Is gold (NYSEARCA:GLD) overvalued?
This is not a simple question to answer. The ability to value gold assumes that the metal in fact has a "correct" value. In reality, the correct value for gold is whatever people are willing to exchange for it. The exchange could be in terms of goods and services or paper money, but the exchange ratio depends as much on the supply and demand for gold as it does supply and demand for other goods, services and paper money. In this sense, gold can be evaluated as a currency, rather than an income-generating asset, with its value determined by the variability of the world around it.
So while Friday's gold close of $1747/oz sounds like a high, and therefore overvalued, number, without the perspective of how other variables, such as the U.S. dollar, equities, the Swiss Franc, etc. are moving in relation to gold this number is meaningless. A high absolute number isn't an indicator of overvaluation, just as a low number isn't an indicator of undervaluation. Moreover, a rising price isn't necessarily an indication of rising valuations, just as a falling price isn't necessarily an indicator of declining valuations. These truths are not only relevant in the world of gold investing, but should be understood by anyone investing in any asset class.
As I alluded to earlier, a stock can be valued by discounting future cash flows into the present. Gold, however, does not produce a cash flow and must be valued in relative terms. Below I have attempted to show how gold has performed relative to a number of other assets and measures over various periods. Highlighting the complexity of gold investing, determining whether gold is undervalued depends on what it is measured against and during what period it is measured. This means that gold can be seen as both overvalued and undervalued at the same time, as we will see below.
The first two graphs indicate that gold may be overvalued relative to the price of various assets. The first graph compares gold with a number of components of consumer spending (food, education, etc.) and raw materials over the past decade. Based on this comparison, gold has appreciated much further than the prices of consumables, services and manufacturing inputs.
The second graph compares nominal home prices to gold over the past century. There appears to be a loose relationship over the long-run, with gold experiencing periods of large divergence. Based on this chart, gold started outperforming housing around 2008. It now appears like the gold price is vastly divergent from real estate prices, suggesting that gold is overvalued relative to real estate.
The next chart shows the same information in a different format. Based on the home-price-to-gold ratio, now might be a good time to consider shifting assets from gold to real estate.
Despite what the above charts tell you, there are other comparisons that suggest that gold is undervalued. As you might have guessed, the relative valuation of gold depends on (a) what you compare it to, and (b) the period analyzed. Change these two variables and you get a completely different view of gold.
The charts below look at gold relative to two variables that more-or-less define the credit-based expansion that began in the early 1980s. Relative to the stock market and money supply, gold appreciation falls far behind suggesting that gold is undervalued. (Of course, the first two decades of this data include a bear market for gold, but if one is using credit expansion as the basis for comparison the time-period is appropriate.)
While money supply and risk-asset growth are the hallmarks of a credit expansion, since these are the variables that most-impact individual nominal wealth, any analysis of credit growth is incomplete without considering debt. For anyone bullish on gold, the growth of U.S. federal debt - as shown in the chart below - adds further support to the view that credit expansion has far outpaced the rise in gold prices. In fact, the growth in U.S. federal debt dwarfs the growth in money supply, equities and gold. By this measure, gold is undervalued.
Bottom Line: The aim of this exercise is to show that gold valuation is fraught with problems. Analyses are period-sensitive and methodology-sensitive. Nevertheless, while some might view the results of the above as inconclusive, I interpret the data to be bullish for gold.
Firstly, I believe the post-1971 data is more robust, since prior to Nixon closing the gold window in 1971 price data was more distorted by government intervention. Secondly, comparing gold against CPI components, such as food and education, may be inappropriate since these are all effects of the same cause - namely, credit and money supply expansion. Just as small cap stocks are expected to rise faster than large cap stocks in an equity bull market, gold may rise faster than goods and services when the dollar is being debased. Moreover, comparisons against goods, services, raw materials and real estate don't adjust for the supply-demand variable in each market.
If one views gold as a currency (a currency that cannot be rapidly expanded), the purest way to evaluate gold is to compare it to the elements that determine the value of the currency gold is priced in. In other words, gold valuation is most meaningful when it is compared with factors related to credit expansion. In this light, and until money supply, debt and equities decline significantly, it appears that gold is vastly undervalued.
Clearly I am hypothesizing, partly to work through the problems in my mind and partly for the sake of debate. So here are the questions I ask you. I'd love to hear your thoughts:
1. What do you think is the best way to value gold?
2. What is the appropriate period for evaluating gold?
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: I am long gold. This is not advice. While Plan B Economics makes every effort to provide high quality information, the information is not guaranteed to be accurate and should not be relied on. Investing involves risk and you could lose all your money. Consult a professional advisor before making any investing decisions.