Monday, November 26, 2012

Gold looks expensive

Here are some charts that put the current price of gold ($1750/oz.) in perspective.


In nominal terms, gold is very close to its all-time high of $1900/oz. Since its low of $254 in early 2001, gold has risen at a compound annual rate of 17.8%. That's almost hard to comprehend, until you compare it to AAPL, which has posted an even more incredible 42% compound annual growth rate over the same period.


In constant dollar terms, gold today is below its all-time high set in early 1980. But relative to the average real price of gold over the past 100 years, gold is trading at a premium of 230%.


It's not a coincidence that periods of strongly rising real gold prices have corresponded to periods in which Federal Reserve monetary policy was "easy," and falling real gold prices only occurred when the Fed was "tight." When individuals perceive that the Fed is oversupplying dollars to the world by keeping real interest rates very low, they tend to react rationally, seeking out and paying a premium for gold for its ability to maintain its purchasing power over long periods. In contrast, when money is tight and real interest rates are high, gold loses its luster as investors prefer financial assets.


This chart compares gold to a basket of non-energy industrial commodity prices. Note that gold and commodities tend to track each other over time. But note also that the right-hand y-axis of gold prices spans a range of 250 to 2000—a difference of 8 times—while the left-hand y-axis of commodity prices spans a range of 200 to 800—a difference of only 4 times. Gold prices have been far more volatile than commodity prices.


When we compare gold prices to crude oil prices, however, the two are very close to their long-term average relationship, in which one ounce of gold buys about 19 barrels of oil. Using Arab Light crude prices, the ratio today is one ounce to 15.4 barrels, which means that gold is a bit cheap relative to crude. But that is mainly due to the fact that Arab Light crude is trading at a substantial premium (about 27%) to American crude as traded on NYMEX because of geopolitical concerns. The ratio of gold to NYMEX crude is a little less than 20 today. On balance, let's just say that gold and crude oil are trading fairly close to their long-term average relationship.

If the Fed continues its massively accommodative monetary policy, gold prices conceivably could move higher. But I think that would require some evidence that inflation is picking up, and that evidence is still lacking. In my view, gold is essentially priced to a significant increase in inflation already. The premium that investors are willing to pay for gold today (defined as the amount by which today's price exceeds the average historical real price) is almost as much as it was in early 1980, when inflation had already attained double-digit levels.

By this same logic, if the Fed were to even suggest that it is contemplating a reversal of its quantitative easing (which could be accomplished by raising the rate it pays on reserves, or by draining reserves), then gold would be quite vulnerable to losses. Gold today is a very expensive inflation hedge.

11 comments:

The Dude said...

I think I get the gist of your point that gold is expensive. Isn't the proper metric that one oz of gold will buy 19 bbls of oil? Good post.

Scott Grannis said...

Dude: thanks for catching that. Now corrected. One oz. of gold buys 19 barrels of oil on average.

Dr William J McKibbin said...

Given that Main Street USA remains mired in economic depression (as evidenced by declining real working wages, declining real home values, and a declining employment to population ratio), gold is not the best investment for the times -- during times of depression and deflation, high quality dividend-paying stocks and rent-earning real estate are your best defensive investments -- beware of gold until the deflation along Main Street USA is reversed, a process that will take at least 2-3 years to correct -- the deflation and depression that has been hammering Main Street USA (and the southern flank of Europe) are the proper gauges by which investors should judge the current state of the economy -- old school macroeconomic measures such as employment, inflation, and growth have been decoupled from the protected Federal economic, which includes the military-industrial complex, the medical establishment, and government workers -- I advise making investment decisions based on Main Street measures instead, which includes real working wages, real home values, and the employment to population ratio -- gold is not the way to go until the Main Street depression and deflation is reversed...

PS: I want to be very clear: prudent investors will study the current state of real working wages, real home values, and the employment to population ratio, while seeking to avoid reliance upon the macroeconomic measures of inflation, unemployment, and growth.

PPS: Also, be sure to grasp the major lesson learned from the economic crisis since 2008 -- that economics and politics are sisters that cannot be artificially separated as assumed by the central bankers of our times.

Benjamin said...

I gotta say, I am scratching my head at this one.

I think Scott Grannis (normally so astute) has conflated many "urban myths" about economics into one post.

If the Fed is "loose," why has the Cleveland Fed's index of inflationary expectations been falling for years, to all-time record lows? That just does not add up. Loose money dies not lead to falling inflationary expectations.

Inflation? The PCE deflator is running under 2 percent for the last five years. How is that inflation?

Oil is a physical commodity, although speculation can swamp the markets for months at a time (as I found out expensively, once).

As a physical commodity, its price is related to its marginal cost of extraction (assuming roughly competitive markets).

If the marginal cost of extraction rises for oil---and does so for technical and geological reasons---this will happen independent of what the globe's major central banks do.

The globe's major central banks can target 2 percent (the Fed) or zero percent (the ECB and Bank of Japan) or 4 percent inflation (the People'sBank of China) and oil will still cost a certain amount to extract, raising or falling depending on geology and technical improvement made in extraction. And government regs, dictatorships in oil thug nations, etc.

Thus we see oil is more expensive even in yen, a currency that been in a deflation mode for 20 years.

Gold is the most fantastic of all investments, purely driven by speculation and the desire for gold jewelry (most gold is consumed by Chinese and Indian upper classes, in gift giving).

I can well understand gold rising in value as Chinese and Indian upper classes expand in economies that growing and are adopting some market reforms (remember we are talking a three billion people. The US population is one-tenth of that).

In short, the world has changed since I wore disco pants and had hair on my head. US monetary policy does not set global commodity prices. The USA economy is far less inflation-pront than in 1972.

By measures that are obvious and make sense--such as the PCE deflator or the Cleveland index of inflationary expectations--the Fed has been tighter than it ever has been in the post-war era.

Zero bound is an example of how tight the Fed has been. You do not get to zero bound in an inflationary economy.

B Terramorse said...

So in our tireless search for the inflation that the irresponsible Fed Policies will create has found confirmation in the pricing of some highly volatile commodities, whose volatility is largely a product of wanton speculation. Other than that, no sign of the predicted hyper-inflation is in sight.

Interesting.

theyenguy said...

The age of prosperity is transitioning to the age of fiat asset deflation where wealth can only be preserved by investing in physical gold.

Despite last week’s rally, fiat assets of Stocks, VT, Bonds, BND, Commodities, DBC, and the Major World Currencies such as the Japanese Yen, FXY, the Euro, FXE,the Canadian Dollar, FXC,the British Pound Sterling, FXB,The Swedish Krona, FXS, the South African Rand, SZR, the Swiss Franc,FXF, the Brazilian Real, BZF, the Indian Rupe, ICN, and the Australian Dollar, FXA, as well as Emerging Market Currencies, CEW, have failed to grow and maintain investment value since September 14, 2012, as the world central banks’ monetary authority is exhausting and carry trade investing cannot work when currencies are sinking.
The inability of stocks to leverage higher is seen in the combined chart of closed end equities, CSQ, trading lower on closed end credit, PFL, specifically peaking and turning lower since September 14, 2012. The failure of neoliberal finance is seen Aggregate Credit, AGG, turning lower, as Mortgage Backed Bonds, MBB, Junk Bonds, JNK, Leveraged Buyouts, PSP, Senior Bank Loans, BKLN, International Treasury Bonds, BWX, and Emerging Market Bonds, are falling lower in value as is seen in the combined chart. Distressed investments, such as those in Fidelity Investments FAGIX, which are the backbone of the US Federal Reserve's balance sheet, are turning lower in value. The Fed’s QE1, was based upon a trade-out of money good US Treasuries, EDV, TLT, for distressed investments held in the Too Big To Fail Banks, RWW, and the Regional Banks, KRE. It was the TARP facility, that gave seigniorage, that is moneyness, to World Banks, IXG, and it was the acquisition of Maiden Lane investments that gave seigniorage to JP Morgan, JPM, and other Investment Bankers, yet both of these turned lower today, the first trading day of this week.

Wealth can only be preserved by investing in and taking possession of gold, GLD, either in physical form or in Internet Trading Vaults such as GoldIsMoney or BullionVault. Jack Chan of JC’s Buy and Sell Signals, … http://stockcharts.com/public/1094070 ... gave his buy signal on gold on Friday November 23, 2012

The investment demand for gold is now accelerating ss fiat assets of all types fall into the pit of financial abandon.

steve said...

I believe in mean reversion and GLD will revert relative to stocks. I agree with scott that any hint of anything other than total accomadation from the fed and it's all over with gld and like all markets, gld will anticipate this.

Junkyard_hawg1985 said...

Scott,

Excellent post as always, but I would caution against comparing the 1980 peak to the current price. Here's why:

Historically, during a period where the price of gold is not manipulated, there is an average of about 0.5% deflation per year. From 1800 to 1913 when the Fed was created, the consumer price index fell from 51 to 29.7 (-41.8%). Another way of saying this is that the inflation adjusted price of gold should rise by about 0.5% per year on average.

Since the creation of the Fed, consumer prises have risen by a factor of 23. If you assume that consumer prices would have continued to drop from 1913 to present as they did from 1800-1913, then the inflationary effect of not using gold for money is really a factor of about 37 since the creation of the Fed.

From here, if you look at the price of gold compared to historical ($18.93/oz), the consistent value would be about $700/oz today. To reach the peak it did in 1980, gold would need to rise above $2700/oz.

You point is still correct that gold is overpriced, but the difference is not that great. Part of the reason gold is overpriced is that real interest rates are negative (as they were in the late 1970's).

Junkyard_hawg1985 said...

Scott,

Looking at the period between 1800 and 1913 (creation of Fed), deflation averaged 0.5% per year. Another way of saying this is that the real price of gold should rise an average of 0.5% per year.

On this basis, gold should be about $700/oz. while gold is above the historical norm, the difference is not as big as it was in 1980. To match that peak, gold would need to rise to $2700/oz.

Your point is still correct that gold is overpriced, but it is not as bad as you report.

Paul Sasina said...

This article has two fatal flaws.

1) Assumes CPI is a measure of inflation. It is not.

a) CPI is an variable index given it's inputs change or are adjusted every year based on the assumption that as prices rise, people will purchase cheaper alternatives. CPI is used to adjust government salaries, entitlement benefits, etc., so there is an incentive to ensure the metric stays in a tight low band (which it has since 1980 regardless of either tight or loose monetary policy).

If you take equation for 1980 CPI, inflation would have averaged over 8% for the last 30 years. Today's gold price would be extremely cheap relative to 'inflation adjusted dollars.'

b) Real inflation is the annual change in $ cost of goods that everyone needs to buy to survive (food, energy, gas, spare tires, etc.) For the past 5 years, real inflation has been over 20% for the vast majority of products that families purchase to survive each year.

2) Gold is the oldest form of money, and the most trusted given governments can not inflate the gold base. As money, Gold has an often manipulated exchange rate with other currencies. That rate will be over $50,000 per ounce once the 2008 financial collapse process completes over the next decade. (higher if/when a secondary collapse occurs due to risk of $1,900 trillion in derivatives bets made in 2012 that will eventually go bad.)

Based on the magnitude of the 2008 loses, major governments still need to expand their monetary bases by over 10 times from today's levels to completely recover (via printing) the $100+ trillion in loses suffered by $800 Trillion in bad derivatives bets made by all world banks in 2008.

You can look up all of the above. They are public record that is ignored by most.

But even without heavy research you can ask yourself 2 simple questions.

1) Do you really think inflation is 2% the past 4 years (with 100% price increases for all basic necessities during the same period)

2) Do you really think the 2008 financial collapse was actually prevented or reversed?

The fed has expanded the monetary base by 3 times already to give you that impression. But your dollars are worth 3 times less as a result.

Their actions have barely scratched the surface of what is required.

I do not fault world governments for trying delay the collapse by a decade by expanding the monetary base enough to erase loses that dwarf total world GDP. But do not for a second think gold is expensive as the author suggests. This is a fools argument fostered by governments so people do not panic and purchase hard assets to protect their wealth.

World GDP is $55 trillion. World savings is a fraction of that. We will need 100 years to repay these debts or 10 years of continued massive real inflation... all while CPI continues in a tight low band so no one panics and entitlement programs do not default too soon.

Vantage Investment said...

Take a look at data from the World Bank website for historical purchases of gold by central banks of the world.

http://data.worldbank.org/indicator/FI.RES.TOTL.CD

These policy makers know how things have been changing and are preparing for the fallout. Gold prices are driven by these buyers, not by gifts from Chinese and Indians, as reported by pundits. Gold is responding to currency policy moves, not commodities baskets.

Vantage Investment has been recommending an accumulation investment stance on gold for over 12 years (since gold was below $600 USD), and we still are. If central bankers are buying hand-over-fist on every 10% price pullback what does that indicate? Answer: change is assured and each country better prepare it's finances. Is the price of gold manipulated? Maybe. It sure could help central banks around the world get on board without too much disruption by being left behind.

Also disturbing are the central bank policies of printing more currency as a solution to a country's problems. This seems to be the first (and only?) option nowadays.

This trend and its effects are just beginning. So, if you want to protect your wealth you will continue to buy gold. It's trading on an upward range so there's still room to buy on the pullbacks. If you heard Buffet or Soros bought into gold bigtime would you consider it significant? What if central banks did so? Wouldn't this be more significant? If you're worried gold prices may CRASH then just buy a futures hedge at the peaks.

Better yet, forget speculating and invest in yourself and the means of producing value in any economic climate.

Best of luck to you all.

VantageInvestment.com
This is not investment advice, just a market observer's opinion :)