Photo: The Economist
A recent Business Insider article implicitly touted the utility of gold as a storehouse of value, pointing out that measured in ounces of gold, the price of college tuition, postage for a first-class letter, gasoline, and food — among other things — has actually held steady or even declined over time. For example, a postage stamp today (45¢) would cost you less gold than at almost any time in the past 110 years. Tuition and room and board at Yale would set you back just about the same quantity of gold today as in 1900. And even with the recent increase in nominal dollar price per gallon, gasoline is still pretty much the cheapest it has been as measured in gold since at least 1995.Of course, the price of gold is up sharply of late: roughly 5% so far this year, 10% in 2011, 30% in 2010, and 24% in 2009. Gold has clearly been appreciating in value faster than the dollar has been declining for the past few years. So, even taking into account the risks of a default in Europe, a war with Iran, a recession in the U.S., a growth slowdown or worse in China and India and so on… is gold overvalued here?
According to the efficient market theory, of course, something is worth what folks are willing to pay for it, so by definition, gold cannot be overpriced — or underpriced, for that matter — so long as it can be freely traded. However, those of us who remember tulip bulbs, dot-coms, and “irrational exuberance” may have a different view.
One way of looking at this question is to examine the change in the nominal dollar price of gold and determine how much of that change is due to the depreciation of the value of the dollar and how much is due to market demand (or lack of it). Theoretically, if gold is a perfect store of value, you would expect 100% of the change in its dollar-denominated price to be due to fluctuations in the value of the dollar. To that end, the following chart illustrates the “expected” change in the price of gold given fluctuations in the value of the dollar — mostly down, but not invariably so — from 1913, when the average cost-per-ounce was $18.92, to 2011:
Source for CPI data (Dec. to Dec.): U.S. Department of labour.
What this chart shows is that given that the year-end 2011 dollar was worth about $0.03 in 1913 dollars, all things being equal, we would expect the price of gold in 2011 dollars to be around $610. In fact, the average price of gold in 2011 was around $1,570. Thus the decline in the value of the dollar accounts for about 38% of the increase in the price of gold and market demand (or something else) accounts for 62% of the increase. Has this big differential always existed, or is it relatively recent (keeping in mind the recent surge in the price of gold)? Here is the same chart with the actual price history of gold overlaid:
Source for actual gold prices: National Mining Association (link opens PDF file).
Clearly big discrepancies are a fairly recent development, although of course the apparent stability for the first 60 years is undoubtedly a function of the fixed price of gold per ounce — $20.67 until 1934, and then $35 until the end of the Bretton Woods arrangement in 1971, since which the dollar has “floated” (some might say “sunk”). Indeed, for some 30 years starting with the early ’40s, the actual price of gold was (slightly) less than the expected price because the fixed price pulled the absolute value of gold down along the inflating dollar.
But after 1971, when the dollar-peg-to-gold was eliminated, the picture has been different. In the late ’70s and early ’80s, when runaway inflation threatened to upset the financial applecart, the price of gold skyrocketed, but then came back to the “expected” trend line. After another brief run in sympathy with the S&L crisis in the late ’80s, gold actually lagged its expected value significantly during the dot-com boom, when tech shares were all the rage.
Then we had the 2008 meltdown. The big differential we are seeing now is approaching record territory: Since 1913, the only year in which market demand accounted for more of the increase in the price of gold than 2011 (62%) was 1980 (66%). The average percentage of the increase attributable to market demand in any given year since 1913 is only 8% — that is, on average, 92% of the increase in the price of gold is attributable to the decline in the value of the dollar — but of course that is deceptive due to the peg that persisted for so many years, artificially depressing the differential. Since 1971 (post-peg), the market-demand share has been 15%… still a far cry from 62%.
So gold is definitely worth more relative to the dollar than it “should” be, and that discrepancy is definitely near the historical all-time high. But does this prove that gold is overvalued?
We can certainly find folks who will object to that conclusion. Fans of collective intelligence (including many Motley Fool CAPS players) would argue that there is momentous meaning inherent in the price signal we are getting from gold: The sky really is falling, or at least in danger of falling.
Gold bulls would argue that the CPI data from the Feds is cooked, understating the extent of inflation and thus exaggerating the discrepancy between the actual price of gold and where it “should” be… in other words, it is not gold that is overvalued, it is the dollar. (Interesting theory, but we would have needed inflation of 10% a year every year since 2001 to get the “expected” price of gold up near where the actual price was in 2011, and no one believes real inflation has been that high.)
The bottom line is that — sorry! — there is no one definitive answer appropriate to everyone.
If you buy gold now, you are paying a higher risk premium than you would have three or four years ago, and possibly higher than you would in a year or so, if we continue to dodge bullets successfully for that long. But whether you conclude that gold is overvalued here probably turns on your own investment situation: age, family circumstances, net worth, current disposition of assets, whether or not you already own some gold, etcetera, as well as on your assessment of the macro risk factors out there. Obviously if you expect we are likely to muddle through over the next year or so, gold at these levels is less attractive than it is if you conclude too many eggs are being juggled and one or more is likely to drop soon with potentially unpleasant consequences. And if you do decide to take the plunge here, these factors will also figure into your choice of investment vehicle: buying physical gold in the form of coins or bars to store in your basement or deposit in a storage facility, or purchasing a gold ETF such as the SPDR Gold Trust or Sprott Physical Gold Trust or perhaps investing in gold mining stock Goldcorp, Barrick Gold, or Newmont Mining, or a gold mining ETF such as Market Vectors Gold Miners.
Even some investors who generally eschew precious metals are reconsidering now given the confluence of macro risk factors. And it is conceivable that someone could determine that gold is relatively overvalued but, on balance, decide to buy anyway. Nevertheless, you should certainly not eschew the due diligence of determining your best guesstimate of a fair value for gold before buying some (or more).
This story was originally published by The Motley Fool.
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