Is gold at the edge of a cliff?

Reader Alert: This is Part One in a Two Part series.

The higher you climb the harder the fall. It’s a lesson from the 1970s that many gold bugs should heed. Back then, after soaring to record highs, the yellow metal fell almost 70% in a jump-off-the-cliff drop. Little surprise then that the frighteningly parabolic surge in gold prices today is making economists nervous. Given the long history of gold, the crash of the 1970s remains a relatively recent incident, fresh in the memory of gold experts.

If history repeats itself, the time may be ripe for the prices of gold to take one hell of a tumble. Is it time then for investors to cash in their chips, pocket the profit and move onto the next table? Analysts and industry experts say no, the game has only just started.

If you’ve been watching from the sidelines, it’s time you got in the game, says Martin Murenbeeld, chief economist, DundeeWealth Economics.

“There’s still time to jump in; I think gold will go significantly higher. On an inflation-adjusted basis, gold has not had a new high,” he says. On an inflation-adjusted basis, the 1980 high of $850 remains the record. To top that in today’s dollars, bullion needs to top $2,400. “Gold is going through at least that,” he says.

Murenbeeld does concede a correction, not a steep plunge, could be lurking round the bend. He has a theory to support that assertion. “The shortest cycle in gold was from 1970 to 1980, [which was] an up cycle; this cycle would last much longer,” he says. “What we do know is that somewhere in the middle of the cycle there’s a massive correction.”

In a long-term down cycle, there will be a year or two where the prices rise. In an up cycle, there will be a year or two when the prices decline on a year over year average basis, he adds. “We have not seen this for gold in this cycle; there should be one.”

The good news is that the correction, both in the short- and long-term, won’t be as brutal as that of the 1970s, “because [then] the policy response was slow, today the policy responses are much faster which mutes the downside correction.”

“When we slip into recession the policy immediately tries to counter it; in the ’70s the attitude was more lax.”

When global factors responsible for fuelling gold prices show signs of abatement, a correction could be expected, “most likely when the market is at least somewhat satisfied that the policymakers in Europe are addressing the market’s concerns, which is the drive behind gold’s parabolic rise.”

Another important factor contributing to gold’s current bull run is the increased interest of large reserve-holding central banks in gold. South Korea, for insistence, recently spent more than a $1 billion in its first gold purchase in more than a decade.

The other factor, he says, is copious amounts of gold being purchased by emerging economies, in particular by India and China. “There are many reasons [for that]; the first is the high rate of inflation, the second is growing wealth, and the third one, which often gets underplayed, is the massive market deregulation in these countries for gold.”

Once past the short-term correction, the gold prices will carry on, says Murenbeeld. “This could go on for 10 years, easily.”

Underneath all this, he says, is the fact that gold is sneaking back to some sort of role in the international monetary system because “new emerging economies [such as China and India] like gold; they have large reserves [of gold] and they are becoming important participants in the IMF.”

Murenbeeld doesn’t rule out the possibility in the foreseeable future of gold being included as a currency in the Special Drawing Rights [SDR] basket which would give gold a “quasi-official” role in the system.

While there are no immediate signs to suggest investors bail out of gold, there are some classic cues investors could look out for. “One classic cue is positive real interest rates, particularly if the U.S. real interest rates moved above 2%,” says Murenbeeld. “It isn’t a slam dunk, just a cue. On the back of such an interest rate picture, a strong U.S. dollar, and on the back of those two pictures, declining rates of inflation.”

With the likelihood of any of the above happening any time soon rather dim, gold has a good chance to continue to shine on.