Gold's Relationship with Real Estate

When I think of gold today, and I try to convince myself to be a bull, I feel a sense of greed more so than the feeling that I've arrived at a logical conclusion. Everywhere I look prices are dropping, yet gold hovers roughly 20% below its all time high. At the same time, the dollar is about 15% off of its lows and oil is about 45% off of its highs… don't get me started on housing.

Yet for some reason, I have this itch to buy gold. I feel like a soon to be loser would've felt at the height of the tech bubble - I just don't want to miss out while other people make money. Take a look at the following chart.

click to enlarge images

Here are some of my observations when looking at this chart.

1) You may be thinking that it makes sense that gold is off 20% on a 15% rise in the dollar. Gold reflects the dollar's value right? As we can see from the chart, a 200%+ increase in the value of gold resulted from about a 30% depreciation in the value of the dollar. If this relationship was set in stone, the value of gold would've risen from about $300 to $390 and then pulled back a little from the recent dollar appreciation. There was obviously more to this gold bull market right?

2) Gold and Real Estate have historically been the two ways to store real value as they are as real assets as you get. So what happens when the value of one real asset is artificially manipulated? We all know by now what caused the bubble in real estate, but, at the height of the bubble it was unknown to the market that it was a bubble on the verge of bursting. At that time, the real value of a house was perceived to be its nominal value. If a house is the core asset of your average family and a reflection of their wealth, does it not make sense that the asset that tracks real values (gold) would rise as well?

The correlation is amazing as you can see in the chart above. What I have noticed is that gold lagged the DJ Real Estate Index and then starting in 2006 responded with more volatile movements until the sharp pullback in real estate price over the past 12 months at which point real estate volatility moved higher. What gold is missing is a sharp pull down of magnificent proportions to properly reflect real value.

3) Real estate has pulled back almost to the point that it truly reflects dollar debasement over the past 9 years. It has now turned to a supply and demand issue. I often argue that much like CPI, gold is inherently flawed as an inflation tracker as most of its movement is based on supply and demand, not the value of the dollar. Now we are seeing the opposite happen. While gold demand has dropped this year in terms of quantity (not in $ terms), it has not dropped nearly as much as housing demand has. In addition, housing supply is as high as it's ever been, while gold supply is struggling to keep up even with the lower demand because of various mining related issues. So these prices have diverged and 'real' value is anyone's guess.

What I can confidently say is that gold prices cannot go up indefinitely if housing prices continue to fall. On the contrary. I think we will still see a further drop in housing prices as unemployment rises and recession pressures are felt. Consumer prices are going down and consumers are moving to deflation expectations. Yet gold traders are still very bullish. A classic signal of a bubble.

Addressing a Dollar Crisis

You may be surprised to hear that I am actually a big dollar bear and I wouldn't be surprised if the dollar has a major crisis in the next several years. It may even be the tipping point from recession to depression. If you are American I would suggest at minimum diversifying your cash position as this recent flight to 'quality' has pushed the dollar artificially high.

However, as I pointed out above, there is significant basis risk in playing a weakening dollar through gold. Now I may be a little early in calling a gold bubble, but the answer lies in liquidity.

Let's assume that we do reach a point where there is a stampede out of the dollar. The first place individuals will look is gold, although the smart money will be moving into all currencies and other non-dollar assets. This demand for everything non-USD will have varying demand impacts depending on liquidity. For example, a stampede into Swiss Franc and Japanese Yen will not cause those assets to move nearly as much as gold because they are far more abundant (Liquid). A sudden explosion of demand, although very beneficial to those currencies, will not move them nearly as much as it will move gold.

Take a look at a chart comparing Yen and Gold over the same time period as the chart above.

The question is, is this still going to happen, or has this been happening while the dollar lost 30% of its value over the past 8 years. Are we in the middle of a bubble, or just the first leg that's going to lead to an even larger bubble? Remember this is your money we are talking about here, your life savings, don't just jump in because you don't want to be the only idiot who didn't like when you bought stocks in the tech boom. Remain diversified as always, even in your cash positions, but don't move all your assets into gold for its perceived safety. You will find far more safety today in the Japanese Yen and less volatility.

Many people try to short in a bubble and get killed as the bubble continues to grow. I will be sitting this one out. If the divergence between real estate and gold prices continues to increase, there may be a trade to bet on the ratio returning to normal levels.

As you can see from both this chart and the first one, the ratio was relatively calm in 2006, but starting in the summer of 2007, gold prices rallied as housing prices collapsed and a huge divergence resulted.

Where is real value? I don't know. I don't believe that anyone does right now. If the U.S sees a similar stagflation environment as Japan saw, deflation may persist with rates as low as 0%. WSJ reported that the 'Smart Money', or the largest hedge fund managers are sitting on the sidelines. There is a lot of uncertainty in the market that could support gold in the short term. However, in order to see a significantly higher move in gold right now, we would likely have to see a very strong upward move in equities and a rebound in housing. If that doesn't happen, persistent deflation may be the name of the game and at some point gold would have to drop to reflect that.

Disclosure: none

Comments

[JudeJin:]

i think what people are missing here is the fact that a lot of houses in the US are built many years ago and have lost real value over the years through wear and tear and out-dated technology and material used to build the house. if we take into account of the wear and tear and outdating of the houses, we may get a far different picture. especially when i believe the median house price in the US is very much skewed towards this large proportion of old houses.

while gold is a perfect and honest store of value. gold can stay shiny and pure for almost forever.

it is very difficult and very confusing to get the real value of gold.

i'd like to use other metrics, like college tuition to guage the true inflation and how gold is undervalued.

i'd like to also share some stats observed in china. i believe currently gold and silver are probably the most undervalued in terms of real estate and salary in thousands years of chinese history:
a crappy 100-sq.-meter apt in shanghai, 20000RMB per sq. meter cost 10 kilos of gold.

i believe gold is very undervalued even against the strongest currency in the world, RMB, let alone the weakest major currency, USD.

central banks around the world are keeping the printing press busy. china, faced with its own real estate crash and economic meltdown, will also loosen up its monetary policy. gold is priced in USD, which is theoretically broke. china will probably try to appreciate RMB against USD much slower than the market will appreciate gold against USD.
this is why i'm not only bullish on gold against USD, but also bullish on gold against all major currencies including RMB.

2008 Oct 15 09:23 AM

[CLH:]

Very good article which gives many reasons why gold must go down (maybe to $300-500) before this debt crisis is over.

The President can no longer make the price of gold go up as Roosevelt did because we dont have a gold standard.

Hang on beause when gold starts down it will be much faster then when it went up. Like oil.

2008 Oct 15 11:59 AM

[Engineer:]

Here's another way of looking at it.

In the early 1970s, shortly after the US defaulted on its gold standard, you could buy an average home in the US for 200 to 300 oz of gold. However, during the subsequent crisis of confidence of 1979/80, the ratio dropped to around 100 oz per home, simply because the value of gold skyrocketed.

In 2001, the average US home in gold peaked at a valuation of around 700 to 800 oz. Since then it has declined steadily to around the 300 oz level. If we are to see a re-test of the 100 oz mark, either homes would have to decrease in value another 2/3 (!!), or gold would have to increase in value by three times, or some intermediate combination of the two.

I'm not sure if this 100 oz valuation will be retested anytime soon, but I do get the sense that Gresham's Law (good money goes into hiding when bad money appears, en.wikipedia.org/wiki/...) will act even stronger in the years to come until we can figure out some way of putting ridges on "paper money".

2008 Oct 15 02:08 PM

[Socialism c...:]

@CLH -- get off the pipe...it is clouding your mental abilities!! The Feds are printing paper to pay for this bailout...tons of it! That cannot be deflationary. Ever. Good luck with that.

2008 Oct 15 03:44 PM

[rockerchic:]

I disagree that homes and gold are equivalent enough to parallel as tangible assets. They are truly different:
Houses are susceptible to flooding, earthquakes, hurricanes, tornados, fire damage, etc.
Gold? No.
Neighborhood values plummet when regional employment/industries go down in the area.
Gold? Take it with you when you move.
Lumber rots, gets eaten by termites, and deteriorates with time.
Gold? Imperishable.
Aging homes become less desirable, lose structural integrity and depreciate.
Gold? Just as precious as it was 7000 years ago.
Home design and architecture changes. Tastes change (who prefers cathedral ceilings and larger bedrooms compared to designs 40 years ago)
Gold? Just as popular as it was in Cleopatra's era.

When everything is crashing and burning... Gold doesn't burn. It just melts and hardens back into solid, beautiful gold. Every civilization has valued it and will continue to. As a safe haven during rough times, it has remained a popular choice for many reasons.

2008 Oct 15 04:03 PM

[freefall51:]

A Katz raises a very important point that I can relate to. Its is called denial.

Every bubble is based on a good story, scarcity of gound fuels the housing bubble, peak oil fuels the oil bubble, printing $ fuels the gold bubble. People believe it must be that way until it isn't.

I believe now that gold must come down if for no other reason than that it is still up like the last man standing. I am not a chartist but I know that a good upward price curve comes out of a consolidated base. For gold that was 6 years ago. Now we are in the 4th inning and the price curve is falling apart. There must be a fundamental reason for that. We will know in hindsight.

I want to side with CHL. I believe he was a recent oil bear. I was in denial and got my butt kicked. This time I am listening. Short GLD.
This is a mild Ponzi scheme anyway.

2008 Oct 16 12:16 AM

[Socialism c...:]

@freefall: "because it is the last man still standing"?? that is *exactly* why gold will NOT fall -- it is a store of value when other stores of value fail!!

2008 Oct 16 11:08 AM

[freefall51:]

@ Socialism,

While I sympathize with your name, I cannot resist to note that GLD is 5 % down today. So much for store of value. Reminds me eerily to my former oil stocks. That makes excellent BEARS!

2008 Oct 16 05:55 PM

[Cesato:]

Yeah USD 530 before, finally somebody got it right

2008 Oct 16 06:58 PM

[Cesato:]

Cash out everywhere and start buying real state, there is a lot bargains out there and it is the only safe investment other than having the money under your mattress, you don't wanna hold your cash in the bank nor is there a safe investment at the moment Gold became just ahother asset class and you won't even be able to sell in a panicky market, real state cannot be taken away is as solid as having the cash in your pocket and historically prices have always rebounded over time in a shorter timeframe than commodities, prices may drop another 10% to 15% in the next 6 months but once inventories start to decrease, markets stabilize and America gets used to spend in an budget (like you one should have been doing for the last 4 years) then you'll get a good return, you would've had your money safer than in a bank, you would've had slept nicely and your cash had been in a hard, uncheatable asset. Not even treasuries are safe at the moment, not because there is a risk of USA not honoring them but because of all those bubles it is about to burst badly.

2008 Oct 16 06:58 PM

[Harry T:]

Homes should never have been used as investment vehicles for the mere fact that a home is similar to a car, it gets old, it gets lived in, and if it has a previous owner the conditions are never 100% transparent therefore a home should always be losing value rather than gaining value.

The philosophy behind owning homes was ingrained into our mindset that if you don't own a home than you won't be as happy as a homeowner, if you were to buy a home to rent and charge a premium to the renter because the renter cannot afford to buy a home above their salary grade than that makes sense as an investment, but when it comes to pure investment homes should be deflating assets, albeit slower than cars.

Gold on the other hand stays the same, today it is gold tomorrow it is still gold. It isn't older gold because its been in your possession for over a year, the gold is still investment grade, it is still jewelry grade, it still contains the same properties as last year.

2008 Oct 17 12:36 AM

[MikeLovesGold:]

Gold should be trading minimally at $6,000 +.

www.goldprice.org/jame...

2008 Oct 17 01:21 PM

[robynfrog:]

Cesato -

Let me guess, you sell real estate, right? I'm not buying.

2008 Oct 17 04:55 PM

[Hugh Thomas:]

Real Estate is taxed, and over time, much of the gains are wiped out by that fact alone.

A house is a wooden box that is always under the constant state of rotting.

The half life of the gold molecule is ten billion years.

2008 Oct 19 08:57 PM

[Mitchjack:]

Compare Gold to housing? Good luck getting a subprime loan to buy gold. The guy who wrote this article just doesn't get it. Gold is real money. It was the first money in use and it has always been money up until 1971. That is when curruptable (freely printed) money began to be used. Since then, inflation has devalued the dollar 99 percent with no end in sight. All currencies in use now are being freely printed to keep up with the new trillion dollars/month that are being created in existance by the fed. Gold should be around $2000 per ounce in 1 years time...maybe $5,000 in several years.

Got Gold?

2008 Oct 20 04:06 PM