Justifying Gold Prices From A Money Creation Perspective

Oct. 8.12 | About: SPDR Gold (GLD)

Gold prices have been trending higher in the last twelve years and might continue to do so over the next decade. This article is in defense of current gold prices from a money creation perspective. Further, this article completely rules out a bubble in gold. Hence, the expectation is that the long-term bull market for gold is intact and gold will surge higher over the next decade.

As mentioned earlier, the focus is just on gold price appreciation from a money creation perspective. The simple logic that works here is that if the supply of gold can't be increased at the same pace as the supply of money, gold will appreciate in fiat money terms even if demand remains stable or relatively sluggish.

In the modern banking and money creation era, debt is essentially money. Had there been no debt, there would have been no money. Therefore, it would be interesting to look at the debt growth multiple from 1980 and the number of times gold has appreciated since the 1980's. I am particularly selecting the 1980s as a reference point because expansionary monetary policies began in the United States way back in the 1980s after the bear market for Treasury bonds ended.

The total credit market debt in the United States has increased from $4.4 trillion in 1980 to $55.0 trillion by the second quarter of 2012. During the same period, the total government debt increased from $930 billion to $15.8 trillion.

Looking at the impact of this money creation on asset markets, the S&P 500 index has increased from 106 in 1980 to 1460 currently. I am certainly not suggesting that only liquidity has resulted in the index surging by 13 times in 3 decades. However, liquidity does play an important role in asset markets. The best evidence comes from the credit freeze as a result of the Lehman collapse in late 2008. The S&P 500 index touched a low of 666 during that period. Very clearly, two quarters of earnings slump did not justify the S&P slipping to 666 levels. The liquidity factor was the most important factor.

Finally, gold prices have increased from $560 at the beginning of 1980 to $1780 as of October 2012. That's a 3.2x increase over a period of three decades.

As evident from the chart, appreciation in gold prices has been much lower when compared to the increase in money in the system over a period of three decades. Clearly, purely from the perspective of the amount of money present in the system, gold looks undervalued and not overvalued or fairly valued.

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Another interesting chart given below can be used to talk about current gold valuations. The foreign reserves in Asia has swelled from $2 trillion at the beginning of 2006 to $5 trillion now - exceeding 45% of GDP. Therefore, over a period of six years, Asian currency reserves have increased by 2.5 times. During the same period, gold prices have increased by 3.4 times.

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The important point to note here is that deficits in the advanced economies have been a source of excess reserves and liquidity in the emerging economies. Further, the 2.5 times increase in reserves does not account for all the new money creation during this period. One can therefore conclude with some conviction that the 3.4 times increase in gold prices during this period is justified.

A strong relation also exists between the US adjusted monetary base and gold prices. As the chart below shows, the gold price has surged in the recent past, along with a surge in the US adjusted monetary base.

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Going forward, with the Fed expected to continue with its expansionary monetary policies, the adjusted monetary base will trend higher and gold prices should also trend higher. It is also worth mentioning here that the CBO expects $10 trillion of budget deficits in the United States over the next ten years. This will result in significant additional money creation in the system. In line with this, gold prices should be supported at higher levels.

I also strongly believe that gold is far from being in a bubble territory. The chart below would serve as a good point in defense of my argument.

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Of the total amount of marketable potentially safe assets, the holding of gold is only 11%. In times of a bubble, the holding of any asset is abnormally high. From that perspective, the government bond sector, and not gold, is in a bubble.

Also, for central banks around the world, gold as a percentage of total reserves is at relatively low levels. This is especially true for emerging markets, which have high reserves.

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Going forward, one can expect central banks to increase their gold holdings as the prolonged economic problems in the advanced world impact their currencies negatively.

All these factors combined make a strong case for another decade of the bull market for gold. I would personally look to accumulate physical gold, gold ETFs and gold stock in my portfolio on every correction in the precious metal.

Investors in the United States can consider exposure to physical gold. As Dr. Marc Faber points out, expropriation of gold is a possibility and investors need to store their physical gold outside the United States. Gold ETFs are also a good option for near to medium-term, and investors can consider exposure to the SPDR Gold Shares (NYSEARCA:GLD) ETF. The investment seeks to replicate the performance, net of expenses, of the price of gold bullion.

Investment in gold mining companies is also a good option at a time when gold prices are trending higher and gold mining companies are making significant operating level profits.

The Market Vectors Gold Miners ETF (NYSEARCA:GDX) is a good investment option for long-term. The ETF seeks to replicate as closely as possible, before fees and expenses, the price and yield performance of the NYSE Arca Gold Miners Index. The ETF holdings have an attractive P/E ratio of 13.8 and an equally attractive price to cash flow ratio of 5.59.

The Market Vectors Junior Gold Miners ETF (NYSEARCA:GDXJ) is another excellent long-term investment option in my opinion. The ETF seeks to replicate, net of expenses, the Market Vectors Junior Gold Miners index. The index tracks the overall performance of foreign and domestic publicly traded companies of small- and medium-capitalization that are involved primarily in the mining for gold and/or silver. Therefore, the risk related to exposure to GDXJ would be relatively higher as compared to GDX. The ETF holdings have an average P/E ratio of 11.9 and an average price to cash flow ratio of 2.47.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.