The debate between fiat currency and variations of the gold standard is intensely political as much as it is economic. My aim is not to discuss the virtues of either system or comment on policy; rather I would like to discuss the realities of present monetary policy in terms of its effect upon the price of gold in the context of value investing.
Value investing can be a rather generic term. The core of value investing, though, is the assigning of value to assets, determining the precision of the assigned value and then inferring an appropriate margin of safety. Can this form of analysis be done with gold the same as it often is in regards to corporate bonds or equities? And if so, what does it say about the attractiveness of gold at its current price of $1,341? Before answering the question, first consider a brief review of gold's use as money in the United States.
The Definition of Money in the United States
Alexander Hamilton’s fingerprints blanket the foundations of the United States economy to such an extent that it remains rather astonishing today. Most famous of these was the deal he brokered with Jefferson that allowed for the federal government to assume war debt belonging to individual states and the creation of the Bank of the United States.
But the legislation that Hamilton authored that led to the formation of the mint is also of critical importance. The Coinage Act of 1792 created a bimetallic monetary standard that lasted until the Civil War. Section 9 of this act (properly referred to as “An act establishing a mint, and regulating the Coins of the United States”) established the value of a dollar as follows:
And be it further enacted, That there shall be from time to time struck and coined at the said mint, coins of gold, silver, and copper, of the following denominations, values and descriptions, viz. Eagles--each to be of the value of ten dollars or units, and to contain two hundred and forty-seven grains and four eighths of a grain of pure, or two hundred and seventy grains of standard gold. Half Eagles--each to be of the value of five dollars, and to contain one hundred and twenty-three grains and six eighths of a grain of pure, or one hundred and thirty-five grains of standard gold. Quarter Eagles--each to be of the value of two dollars and a half dollar, and to contain sixty-one grains and seven eighths of a grain of pure, or sixty-seven grains and four eighths of a grain of standard gold. Dollars or Units--each to be of the value of a Spanish milled dollar as the same is now current, and to contain three hundred and seventy-one grains and four sixteenth parts of a grain of pure, or four hundred and sixteen grains of standard silver. Half Dollars--each to be of half the value of the dollar or unit, and to contain one hundred and eighty-five grains and ten sixteenth parts of a grain of pure, or two hundred and eight grains of standard silver. Quarter Dollars--each to be of one fourth the value of the dollar or unit, and to contain ninety-two grains and thirteen sixteenth parts of a grain of pure, or one hundred and four grains of standard silver. Dimes--each to be of the value of one tenth of a dollar or unit, and to contain thirty-seven grains and two sixteenth parts of a grain of pure, or forty-one grains and three fifth parts of a grain of standard silver. Half Dimes--each to be of the value of one twentieth of a dollar, and to contain eighteen grains and nine sixteenth parts of a grain of pure, or twenty grains and four fifth parts of a grain of standard silver. Cents--each to be of the value of the one hundredth part of a dollar, and to contain eleven penny-weights of copper. Half Cents--each to be of the value of half a cent, and to contain five penny-weights and half a penny-weight of copper.
In summary, the relative values of the dollar, gold, silver, and copper were as follows. As a note, pure gold and silver are rather soft and so it is usually alloyed with another metal for coinage and thus the establishment of a “pure” and “standard” amount of material in a coin. This is not necessary for copper. So, all the “pure” and “standard” figures indicate were that the gold coins were 92% pure (or 22 karat gold) and the silver coins were about 89% pure.
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Although this specifically refers to coins, paper currency was backed by proportionate amounts.
Notwithstanding some slight adjustments, this bimetallic system stayed intact until the Civil War when unbacked paper currency (“greenbacks”) was issued to pay for war. This was reversed at the beginning of 1879 when Congress declared that the roughly $347 million of greenbacks still in circulation (from an original amount of about $450 million) be convertible to gold, but Congress not only backed paper money with gold they also backed silver with gold at a conversion of 16 to 1 (Hamilton’s original ratio was 15 to 1). Silver supplies grew more quickly than gold and gold predictably fled the treasury until a crisis ensued in 1894 when J.P. Morgan engineered a plan to save the gold standard.
Two key events in the past century are responsible for permanently ending the gold standard in the United States. First, Franklin Roosevelt ended the gold standard through multiple acts in 1933 and 1934 that ordered all gold bullion be returned to the treasury and made it illegal to trade gold. The establishment of what became known as the Bretton Woods system following the Second World War returned some semblance of the gold standard. It was still illegal for individuals to hold gold but the price of gold was set at $35 and gold could be redeemed at that price by foreign central banks.
As such this system had more to do with fixed exchange rates than a gold standard and the collapse of fixed exchange rate systems are usually the result of a lack of confidence. As world economic output grew, the necessity for central bank reserves grew as well and these were mostly denominated in dollars. At some point push comes to shove and people realized that the United States would not be able to permanently honor the conversion of dollars to gold at $35 per ounce and the system ended in 1973.
It may be dry, but I hope that this history helps explain the historical willingness to hold gold and points towards a means of understanding what value gold may hold today. It will also be a starting point for examining various historical price points of gold. Gold is basically indestructible and cannot be created out of thin air. This is why it has made an ideal monetary asset: those holding it do not typically have to worry about unexpected devaluations compared to fiat currency.
Many base a determination of the value of gold on the level of inflation over time. This is not altogether appropriate if gold is to be viewed as a currency rather than a commodity. Suppose that over a meaningful period of time the money supply increases at a rate of 3% a year. Does this mean that the inflation rate would also rise at 3% a year? No. If output growth also occurs the demand for money to be used in transactions will also rise. If real output growth is also on the order of 3% then inflation will actually be about zero.
This is by no means a law, but so long as the demand for money mirrors output growth it is a reasonable approximation. If gold was used as a currency over this same time period and gold production increased aggregate stocks at a rate of 1% a year, the result would be deflation despite increasing gold supplies. To strictly interpret gold in this manner would indicate that the price of gold in dollars will vary with the supply of each such that if the aggregate dollar money supply increases by 5% and gold production increases global supply by 2%, then the price of gold would increase by 3%. (This is a linear approximation, but produces a very close estimate to the true value.)
If instead gold is best viewed as a commodity used in jewelry and electronics then it would seem reasonable that its price would mirror inflation.
Aggregate Money Supply, Gold Production, and Inflation Since 1913
According to Federal Reserve Bank of St. Louis data, M2 has increased at a rate of 6.34% per year since 1913 and inflation as measured by the CPI has increased at a rate of 3.24%. The World Gold Council states on its website that the total gold stock in 2009 was 165,600 metric tons and the US Geological Survey provides annual production numbers. Combining this information gives the historical global stock of gold. It has increased at a rate of 1.55% per year since 1913.
Based upon the previous argument that would stand to reason that gold prices should have increased at a rate of 4.79% per year, but it also leads to a difficult problem. In order to determine the fair value of gold today we have to decide on a fair value at some previous time. Was the price of gold fairly priced in 1913 when the Federal Reserve was chartered? Was it fairly priced in 1934 when Roosevelt devalued the dollar to $35 per ounce? Was it fairly priced at the birth of the Bretton Woods system?
The chart below compiles a handful of important events, the subsequent growth in M2 and gold stocks, and the implied current fair value if gold was at fair value at the time of the event. The values largely form two clusters.
It is safe to disregard the price of gold at the time that private entities could begin trading it in 1968. After all, if gold had been fairly priced the system would not have collapsed. The other values are open to interpretation. My best estimate, viewing gold as a currency, is an average of the last top and bottom which implies a value of $1,315.
The chart below shows, starting in 1913, the price of gold adjusted for the gap between money and gold growth (blue), the price of gold adjusted for inflation (green), and the actual price of gold (red). The nominal gold price used is a yearly average.
It seems that historically the actual price of gold has been bounded by these two values. That may be a strong suggestion that the view of gold has drifted between a commodity to be used and as a monetary asset.
Additional Reference Points
The number of troy ounces in gold required to buy the Dow Jones Industrial Average is an often quoted figure. Since 1913 there have been three tops: in 1929 (13.3 to 1); 1965 (26.2 to 1); and 2000 (39.9 to 1). The two bottoms that occurred have been in 1934 (2.9 to 1) and 1980 (1.47 to 1). It is somewhat unexpected that the 1980 bottom was at a lower level than the 1934 bottom. Although volatile, the trend has been towards an increasing ratio.
A simple exponential regression in excel puts the current fair value ratio at about 15, while the average since 1913 has been 11. The Dow is currently 11,871 and the price of gold $1,341, so the current ratio is a little less than 9. It would seem that the stock market is historically cheap in terms of gold. The chart below is derived from yearly averages with an exponential trend line.
During the 19th century significant silver discoveries and production caused the gold price to silver price to spike. Despite volatility, the long term ratio over the last hundred years seems to have been more constant as this chart depicts. The current price of silver puts the ratio at about 50 - very close to the average over the time period displayed.
A Value Perspective
Based upon the preceding analysis it does not seem that gold is in any way priced in levels that would deem it to be significantly overvalued, but nor does the current price seem to offer a margin of safety. The current price of $1,341 seems to be close to fair value and calculating any fair value for gold is somewhat imprecise. Bull markets do not tend to move an asset back towards fair value and then die - they almost always overshoot. It is very much a possibility that the current bull market in gold (despite unavoidable corrections) will take gold much higher, but this is speculation and not value investing. For those believing that gold should strictly be viewed as a monetary asset, fair value may be close to $1,800 to $2,000 and that price may in fact be supported by central bank purchases around the globe. Markets, though, to not seem to be historically unanimous in viewing gold in this way.
For those wishing to have exposure to precious metals it should be noted that silver seems fairly valued against gold, so there may not be much advantage to investing in silver rather than gold.
Today's environment provides few extremely attractive opportunities. The stock market is not deeply discounted, interest rates are still low (particularly short term interest rates), real estate has corrected but not beneath its long term trend, and after a decade it has become hard to argue that commodities are cheap. With gold, as with these other asset classes, patience is important. For now, the best course seems to be to selectively invest in equities that are cheap relative to the market and position yourself to be able to exploit future opportunities whether they be in gold or elsewhere.