Gold Approaching Overvalued Mark

by: One Eyed Guide

Gold may have a little more upside due to the flight to safety effects but it is extremely limited. A drop in Brent crude oil will put a sell sign on gold at $1,700.

The traditional sell sign for gold has been when it could purchase over 20 barrels of oil per oz. of gold. It's a little more difficult to use this rule today because there has been a divergence in the price of Brent crude and West Texas Intermediate (WTI) since the beginning of 2011. The chart below shows that Brent crude has been about 25% above WTI most of this year possibly due to speculation concentrated in Brent crude (maybe someone can give details of issues causing this spread).

West Texas Intermediate versus Brent Crude Oil
(Click to enlarge)

At Monday's close, gold was in overvalued territory at $1713.4 against WTI, buying 21.1 barrels at $81.16. It's more or less fairly priced against Brent crude at $103.83, buying 16.5 barrels so there's really no strong sell indicator at this instant.
The issue is the looming, downward, deflationary commodity price trend driven by a slowing world economy. Gold is an inflation hedge and it will give below average returns in a deflationary world. Gold purchases have plunged except as an speculative inflation hedge and deflation could violently pop the gold bubble.

The chart below shows that prior to 2000, gold more or less responded to changes in the inflation rate. After 2000 there was a disconnect as gold rose in tandem with all commodities as the world debt bubble expanded. Now other commodities have started to drop and at some point gold will become relatively overvalued. As gold is well over the marginal cost of production, the drop could be rapid. Gold versus CPI
(Click to enlarge)

If deflationary pressures cause the Brent crude price to collapse to the low 80s to match WTI, gold will clearly be in overvalued territory and prudent investors will take their profits. Courageous (or foolhardy, your choice) ones can see how close gold will get to the upper bubble limit of 30 barrels per oz.

Gold's pullback should not start until after the current economic uncertainty in the United States and Europe clears a little and there's either strong government action to improve world economies or continued deficit fighting leading to recession. The July CPI release on August 18 may generate a significant downward move in gold if it shows a negative total and dropping core inflation.

Lacking government stimulus, if the oil price collapses to the $60 level as is possible based on recent history, gold could quickly pull back to $1,400 to $1,500 or lower. An inflation adjusted price puts gold at $800 or less while the marginal cost of production is reported to be $1,000/oz.

Disclosure: I have various short positions on individual stocks, SPY and NASDAQ but have no current positions in gold or oil.