Stocks have quite a few variables that can affect their prices. Free cash flow, earnings per share, future expectations, "secular rotation," and right now, the whims of Angela Merkle and dozens of other European politicians. It seems like European Central Bank President Mario Draghi is the latest market driver, sending stocks and bonds in various directions, based on his comments regarding Spanish debt.
Rumors about QE3 (the third round of quantitative easing) are swirling leading traders and investors alike to a renewed interest in the yellow metal. Some have speculated that the printing press is getting warmed up to unleash billions of dollars into the US economy.
Relatively speaking, gold prices seem simple. It seems like classic economics. There is a downward sloping demand curve and an upward slopping supply curve. You find where these two intersect, and you magically have a market price. So simple…unfortunately, it's not that easy, and the recent volatility in the price of spot gold suggests that the market really can't settle on the efficient market price.
Does that mean free markets don't work? Absolutely not, but at www.valuentum.com, we try to find the intrinsic value of assets, which makes determining the real value of gold much more difficult than you might expect. Unlike stocks, you won't see gold paying out cash dividends, nor does it provide any free cash flow. If you think gold can outperform other assets, it literally has to be a supply and demand case. Either the supply decreases or the demand increases, and the price of gold will go up accordingly.
However, the factors driving supply and demand are what truly need to be in question. We believe the demand of gold is driven primarily by two forms of demand: speculative (investment) demand and end-user demand.
Don't let the name "speculative" alter your view. In spite of popular opinion, there isn't anything wrong with speculation. Often speculation brings more liquidity to markets and has made (and sometimes lost) many fortunes. But it enables price discovery...eventually.
In this instance, gold has exhibited many "greater fool" tendencies and the making of what many characterize as a bubble. The aggregate demand for gold has fluctuated, but there's a clear relationship between the price of gold and the tonnage allocated to investment. ETF inflows - into the SPDR Gold Shares EFT (GLD) - are also a key consideration.
What about the potential for tremendous inflation?
We believe the odds of rampant inflation touted by several pundits and gold bugs are grossly overstated. Though the Federal Reserve has been "printing money," inflation has hardly budged. After a brief commodity spike, inflation was minimal in 2011. You might even expect a more rapid increase following a large decline in the CPI, but rampant inflation has yet to hit. Assuming Bernanke continues to target inflation at 2%, we think he'll take the precautions necessary to prevent high inflation when economic growth accelerates.
The total money supply in the US economy (as measured by M2) has grown exponentially, but it appears the Keynsian Liquidity Trap Theory has held up pretty well. The demand for money has remained flat, even as the money supply expands rapidly. Fed Chairman Ben Bernanke's recent comments about keeping interest rates low until at least 2013 confirm that the Federal Reserve isn't expecting any inflation. We think the Fed is more concerned about preventing deflation that could absolutely destroy a deleveraging economy.
Oversupply could be on the way...
Commodity cycles are susceptible to the animal spirits just like any other asset class. With the price of gold up almost six fold since the turn of the century, previously unprofitable mines are now ripe for harvesting. Per ounce costs of $500+ were unattractive not long ago, but are now considered highly profitable. We think increased supply will continue to hit the market as long as the price of gold remains high. However, this means that if the price falls (and the animal spirits kick in to the downside), the real balance of supply and demand will lead to an even lower price.
Producers of commodities have shown themselves to be incapable of moderating supply in times of robust pricing, and we think gold could easily fall prey to the same trap. We don't think gold miners such as Newmont (NEM), Goldcorp (GG), and Barrick (ABX) - will be able to exercise discipline with respect to supply over the long haul.
What's the real demand for gold? If we net out jewelry, the real demand isn't much. Real demand for gold varies, but end-uses can include electric wiring, semiconductors, cloth lining, and inclusion in vodka. However useful it is, producers tend to substitute away from gold when suitable replacements exist and are cheaper.
Though the real intrinsic worth of gold is difficult to estimate, we suspect - given the large amount of investment and speculative demand - the "true" value of gold is considerably lower than it is today.
As Warren Buffett recently said in his annual letter to shareholders:
"Today the world's gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce - gold's price as I write this - its value would be about $9.6 trillion. Call this cube pile A.
Let's now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world's most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?"
As is often the case, we agree with the Oracle of Omaha. An ounce of gold will never be more than just that - an ounce of gold. But investors will continue to receive output from intelligent equity investments as well as from farms and oil fields. We're not gold bulls or bears, but we have little interest in tying up our capital in the yellow metal.