Thursday, June 18, 2009

Clarification on gold


In the Seeking Alpha discussion earlier today (see previous post), I mentioned that I thought gold was trading at a significant premium. I guessed that the mean-reverting value of gold today was about $500, but in updating this chart I realized now that $450 sounds better (and that is the average real price on this chart). Regardless, I think the chart makes it obvious that when you adjust for inflation, which gold seeks to offset, you are paying a pretty high price relative to the historical average.

When money is easy, it finds its way into the gold market and gold prices rise. Gold is an advance indicator of official inflation. Jude Wanniski argued that gold was a real-time indicator of the true inflation rate. Either way, rising gold prices are the market's way of saying that there is an imbalance between the supply of and the demand for money, and that imbalance is undermining the value of the currency. The market is aware of the inflation problem, and so you need to pay a premium to hedge that problem with gold. Gold is expensive today, and it doesn't pay interest. So even if you know for sure that inflation is going up, it is not obvious that gold is a good investment. For gold to rise the inflation problem has to be worse than what the market already thinks it is.

21 comments:

Mark A. Sadowski said...

Scott,
Another fine objective post. Remember that I sold my limited stockpile at $993 when I said it would go no higher (at least in the short to medium term). I still don't think I'll have to eat my words. I see it going down to at least $600 once people realize the inflation risk is way overblown (remember Japan).

alstry said...

Scott,

Gold is also a perceived flight to safety....espeically in a feared dollar collapse.

This summer expect the fear "o" meter to go off the charts as hundreds of thousands of teachers and professors lose their jobs....permanently!!!!! In addition, expect even more, perhaps a few million, state and and municipal workers to get fired or suffer material wage reductions.

The fallout to the economy will be severe as interest rates are likely to skyrocket due to few wanting to fund our growing deficit without much productivity behind it.

If people fear the dollar could collapse...Gold could rise to $5000 per ounce.

Public Library said...

Scott,

Your stance is a tad confusing. On one hand, you think everyone is overly pessimistic and that the economy is on the mend and should resume 2-3% growth in fairly short order while the other side of your coin pictures a Fed/Treasury with unsafe amounts of potential inflation fuel simmering in the pipeline. What kind of market do you see generating 3% growth and $600 gold prices? In my eyes, that would require the monetary authorities pitch a perfect game and based on the past 15 years nothing short of a miracle would suffice. We live in a bubble producing nation so where do you think the next one will pop up? Seems people are betting the Fed keeps the peddle to the medal far too long and that once the genie is out of the bottle good luck getting it back in…

Thucydides said...

Given the long term collapse in the purchasing power of the dollar since we went off gold in 1934, the project of trying to come up with a theoretical ("mean-reverting") dollar price of gold seems odd. Of what theoretical importance is some long term average, expressed in terms of a base that has rapidly depreciated, all without regard to supply and demand, which change all the time? To call gold's price "high" says only that it is on the high end of historic prices, at least as expressed in our fiat currency. It really implies little or nothing for the future of the price.

Scott Grannis said...

Public: my "stance" tries to incorporate all that I see out there in the market. Gold is saying inflation is going up, but the bond market says its not. Commodities say yes. The dollar says yes. I've recommended TIPS. Recommending gold is a trickier proposition. TIPS aren't priced to higher inflation, so they are cheap relative to Treasuries; plus, the downside to TIPS is quite limited. Gold is priced to higher inflation, so to make money with gold you not only need inflation to rise, you need it to rise a lot. Gold could maybe double but it could drop by half also. I prefer bets that are more asymmetrical. Commodities don't seem very expensive, on the other hand, so I think they make sense to have.

Scott Grannis said...

Thucydides: Part of the allure of gold is that it has held its purchasing power relative to other things very well over time. One oz. of gold buys about 18 barrels of oil on average, going way back in time. So if the inflation rate accurately measures the rise in the prices of things on average (a rough approximation), and gold maintains its value vs. things over long periods, then adjusting gold prices for inflation should give you a chart with prices moving up and down but always around some mean. I think that's what the chart in fact shows.

It's a way of trying to estimate whether gold has asymmetrical risk or not. Sure gold could go up a lot more, but the chart says it has more potential downside risk--if held for many years--than upside potential.

Thucydides said...

Mr. Grannis: Thanks for your thoughtful explanation. It seems to me that if gold bears a fairly steady relationship purchasing power relationship to other things, then the risk of its price falling steeply depends upon strong action by central bank issuers of fiat currency to bring about deflation. A repeat of Volcker's actions in 1979 - 1982 seems unlikely. Pending some move to "take away the punch bowl," and given the not insignificant risk that current fiscal and monetary pumping will set off various bubbles and lead to serious inflation, the bet seems favorable, at least for now.

MW said...

How are you estimating "fair value" for gold? Is this simply based on a long-term average of the nominal USD price? Or is this based on an econometric model (which may or may not be any better)?

dave said...

Scott,
I read the Seeking Alpha exchange, with you Schiff and Sunshine.

A couple of take away's,

1. Sunshine admits near the end that he doesn't really understand the effect of monetary policy and how markets adjust to changes in supply and demand.

2.Peter is paranoid, almost understands monetary policy but not quite. He says some strange things about real estate and farms and export outside of the United States, as though commodities in the US can't work as an inflation hedge.

3. Those two looked like amateurs compared to you.

Finally on this mornings post:, Gold has discounted the feds errors to date, not into the future.There is still plenty of room for error going forward.

The Obama Administrations shift from the war on terror to a war on business compounds these errors by reducing future growth in the economy, with higher taxes and more and more regulation

I think Bernanke now has his eye on gold but doesn't quite understand it's value in conducting monetary policy.

Tom Burger said...

Scott,

I think this kind of calculation has very limited value. The value of anything depends on purely personal and subjective valuations by individuals meeting up in a market place. Adjusting the historical price of gold with the CPI is an interesting excercise, but it certainly doesn't give you the "real" price of gold.

The very high cost of gold in the 1970s, for example, was in my opinion based on subjective valuations that the US dollar might collapse. It didn't, but that is just an historical fact. If Volcker didn't come along, the dollar might well have gone the way of the Argentine peso.

The relatively high cost of gold now is fueled by a similar fear, and the future cannot be known. If our authorities stop trying to destroy the dollar and capitalism in general, those fears will turn out to be excessive. As of now, however, the jury is still out.

I think your positions right now require a lot of optimism. There is precious little evidence that Washington is going to change its behavior any time soon.

d said...

I think gold is positioned to go much higher IMO. If the FED keeps printing money, the way it has been for the last 2 years, the dollar will continue to loose its luster. Any significant drop in equities will trigger a huge gold rally that could see it pass $1000.

Gold is bitter sweet in a lot of ways. If you buy gold, you are betting against the dollar, and against the US. But you are also protecting yourself from what could come our way. And seeing how bad the Obama administration is handling things, I would place my bets on continued weaker dollar, and higher inflation.

Scott Grannis said...

MW: The "intrinsic" or "fair value" for gold as reflected on the chart is simply the average real price over the period shown on the chart.

Scott Grannis said...

dave: Thanks for the comments. Towards the end of the discussion I began to feel like I was talking to myself.

As for gold: I agree with you that there is plenty of room for error, and that it seems likely. Presumably, should that occur gold could move higher. I'm not saying it won't, just that the burden of proof is on the buyers at this point. There must be further error to stand a chance of making a profit.

If Bernanke came to understand gold, that would be fantastic for the world, but very scary for gold owners.

Scott Grannis said...

Tom: Of course the price of gold at any given time will be a function of many things, and that is the point of this exercise, to try to understand what pushes gold up and down relative to its long-term historical average in real terms. Gold is not going to go up forever in real terms, nor will it go to zero. There is some intrinsic value which prevails over time in spite of the ups and downs.

I've tried to explain that I'm not forecasting gold. It could go to $1500/oz, or it could drop a lot. It all depends on what the Fed does going forward. I think the current gold price embodies a lot of fears that the Fed is going to make an inflationary mistake. So to justify current prices, the Fed must make a mistake. For gold to go higher, the Fed must continue to make mistakes and fears must rise to higher levels than we see today.

lb100 said...

Scott,

Your chart provides a nice departure point for discussion. I'm not sure, though, you adequately qualified the use of these very long-term temporal "price" comparisons. You note, for example, that an ounce of gold has bought 18 barrels of oil for many years. The problem, though, is that a contemporary refinery can do much more with those barrels than could a 1910-era refinery, and consumers are willing to pay more (in dollars or gold) for these newfangled products. Garden fresh vegetables might provide a basis for comparison, but with changes in eating habits I'm not even sure about them.

Isn't part of what's driving gold prices all of those dollar bills sitting in overseas vaults, and the uncertainty surrounding what the Chinese, Russians, etc. will do with them?

Tom Burger said...

Scott,

I agree with what you are saying -- except that I believe the Fed has already made a long series of terrible mistakes. The Fed created the Tech Bubble, the Housing Bubble, and now it's going for the Government Finance Bubble.

As far as future mistakes go, Bernanke really believes that loose money can prevent a depression if it is continued long enough. Unless Bernanke changes his mind or we get a new Fed Chief, future errors are a certainty. We will need another Volcker at some point to prevent a dollar crisis. Somebody just has to say NO!

We have a situation today that is monetarily without precedent: a whole world populated with fiat currencies and central bankers operating with catastrophically bad theories. It's not like we can look at the average result when the Fed Chief decides to create a trillion new dollars and then "suck it out" when the time is right. Our government and the central bank are just "trying things" -- hoping upon hope that something "works." These people don't have any idea what they are doing. Thinking that this is all going to come out right requires a lot of optimism.

In my humble opinion, of course.

Scott Grannis said...

Tom: The Fed has indeed made many mistakes in the past. We agree on that. But I would argue that they have not necessarily made a mistake since they started quantitative easing last September. They probably will make a mistake since it will be hard to withdraw their liquidity injections in a timely fashion. But that remains to be seen.

In the meantime, would you not a agree that there is no sign anywhere out there that what the Fed has done since September is a huge mistake?

Gold prices are virtually unchanged since September. The dollar is a bit stronger. Commodity prices are in fact down. T-bond yields are roughly unchanged. TIPS spreads are roughly unchanged. Credit spreads are WAY down. Volatility (VIX) is roughly unchanged. TED spread is way down. Bond volatility is roughly unchanged.

Ok, equity prices are down, but that is the only market price I can find that suggests the Fed has done something awful. But the equity market might be down because (and I think this is the most likely explanation) Obama's policies have diminished the future growth potential of the US economy. Or, and this is equivalent, Obama's deficits mean that the after-tax present value of corporate cash flows is worth less.

As I learned from my London colleagues long ago, "value over view." You may think you're right, but the market is clearly not supporting your view.

Tom Burger said...

Scott,

Time will tell. The markets loved the housing boom, too, and that has caused a great deal of grief for a lot of people.

The truth is, when the Fed and the Treasury behave as they have, we no longer have anything resembling free markets. We have a lot of people gaming the system.

Scott Grannis said...

lb100: Here's what I think is driving gold to a premium above its long-term intrinsic value: a) fear that the Fed will end up making an inflationary mistake, and b) fear that the global financial crisis will get worse and may cause unintended and unforeseen and dire consequences. All currencies are going down against gold. Everyone is worried about more government intervention in the economy.

lb100 said...

Scott-

Thanks. I certainly agree with points a) and b). However, isn't every currency of consequence backed to a considerable extent by (some of the trillions of overseas) dollars and/or Treasury debt? A weakening dollar will ultimately drive down all currencies. Gold becomes more valuable relative to all currencies, as the likelihood of a run on the dollar increases.

And isn't the notion that gold has an "intrinsic value" a variant of the physical fallacy? The value of anything, including gold, is ultimately determined by countless subjective comparisons with other goods, whose values are also constantly changing (e.g., including crude oil).

Scott Grannis said...

lb100: The dollar does ultimately back up a lot of the reserves of other currencies, and a collapse of the dollar could bring down other currencies as well. But the thing that is really going on is that a lot of other central banks like to keep their currency from getting too strong relative to the dollar (for a variety of reasons which are the subject for another day). So they are likely to follow the dollar down.

My notion of an "intrinsic value" of gold is a relative concept. Gold tends to hold its value relative to other things. Of course relative values change from year to year, but over long periods gold seems unique in its ability to retain purchasing power relative to a basket of stuff.