For those who believe in hard money and understand the magnitude of inflation being created, gold’s valuation (when priced in USD) is worth taking a look at. Though the practice of trying to determine a rough estimate of the intrinsic value of the gold price is essentially a fool’s errand if taken literally, it can help illustrate to what degree gold is undervalued. The following indicators (which many may know already) all point towards a strong uptrend in gold over the coming years. To be conservative and as broad as possible, using the M3 monetary aggregate serves as the best measure of the money supply to use.
· M3 Yield – Meant to give a very rough estimate of what the current price of gold should be if we were to revert back to the gold standard. For simplicity’s sake, excluding the growth in the gold supply is used to determine the ratio. This should more than be negated by excluding worldwide ownership, etc.
o In Feb 1914 – M3 yield = 100%
o As the US inflated the money supply in the early '20s in order to help Britain, the yield declined to nearly 38%. As this was a period of a partial gold standard, the government was forced to debase the currency relative to gold (increasing from $20/oz to $35/oz). Thus in 1934, the M3 yield surged to 75%.
o This yield continued to decline, and lay at 50% before WW2. As the government was forced to inflate once again (to fund war efforts), the yield came under enormous pressure, declining to 20% by 1949.
o Following the war, all the Fed Chairmen instituted an easy money policy. In other words, the yield became under a prolonged period of downside pressure, reaching 10% by 1962. By 1970 (which marked the end of the partial gold standard era), the ratio has declined to 5%.
o Despite the easy money policies of the 1970s, gold was still considered real money. As the fixed exchange rate between the USD and gold was lifted, the yield doubled in less than three years. As consumer price inflation took hold during the mid-late 70s, the ratio shot up 350% to 35% in 1980.
o Conclusion: Reverting back to a gold standard today would require a minimum gold price of $ 5,000/oz. This excludes the projected 7-9 trillion dollar deficit by 2015 (the sum of all the budget deficits from 2008-2015) among other things.
· The Fear Index – (Highlighted by James Turk) –. The aim is to determine whether gold is attractively priced at any given period of time.
o ( US Gold Reserve ) * ( Current Gold Price ) / M3
o The fear index (currently at 2%) has not seen this level (pre-2000) since Nixon abandoned the gold standard as the USD became the reserve currency.
o This index has been rising since the start of 2000, despite the enormous downside pressure with the growth in M3
o This index has averaged over 7% since the institution of the Federal Reserve, spiking to a high of 30% over this time period. A better comparison would be that of the mid-late 70s. Although I don’t think it is possible to escape with that outcome this time around, it is still worth looking at the fear index during this period. The Index more or less rose constantly from 1970-1980 or from 1.98% (1970 low) to nearly 12% in 1980.
o Conclusion – The fear index indicates gold is undervalued.
· Projection based on monetary expansion –
o The M3 money supply has increased 303 fold from the institution of the Federal Reserve to Dec 2009.
o Assuming gold was accurately valued in 1914 (when gold reserves were able to back the entire money supply), the inflation adjusted price equates to $6500/oz.
o Assuming gold was accurately valued at $35/oz when the gold’s exchange rate was adjusted, the adjusted price today equates to $3600/oz.
o Assuming Gold was worth $150/oz in 1972 – the inflation adjusted price would be $3331/oz.
o So a gold price in a range between $3331/oz - $6500/oz should prevail today. We also have to take into account the magnitude of the inflation not taken into account via M3. Assuming we do get away with an annualized inflation rate of 6% over the next decade (fingers crossed...), the range of gold’s fair market value rises dramatically ($6,000/oz - $11,500/oz).
o Conclusion: The Gold price is undervalued
· Sound Money Indicator – (Also highlighted by James Turk)
o An alternative measure of what price gold would have to be in order to revert back to the gold standard. This doesn’t use any monetary aggregates, just an approximation of how much a 1934 dollar has retained in purchasing power. The SMI is (1/purchasing power retention) * Current gold price.
o Using James Turk’s 11.5%, it would cost approx $9,391/oz in order to return to a gold standard. Whether this is accurate is immaterial as substantially higher values still render a gold price many times lower than the current $1,080 spot.
o Conclusion: The Gold price is undervalued
These all show gold is undervalued, and to what degree is also up for debate. While some of these seem rather outrageous it is important to remember these measures only take the U.S. into account. Investment demand will play an enormous role going forward because it isn’t just the U.S debasing their currency, but rather all of the major world economies.
Disclosure: No Positions