primarily between governments at a fixed price of $35 per ounce. When the dollar was set free of gold in 1971, that released a decade of pent-up demand by investors who were not allowed to own gold before 1975. The resulting combination of high inflation and rapid gold price expansion in the late 1970s gave rise to the myth that gold and inflation will always accompany each other in the future. That has not proven true.

Gold Vs. CPI

Gold fell while inflation rose, 1980 to 2001, then gold “caught up” as inflation slowed.
Source: “Marotta on Money” (by David John Marotta)

From January 1980 to April 2001, the general level of prices more than doubled and the money supply nearly tripled, but gold and silver stumbled badly during those 20+ years (blue line, above). Put another way, the Consumer Price Index grew 127% while the price of gold fell 70% and silver fell over 90%.

Gold made up for this 20-year “Rip van Winkle-style” hibernation by gaining over 7-fold from 2001 to 2011, but inflation was clearly not the cause of that increase, since the CPI only rose 27% that decade. (The more likely explanation, which we will see, is that the dollar declined sharply from 2001 to 2011.)

Inflation Means Increasing Money Supply, not Rising Prices

So far, we have used inflation in the traditional sense that most people understand the term – rising prices – but rising prices are merely one effect of inflation – which is defined as expansion of the money supply.

“Inflation” means to pump up. We use the term “inflating a balloon” to mean blowing more air into it. In monetary economics, inflation means an increase in money supply. From 1980 to 2016, the M-1 money supply rose 8.3-fold (+730%), while the amount of dollar-denominated credit rose even faster, up 13-fold.

After the 2008 financial crisis, the Federal Reserve quintupled its balance sheet, from $800 billion to $4 trillion as part of its various Quantitative Easing (QE) plans, which amounted to a clever new term to describe increased liquidity – new money – without creating the need of printing new dollar bills.

The Fed launched QE-1 and their zero-interest-rate policy (ZIRP) in December of 2008. Their third and final iteration, QE-3, was announced September 13, 2012, when the Fed said it would begin a $40 billion per month purchase of mortgage securities. Then the Fed announced that they would buy $45 billion per month of longer-term Treasury securities, amounting to $85 billion a month, or $1.02 trillion per year.

Far from pushing gold’s price higher, gold suffered its sharpest retreat in the spring of 2013. Then, when the Fed’s QE process ended in 2014 and the Fed raised key interest rates for the first time in almost a decade (in late 2015), gold started rising again. As Ivan Martchev has shown in Louis Navellier’s Market Mail over the last few years, the CRB Commodity index has been in a bear market during the Fed’s era of Quantitative Easing – which ran from December 2008 to December 2015. Most “gold bugs” who believe in the “inflation hedge” role of gold would have predicted that gold would soar due to quantitative easing.

Table 4

The Reuters/Jefferies CRB Index fell 64% during the seven years of Quantitative Easing (QE) and 0% interest rates
Source: StockCharts.com, reprinted in Louis Navellier’s MarketMail, January 6, 2016

It’s almost as if the gold market were chortling at how much it could turn the average investor’s assumptions 180-degrees off alignment. Gold finally reached its 10-year low on the very day after the Fed first raised rates in this cycle, on December 15, 2015. Gold fell to $1,049.40 on the London pm closing the next day, but then gold started rising and it hasn’t traded below $1,100 since January of 2016.

During all those years of QE fiddling and delayed Fed fund rate increases, the pundits not only proclaimed that gold would likely fall if rates rose, they then began handicapping the chances for a rate rise based on every little economic statistic that emerged from the government’s number-mills. Here’s one example from the October 19, 2015 Wall Street Journal (“Gold Role as Safe-Haven Investment Wanes: Price of the Precious Metal Fluctuates with Expectations on When the Fed Will Raise Rates”):

“Traders and analysts say the precious metal’s role as a haven investment in times of turmoil has waned recently, with the price more likely to fluctuate because of shifting expectations about when the Fed will raise interest rates. Gold has rallied 5.2% this month after a sour September U.S. jobs report encouraged investors to bet there will be no increase this year. Higher rates, when they occur, are widely expected to undermine future demand for gold, which doesn’t pay interest so becomes less competitive against investments that do. Prices slumped to five year lows in July, when expectations for a rate increase ran high.”

Notice all that wiggle room about what moves gold’s price: First, gold isn’t a crisis hedge any longer – at least not this time around! Next, gold is only concerned about interest rates, but since we don’t know what the Fed will do, we need to look at every government statistic for clues. That month, gold rose 5.2% on a weak jobs report but it will slump (and has slumped in the past) if a good jobs report comes out next time.

How confusing, how counter-productive. In 2015, when gold was nearing its post-2010 lows, investors were supposed to watch jobs report and confusing speeches by Federal Reserve officials to decide whether to buy gold? Investors who listened to this advice would likely still be on the gold ‘sidelines.’

Here’s a radical thought: Gold is an alternative to currencies. When currencies fall in value, gold tends to rise. Gold rose 2001 to 2011 when the dollar was weak. Gold is down since 2011, since the dollar was strong. The dollar has weakened this year and gold is up, but there’s more to this story than currencies.

Gold is also a “prosperity hedge,” in that it is a luxury purchase for investors of high enough net worth to accumulate multiple ounces of gold as a small portion of their overall portfolio – a balance to stocks and bonds – a replacement for their weak currencies. Establishing a 10% position in precious metals with a meaningful position of 10 ounces or more (at $1,300 per ounce) requires a portfolio of at least $130,000.

When enough investors in China, India, the Middle East, Europe and North America reach that level of disposable funds, gold will likely rise in price when its narrow available “float” meets the overwhelming demand of millions of new investors seeking to balance their portfolio with the Golden Constant.

Don’t wait for the next inflation report, or Fed decision, or global crisis to buy gold. The time to buy is when you have sufficient funds to balance your portfolio with a meaningful (10%) portfolio position.