A couple of years ago, Wen Jiabao, the Chinese premier, told The Financial Times: "Confidence is the most important thing, more important than gold or currency."
Confidence allows business people and investors to assume higher risks as they seek a return on their money. When they have confidence the market will support fair compensation for the risks they assume, they are more willing to put their capital at risk and buy real , bonds and stocks. This, in turn, drives up prices for those assets.
Gold prices work in the opposite direction. When confidence is on the rise, the price of gold tends to fall.
But when investors and business people believe the market will not give them fair compensation for risks, they hang on to their capital. Lack of confidence in the market drives investors to settle for a return of their capital rather than a return on their capital.
And it is precisely that lack of confidence that drives investors to seek the protection of gold.
It's a Question of Confidence
There are two surveys that provide a fair measure of consumer confidence. The Consumer Confidence Index (CCI) measures the degree of optimism in the economy as expressed by consumers via their spending and saving activities. The Conference Board conducts the survey once a month, publishing a detailed report on "consumer attitudes and buying intentions."
The other widely quoted measure of consumer confidence comes from the University of Michigan’s Institute for Social Research. Like the CCI, the University of Michigan Consumer Sentiment Index is published monthly and tries to assess the attitudes of consumers toward their spending plans, personal financial situation and the business climate.
Let's take a look at the University of Michigan Consumer Sentiment index chart below.
Second, and perhaps not so obvious, we can see that when the dot-com bubble burst in the early 2000s, consumer confidence did not fall as far as in the recessions of 1980, 1990 and 2008. So, if we believe the correlation of confidence to demand for gold is true, we should be able to see a measure of this relationship.
Gold’s Confidence Correlation
By using the ratio of the price of gold to the price of the S&P 500, we can measure investors' preference for gold as a store of value during times of crisis vs. their preference for risky assets like equities.
The chart below shows the gold to S&P 500 ratio starting in 1990 and ending in early September 2010. If we look at the chart above, consumer confidence hit one of its lowest points during the recession of 1990. And if we then look at the chart below, we can see that during the same period, the ratio of gold prices to the S&P 500 was hitting a twenty-year high.
Confidence rose to an all-time high by 2000, just before the dot-com recession. But while confidence fell in the subsequent recession, it did not fall to the level seen in 1990, but rather it remained relatively close to the levels seen during much of the 1980s and 1990s.
Interestingly, the ratio of gold to the S&P 500 fell to a 20-year low just before the recession of 2001. The ratio remained at a relatively low level until consumers began to feel the effects of the big recession of 2008.
But then the ratio shot up as confidence waned and many feared the worst. As the price of gold took off and the S&P 500 fell, the ratio returned to the level it had reached in the early 1990s. Investors were seeking the return of their capital rather than a return on their capital. The ratio continues to hover near historic levels.
When fear of a major crisis drives confidence down, placing some of your capital in gold makes sense. As fear drives gold higher, you can ride along. But the reverse also holds true. When confidence hits its lowest point and then starts turning up, it may be time to start reducing your gold holdings.
Since the price of gold follows consumer confidence, align your gold holdings accordingly. When consumer confidence peaks, it is time to own gold. As consumer confidence turns up from a low point, you have a signal to reduce your gold holdings and take your profits. If you let confidence be your guide when investing in gold, it will give you the signals that allow you to buy low and sell high.