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For the past 10 years, investors have had almost nowhere to hide – that is, almost no asset that would let them preserve wealth and make a little money over and above inflation.
Oh sure, a few stocks have done well – including a number of our recommendations. But stocks in general, bonds, cash, real estate, etc. have been disappointing.
The one exception has been gold. Gold prices have risen each year since 2001. From its low of around $250 in the late 1990s, an ounce of gold today costs roughly 5X more, and its annualized rate of return since then has averaged 15% - far in excess of the inflation rate. In fact, no other major asset class has been so rewarding during this period.
Moreover, gold has withstood the test of time. Since it started trading publicly in the early 1970s, its returns have closely matched those of the S&P 500.
Traditionally, investors have regarded gold as an inflation hedge. It certainly served that role in the 1970s. However, gold is more than just an inflation hedge or a tool for diversification. It's also a powerful deflation hedge.
For example, one way to get an idea of how gold has fared over the long term is to look at the history of Homestake Mining. This gold company, which is now part of Newmont, began trading in 1879 and was listed on the exchange for more years than any other stock. During the deflationary period of the Great Depression, from 1929-36, Homestake's share price went from $65 to $544.
Gold also rose 100% during the deflationary period from 1814 to 1830, and its gains over the past 10 years were made under deflationary conditions.
In fact, if we look a little deeper, we can see that gold is not really a ‘flation hedge but a hedge against the debasement of currencies, particularly the U.S. dollar. Gold functions as a currency more than a commodity. It was used as money for most of history, and it is still the money of last resort when all others fail.
Both inflation and deflation can lead to the debasement of currencies, and that's why gold prices rise during both phenomena. Gold prices soared in the 1970s as higher oil prices led to a higher cost of living and thus a weaker dollar. Today, governments around the world are trying to combat deflation and recession by debasing their currencies through liquidity and spending. So again, weaker currencies mean higher gold prices. Whatever 'flation we get, it's good for gold.
With gold prices rising so strongly, many have started wondering if gold is in a bubble – and just how high gold prices can go before they peak.
We said last week that gold could take a little breather in the next few weeks. However, looking at the 5-year horizon, gold appears far from expensive today. If anything, its upside potential is tremendous.
One way to judge whether gold is over- or under-priced would be to look at the ratio between the gold supply and the money supply. However, nations today have very different ways of measuring money supplies. (For instance, the U.S. no longer calculates M3, which was a very useful measure in the past.)
A more accurate way to evaluate gold today is to look at the ratio between gold prices and the Gross World Product (like GDP, but for the entire planet), before inflation. This tells us how much gold there is in the world versus the goods produced in the world. Because gold is one commodity that doesn't get consumed or destroyed the same way as oil or iron, the price of gold is a good reflection of the total value of its supply.
The simple premise here is that the more volatile and iffy the world the greater the need for a shelter. And the larger the ratio of gold should be to underlying economic activity.
Since the early 1970s, the ratio of gold:GWP has averaged 0.65. Today, it stands at 0.57, which tells us that gold is actually cheap today, despite its gains over the past decade.
So how high would gold prices need to go before they could be considered overvalued? The last time gold peaked was in 1980, when the ratio averaged 1.72. At the absolute peak in February that year, the ratio was over 2. Therefore, gold prices would have to more than triple from today's price before we would consider gold overpriced relative to its past peak. Specifically, we would be looking at a gold price of $4,300 per ounce.
However, we actually think gold's potential is even greater. In the 1980s, for instance, there were ready answers as to what was wrong with the world and how it could be fixed. Today, the solutions are not so clear. We have no Paul Volcker-like figure who can assure us that commodity prices will stop rising, that China will stop growing, or that U.S. real income will stop falling. There are no magic bullets in the chamber, and the cavalry isn't racing towards us over the horizon.
Besides, we calculated that ratio based on today's GWP. Over the next five years, growth will rise some 5% annually (remember, this is nominal growth, not real growth). The price gold must reach to return the ratio to its previous peak will also rise. Our five-year target for gold prices comes to $5,500 per ounce.
Of course, this assumes that the process of currency debasement will be no worse than it was in the 1970s. In fact, it could be much worse, which would mean the gold:GWP ratio could rise much higher before peaking.
The bottom line is that, until we have a basis for low-inflationary economic growth – that is, growth without currency debasement – as we had in the 1990s, gold prices will continue to rise in an accelerating trend.
The other question you may have is whether gold or gold stocks will give you the best return. We lean towards gold stocks as the potentially largest source of investor profits. However, at the same time, we must be careful what we wish for.
Since 1972, the ratio of gold stocks to gold has averaged between 0.2 to 0.4. At the peak in 1974, the ratio reached 0.61. That's when gold stocks were worth the most in terms of gold.
A high gold stock:gold ratio turns out to be a good sign that gold is in a bubble or at least ready for a big correction. A high ratio (everything else equal) means investors are pricing larger gains in gold than they do on average. In the years that followed 1972, gold prices fell by a third. (Gold stocks also corrected, but not as much.) And this has been the pattern over history. The higher the relative strength of gold stocks, the less likely gold prices will rise.
On the other hand, when the relative strength of gold stocks falls under 20, as they did in 1979, it bodes very well for investors. Gold prices spiked to a record high in 1980 that stood for the next two decades.
Today, the ratio of gold stocks:gold stands at a very low 0.1474. Apart from October 2008, this is the lowest level the ratio has ever been at. It tells us that investors are still pessimistic about where gold prices are headed. This confirms our opinion that gold is undervalued, and that gold stocks have a very long way to rise.
In fact, if gold prices do rise more than 4X over the next five years, as we expect, gold stocks would have to soar 8-10X higher just to reach the historical average.
All this tells us that investors ought to be buying gold now and buying aggressively on any dips that arise. We used to recommend you hold 10-15% of your portfolio in precious metals, but we have no objection if you want to raise that percentage. The more nations debase their currencies, the more gold will reward you.
Even if you just see gold as insurance against potential 'flations, that insurance is very cheap right now. What's more, until the world economy gets a lot healthier, your need for insurance is very high. So take advantage of the opportunity.
If you've been reading TCI, you know the easiest way to invest in gold bullion (NYSEARCA:GLD). Regarding gold stocks, we like large caps such as Barrick (NYSE:ABX), Randgold (NASDAQ:GOLD), and Newcrest, or a basket of miners like ASA Ltd (NYSE:ASA). We also expect some of the highest returns will come from small caps like Osisko and NovaGold (NYSEMKT:NG) that have large resource bases and huge growth potential.
Source: Gold's Price May Be Up, But It's Still Cheap