In a previous article I introduced a model to explain gold price fluctuation in terms of M2 and the dollar index. The model was found to explain 90% of the variability in the gold price over the time period sampled, and it also found that the price of gold should be headed to $1400 an ounce. Given the rally that we have had in gold to start the year, $1400 an ounce is far from an impossibility.
Still, since then I have wanted to include a model that uses the monetary base to explain swings in gold prices. The reason for this is that the Fed is more directly responsible for changes in the monetary base while they generally have less control over all of the components of M2. While this has been attempted in the past, these approaches have fallen short because of the massive increase in monetary base that we saw in 2008. Most of that money went into excess reserves and so still to this day has not entered circulation. Removing this component may give us a keener eye into what is going on with gold prices.
Shown in blue (and red due to excess reserves data issues) is the model. Simply put, it is the monetary base divided by the dollar index. What is interesting to note is how well this model explains the poor performance of gold throughout the 1980's and 1990's, while at the same time explaining the stellar performance of gold after 2000.
The early 1980's seem to be dominated by a bubble in gold that was quickly wiped out but seemed to take nearly a decade to finally correct (or rather, the base finally caught up with the price of gold). Starting around 2000 is when we finally see a marked increase in the model, and gold correspondingly follows.
What I especially like about this model is the fact that it is more directly correlated with Fed actions, and that it explains even smaller movements in the price of gold (such as the mini crash in 2008). Also somewhat explained is the negative movement in gold since the early 2010's. While not going so far as to explain all of this movement, we do see that the model predicts some downward movement in gold, and the length of this downward movement has not been seen since the 1980's.
Still, that huge disparity is glaring, and according to this model gold should be sitting closer to $1600 per ounce instead of around $1200.
This chart has been thrown around often, and quite negligently. According to this simple monetary base to gold ratio, now is the best time to buy gold over the past 40 years. What has always unsettled me about this idea is the fact that gold has been performing so poorly ever since the start of this "best time ever". So what is going on? The problem is the same as before: forgetting to take into consideration excess reserves.
With excess reserves taken out of the picture, we can see a definite devaluation of gold, but we are not looking at the best time ever to buy gold. That said, I do not think that the previous chart can be totally ignored. Excess reserves do matter, and if they spill out then the price of gold will go up in a big way. What I like about this chart is that it shows that even if excess reserves do not go up, that the price of gold will increase from here. There is yet another ratio, however, which may be my favorite currently.
This ratio combines all of my favorite correction factors. It removes excess reserves, but also takes into account GDP. The GDP term in effect models the dollar index itself, as I showed in another article. In essence, this ratio uses the monetary base with excess reserves subtracted and divides by the velocity of the monetary base. This then is divided by the gold price. In all this ratio looks very similar to the previous one, but now more accurately captures the massive move in gold price over the past few years and shows just how unsustainable it has been. Deciding between this model and the previous one is all about whether you trust GDP or the dollar index more. Since last year I have been calling the dollar index a bubble, and so for that reason I trust this second chart more, and so am stocking up on gold.
Summary and Action to Take
Based on the fundamentals I have presented, gold is set for a substantial rise in price. Within the next few years I predict gold will return to at least $1600 per ounce. Over a longer time horizon we are looking at $2000 per ounce. Perhaps most bullish for gold investors is if the Fed loses control of excess reserves, we are then looking at gold far above even this.
For this reason I recommend loading up on gold bullion (the fundamentals for silver are even stronger given that the gold-silver ratio is very high currently as well). This is the safest way to invest in gold since it has no counterparty risks. For those looking for gold equities (and more alpha), try the gold miners. For broad exposure there is the Market Vectors Gold Miners ETF (NYSEARCA:GDX) and for those who really want alpha (and its corresponding risk) there is the Market Vectors Junior Gold Miners ETF (NYSEARCA:GDXJ). Invest according to your risk appetite, and make sure that you have a long time horizon. There are plenty of forces that want to keep the gold price down, and they will not go down quietly.
Disclosure: I am/we are long GDXJ.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.