Today, the price of gold is over $1,700. Could it be "worth" far less. "Yes", by certain quantitative approaches, and absolutely "No" according to the "faithful" .
Price and value are not the same thing. Prices tend to vary more often and more significantly than value, but how to get at value. Price discovery is easy. Value discovery is not.
Figure 1: Indexed London Gold Monthly From 1968
There are many voices with price predictions well above the current price, and a small few with predictions below the current price by way of a correction. However, there are scant few if any with predictions for sustained prices much lower than present.
Note: We own some gold via GLD, and sell covered calls and cash secured puts around GLD to generate income related to this otherwise non-yielding asset ... but we don't accept price as value.
In our last article, we made a chart case for the possibility of a correction as far down as $1,300 (if a new generalized market dive as in 2008 should occur over something like the fiscal cliff). Gold went down 30% due to 2008 ... and if it reacted similarly from the current price, it would go to about $1,300.
That, however, would merely be a correction, not a sustained repricing of gold.
But What Is Gold "Worth"?
The problem with the question is that there are no internals for gold on which to make a valuation. There are no revenues, no profits, no dividends, and therefore no price-to-sales, no price-to-earnings, and no yield. That makes rationally selecting a value quite difficult.
There are those who are chartists who extend trends, but trends continue until they don't.
There are the faithful, who reference thousands of years of use of gold as a medium of exchange, and who see it as the solution to the ever expanding fiat currency base of the world; or who simply believe in it.
A good expression of the view of the faithful was posted as a comment on our last article by gold dealer Doug Eberhardt who said,
Gold and silver are one of only a few ways to counteract this debt and monetary destruction. ... Gold is insurance against the coming banking crisis, future inflation ... Gold investors don't care about price. It's a philosophy. It's also an enlightened understanding of what gold really represents ...
We get the crisis bit, but are not sure about inflation correlation. We can't make the leap of pure faith. We want to find something more tangible to avoid simply accepting and taking whatever the market asks for gold at the moment.
All asset prices overshoot and undershoot value. The question is how can we possibly guesstimate when a price is over or under valued.
CPI Doesn't Work
We reviewed the price of gold from 1968 through September 2012 (45 years) and found that gold far outstripped inflation. Gold was up almost 50 times, while the US "all items" CPI was up less than 7 times over that period.
Well, maybe the London price of gold was somehow held down artificially by the fixed price in the US gold standard. So we looked at the change in the price of gold from 1976 through September 2012.
That gave gold 5 years after the gold standard was abandoned to adjust to an unconstrained price before we started our gold price versus inflation review. In that case, gold was up over 13 times while "all items" US inflation was up just over 4 times.
Gold did cover inflation, but inflation is not the metric that explains the price of gold.
Recent Inflation Doesn't Work
Figure 2 shows that gold spiked in the vicinity of 1974 and 1980 as inflation raged, even as interest rates were high and the opportunity cost of not earning interest weighed on gold.
Then gold declined as inflation expectations declined (gold had overshot, apparently), and now is rising as the economy languishes and inflation is below historic averages (but many expect inflation from endless stimulative monetary expansion).
Figure 2: Gold vs. 1-Year Forward US Inflation ("all items")
What Make Sense Logically?
Call us doubting Thomas, or preferably that we are from the Show Me state of Missouri, but either way; we have an intellectual need to be able to relate the price of gold to something other than blind faith in the yellow metal.
The fact that gold has been money in the past; the fact that paper money in our lifetimes has been pegged to gold; the fact that the stock of currency printed and circulating continues to grow unabated; the fact that is currency alternative use is much greater than its jewelry or industrial use; and the fact that a significant portion of the jewelry use is a quasi investment versus decoration decision, tells us that the logical basis of valuing gold is to find its equivalent in terms of currency in circulation.
Figure 3: Growth Of Total World Currencies In USD
What Is The Currency In Circulation "Value"of Gold?
Our logic would say that if we add up all the world's currencies in circulation and convert them all to their US Dollar value, and then divide that sum by the total number of ounces of gold that are estimated to be above ground at this time; then that is the paper money value of gold.
That number is about $1,100.
If that is true, then gold is either in a major overshoot at the moment, or currency in circulation is about to explode up by about 50%.
Both of those ideas seem plausible, but it should give some pause to see how far ahead of present currency in circulation the price of gold is. Price and value are not the same thing.
We are not saying gold is going to $1,100, but we are saying that one logical method of estimating "value" (not price) says $1,100.
Data Behind The Calculation:
Total Currency: We looked up the currency in circulation for key currencies (US Dollar, Euro, Japanese Yen and Chinese Yuan), converted them to Dollars, and accepted Mike Hewitt's data that the first three currencies represent 60% of world currencies.
When we added in the Chinese currency the total is about 70% to 75% of world currency in circulation.
So, with 70% favoring a higher gold price, we gave gold the benefit of the doubt and we grossed up the Dollar value of the four currencies by a factor of 1.43 to get an estimate of total world currencies, which came out to be about $US 6.4 Trillion.
Figure 4: Total World Currencies
How Much Gold Exists Above Ground?
The World Gold Council estimates that the total of all gold mined over time is 166,600, tonnes. There are 35,274 Troy ounces in one Tonne. Multiplying the two figures, we see 5,876,648,400 (5.88 Billion) ounces.
The estimated total currency in circulation globally divided by the estimated gold above ground yields $1,095 of currency in circulation per Troy ounce of gold above ground.
Is That Value?
We don't know, but it is the most direct and tangible argument we can think of to respond to the prevailing argument that gold is an alternative currency, that represents constant value, and that should be the exchange value of fiat currencies.
This notion does not support faith that price does not matter. However, it is probably worth consideration, by those who require more than faith when they risk their fiat currency.
Not too many years ago, if someone said that home prices were simply too high relative to incomes and to rental alternatives, they were confronted with the faithful who believed that home prices simply go up.
In the late 1990's, if someone said that dotCom companies had no good underlying valuation basis, they were laughed at by people riding the wave.
There were many more unchallenged bubble assumptions in times long gone by ... tulips anyone?
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