Gold: Exactly How It's Valued -- A Required Yield Theory Mechanism

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 |  Includes: DUST, GLD
by: Julian Van Erlach

Accepted thinking on gold valuation is that its price is somehow set on a churning sea of supply and demand, fear and greed cross currents. Some fairly compelling inverse correlation has been shown with real interest rates under the premise that since gold "pays no dividends or interest" its alternative holding cost is less when real rates are low, but with no mechanism that shows how the price of gold gets from A to B across peaks and troughs.

This website announces the solution to gold valuation that achieves the below graph without using regressions or other retro-fitting techniques by positing that gold has an actual yield. The model has less than 16.5% absolute variance to actual price 1978-11/18/2001 by applying each key premise below to concurrent publicly available macro economic variables. It fully captures gold's late 70's rise and early 80's fall, flat-line decade and recent parabolic rise.

Graph I Gold vs RYTClick to enlarge
(Click to enlarge)

  • Based on the above ground gold stock/world GDP ratio wherein gold stock has to grow at the rate of world population (explanation in my 2005 Jrl. Of Investing paper) gold yields the same as world GDP/capita growth per Troy Oz. This means the price of gold rises long term, at the rate of nominal world GDP/Oz. (it's more than a constant store of value).
  • There is an effective exchange rate between cash and gold (cash yields minus the inflation rate while gold yields real per capita productivity growth) so when the expected rate of inflation falls, the relative purchasing power of cash rises and gold price falls proportionately and vice versa.
  • When real interest rates fall, gold's worth more, like a long Treasury bond is; and less when real rates rise.
  • The local e.g. USD$ price of gold is also an inverse function of GDP-weighted exchange rates.

Data Elements Used in the RYT Gold Valuation Model

  • IMF World GDP Forecast; Actual GDP Growth; World Population World Bank, Maddison World Data.
  • IMF World Inflation Forecast; Actual Inflation Rate.
  • World Gold Above Ground Stock; Mine Production: World Gold Council.
  • U.S. Exchange Rate: DXY and related measures.
  • Treasury yields across the term spectrum; U.S. and World
  • TIPS yields.
  • Blue Chip Inflation Rate Forecast.
  • Effective marginal capital gains, income, deferred tax rates.

Overview of the Valuation Mechanism

The mechanism in the referenced paper is patented and the exact, since enhanced valuation formulas are patent-pending, but to boil it down: the price of gold is fair now. The near-term keys to gold price are real rates and inflation expectations with minor exchange rate impact. If real rates fall along with potentially lower world growth outlook, gold will rise. However, since lower inflation expectations, unless offset by massive QE, tend to go hand in hand with lower growth, these will work against gold. Bottom line: not great upside for gold from here with plenty of downside if inflation expectations fall faster than real rates do. If the latter happens, downside to stocks makes the gold mining companies' downside greater than that of gold itself. I'd be long DUST, the leveraged gold miner ETF if you believe that near-term growth and inflation prospects are falling.

What's happening today (11/21/11) as I write is that the USD$ via the DXY is up .3%, real rates are falling, BUT expected inflation is falling FASTER via the TIPS spread to like term Treasuries, so gold is off nearly 3% EXACTLY as the model predicts.

For a more detailed discussion including the solution to Gibson’s Paradox which proves that gold has a real yield, see here.

Intellectual Property Notice:

Required Yield Theory and RYT are trademarks. Required Yield Theory is patented in the U.S. under two patents (US #7,725,374, and allowed Serial No. 12/766,956). Public domain formulas may not be used in computer applications without license from the author. Asset managers wishing to learn about the applications for gold valuation may contact the author. Formulae and data will be provided under NDA for evaluation.

Disclosure: I am long RUSS. I am also long YANG