Gold Revisited

The other day, I asked how should one value gold. Specifically, what metrics should you follow to see if gold is overpriced or underpriced? My post was reposted at Seeking Alpha. As I expected, nearly all the comments were completely useless rants from gold bugs. Yes, I know why gold is used, but that doesn’t tell me anything about the current price.
One comment, however, stood out and I felt I should acknowledge this from silveraxis who blogs here.

The proper way to value gold is based on its monetary qualities, or in other words what it could purchase. Many people use inflation rates such as CPI as a proxy for fair value of gold but this is not very sophisticated for several reasons, the most significant of which include accuracy issues as well as the fact that the aboveground stockpile of gold grows every year. I prefer to use a ratio of gold to the global economy, stock markets, U.S. Treasury debt and/or global asset base.
Global economy is reasonably estimated using global nominal GDP (currently around $55 trillion). There are also available figures for Treasuries and stock markets (an effective if rudimentary approach is simply to use the S&P 500 as it is already market cap weighted).
Global assets are much harder to estimate but this is probably the most relevant ratio because it reflects gold’s relative purchasing power. Clearly it wouldn’t make sense for all of the world’s gold to be worth more than every asset that could be purchased! Indeed, gold could only be realistically worth some fraction of total assets which throws some of the wilder (Jason Hommel, Ted Butler, etc.) gold price predictions right out the window. In any case, you basically add global stock market capitalization, real estate, private equity, debt collateral, fiat money in circulation, etc. but exclude all credit-based money, derivatives and other financial products that are zero sum (offsetting asset and liability). Let’s say the current number for the global asset base is $150 trillion (probably a bit high but not that far off).
Now calculate the global market cap of gold: 5 billion ounces times $900 = $4.5 trillion. Thus the gold to global economy ratio is roughly 12 ($55T/$4.5T) whereas the gold to global asset ratio is currently around 33. Similar ratios can be computed for stock markets and U.S. Treasuries.
To determine if these ratios and thus the gold price is fair, too high or too low, you need to come up with similar ratios for various points in time, such as the 1980 high in gold, the 2001 low, under Bretton Woods (pre-1971), etc. as well as an average over time. If you do the math it basically says that gold is currently comparable to where it stood in the mid-1970’s after the 1974 high and before the 1980 high. At the 1980 peak, the ratios were anywhere from 3 to 7 times lower. That implies if gold were to reach a similar extreme today, it could rise 3-7 times from current levels assuming the denominator (GDP, stocks markets, etc.) stays the same.
Alternatively, the average gold ratios over the past 40 years or so imply that fair value lies in the range between $500 and $1000. If we strip out most of the 1990’s when the novelty of gold mine hedging and central bank leasing were at their peaks, these fair values become $600 to $1200. I believe at least several of the analysts that predict $1200 gold are basing their numbers on a similar model to the one I am describing.
Finally, my own studies indicate that the historical ratio of global asset values to gold may have been approximately 5 under the gold standard. In other words, gold might have typically represented approx. 10-20% of the world’s material wealth in the past. Perhaps this could be viewed as the ultimate fair value of gold. If so, assuming a global asset base of $150 trillion would mean gold has a fair value of $3000 to $6000/oz. ($150T/5/5 billion ounces). Such a price assumes the adoption of a worldwide gold standard and no consequent deflation in asset prices, which may not be realistic. Perhaps $75T might be a better number given the already ongoing global asset meltdown in which case the fair value gold price under a gold standard could be $1500 to $3000.
Keep in mind all of the above gold prices are real and therefore don’t need to be further adjusted for inflation because the ratios’ denominators already account for changes in price over time.

This is a thoughtful answer and he’s clearly given the topic serious consideration. My major objection is that the variables needed seem to be very hard to come by and there must be very large room for error.
My view is still the same. I think the safest way to look at gold is to consider its price to be wholly irrational.

Posted by on April 8th, 2009 at 11:21 am


The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.