Tuesday, December 30, 2008

Intrinsic value of gold

It is said that gold is precious because it doesn't oxidize, it is relatively scarce, it is beautiful, and it is the only thing proven to hold its value over long periods. If gold is a good store of value, maintaining its purchasing power relative to other things over time (e.g., one ounce of gold buys about 20 barrels of oil on average), then it must have some intrinsic value around which its actual value fluctuates.

This chart is a crude attempt to find that intrinsic value, which I'm guessing is about $400/oz. give or take a bit. My rule of thumb for interpreting gold prices (which I don't try to predict) is that when gold trades above its intrinsic value, as it is now, that means that people are willing to pay a premium for its qualities. It's trading at a premium today because monetary policy is accommodative, and because geopolitical tensions (e.g., India/Pakistan, Israel/Hamas) are elevated. Gold tends to trade below its intrinsic value (e.g., in the 50s and 60s) when monetary policy is tight and inflation risk and geopolitical risk is relatively low.

So if you are considering buying gold these days, you need to keep in mind that it is somewhat expensive. That's not to say it can't pay off, but there is a hurdle that needs to be overcome (i.e., fears of rising inflation and geopolitical disasters need to be realized) before gold prices can move higher. In addition, there is the issue of timing: over the next 10-20 years I would predict that gold will tend to drift back to its intrinsic value, thus rendering it a very poor investment—and don't forget that gold is one of the very few things that doesn't offer any yield. But that doesn't rule out gold going to $1500 should the Fed fail to withdraw in a timely fashion the massive amount of money it has supplied to the market in recent months.

Something to think about.


prophets said...

1. how exactly do you compute this intrinsic value other than just taking the arithmetic average of the price over an extended period of time?

2. why does the intrinsic price of gold never increase in time according to your chart? by your method, it seems like there should be only 1 flat price for oil, wheat, silver, or any other commodity over the course of 100 years.

3. how is the fed going to be able to withdraw such a mountain of liquidity to the market? part of arresting control of deflation is predicated on accepting the knock on effects of higher inflation later, such that you eventually even out to 1-3% inflation (ie. price stability).

continue to enjoy the blog and your thoughts. happy new year calafia.


Scott Grannis said...

This is not science. I'm guessing that the intrinsic value of gold is the average inflation-adjusted price over long periods. The price around which it fluctuates over time.

The chart shows prices in constant inflation adjusted dollars, so it really shouldn't increase or decrease over time if gold holds its purchasing power.

I think the chances of the Fed withdrawing liquidity in a timely fashion--and thus avoiding an increase in inflation--are slim to none.