Using History to Determine Gold's Intrinsic Value

Includes: DGL, DGZ, GDX, GLD, IAU, UGL
by: John Tobey, CFA

One of the most troubling questions to non-owners of gold is what gold’s value should be. They have watched the price climb in puzzlement. It just traded at $1,460. Last year at this time it was $1,140. In 2009, it was $880.

Investors hear that gold is an inflation hedge. But that 65% increase over the past two years is over twenty times higher than actual inflation. Even in stable Switzerland, gold is rising. Crazily, deflation-burdened Japan is watching gold climb.

What’s going on with gold? Are we running out? Are there new, large industrial uses? Have investors found a way to squeeze some income out of the metal? No, no and no. The cause is simply supply and demand. Basically, supply is stable and demand has grown. In order to entice sellers, buyers have had to bid up the price.

Why should the price rise from here?

Proponents think gold’s price is too low for a number of reasons. Primary is that coming inflation will be very high, brought on by excess government spending, borrowing and money printing.

As a follow on to that high inflation, they think governments will begin moving (voluntarily or involuntarily) toward a "hard currency" and away from the current fiat (paper) currency systems. Gold’s supporters see the price rising dramatically as the enormous monetary systems have to be meshed with gold’s much smaller supply.

They also think gold is "under-owned," meaning there are many natural investors (both individuals and institutions, like pension funds) who have yet to understand gold’s merits. When they do, the added demand will cause gold to rise.

Now back to the original purpose: Determining gold’s intrinsic value

Investors know that their bond and stock holdings have ways of being valued. Those investments can’t sell at simply any price. There is a market-derived balance as investors, each with their own thoughts about value, decide to buy and sell based on the security price’s relationship to that value.

But what about gold? Where are the valuations? Because gold doesn’t provide income, yield calculations are out. Likewise, there is no management of those gold bars, looking to turn a profit by making a better use of the metal. And, unlike virtually every other commodity, industrial uses are paltry. Decorative uses (especially jewelry) are bedeviled by both producers’ and buyers’ actions – i.e., using less quantity, lower quality and even substituting other metals to keep prices/spending in line.

The answer: Derive gold’s intrinsic value from its monetary history

We do have a way of backing into gold’s intrinsic value: Examine its lengthy history as money.

While there are good records for the U.K. going back centuries, it’s more relevant to examine the U.S. history. During the decades of "hard money," the dollar prices equated to ounces of gold. This link was due to properly weighted coins and currency exchangeable into gold.

The beauty of this link is that we can then analyze the U.S. price history in ounces of gold, bypassing the middleman, dollar.

Here is the graph showing the fluctuation of prices in gold ounces for the U.S. monetary history. (I realize this is a busy graph but felt it was important to place all the information together.)

Gold price historyClick to enlarge
(Click to enlarge)

Here are a number of points to note:

The lines show the number of gold ounces to make an inflation-adjusted purchase (the CPI basket) worth $1,000 today. For example, that basket’s price was 2.14 oz. in 1790 when the official gold price was set at $19.39. The dollar price, then, was 2.14 oz. times $19.39, or $41.49.

As noted on the right-hand scale, a rising line can be due to inflation (usually) or "revaluation" (rarely – for the U.S., never). Conversely, a falling line was due to either deflation (often associated with a recession/depression) or devaluation (in the U.S., done twice officially – 1834 and 1933 - and then continuously by letting market forces take over – beginning in 1971).

Clearly, wars were inflationary periods as goods became scarce, and prices rose – i.e., more ounces of gold were needed to make purchases.

The purple line is based on the market price of gold. The green line uses the government’s official price of gold. The only real separation occurred during the Civil War when the New York market price for gold rose well above the official price.

The key points:

Each setting of the government’s official price took the ounces of gold needed to buy the CPI basket to about the same level. Since 1971’s market-based pricing took effect, similar average levels have occurred, although the swings have been large.

1790 initial setting = 2.14 oz.

1834 devaluation = 1.84 oz.

1933 devaluation = 1.75 oz.

1975-1976 market devaluation base = average of 1.75 oz.

1980-2001 market average = 1.80 oz.

2001-current market average = 1.83 oz.

And the answer is …

Using these numbers, we get a range of intrinsic values from $467 (times 2.14 oz. equals $1,000) to $571 (times 1.75 oz. equals $1,000).

In summary

By looking at gold’s purchasing power over the past 200+ years, we get an indication of an intrinsic value. Is that 1.75-2.14 oz. range still appropriate? It’s hard to say with certainty, but even during the past 35 years it seems to have held – albeit with wide swings. Two results come out of this analysis:

  1. History has provided a long-term indication of intrinsic value, and it can serve as a place to start – a "null hypothesis" that needs to be disproved by those who believe today’s price (or beyond) is the "new normal."
  2. While the market-based swings from 2.08 to 0.62 to 2.98 to 0.69 have a representative average, they lack agreed-upon rationale. These moves, then, can serve as good case studies to provide the answers that skeptical investors need.

A final point for investors

Gold’s current value, at 0.69 oz. ($1,460 per oz.) has no historic basis other than the 1980 bubble level of 0.62 oz. And that was a bubble. Therefore, today’s gold price carries high risk.

For some additional views and analysis, see my previous write-ups:

"Gold: A Wonderful, Terrible Global Investment" (June 9, 2010)

"Gold: 1980's Highs May Dampen 2011's Enthusiasm" (March 18, 2011)

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.