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Gold Sub-$1,000: Required Yield Theory Is Negative

by: Julian Van Erlach

Required Yield Theory (RYT) values gold just under $1,000/oz. near term; more pessimistically than Credit Suisse or Goldman Sachs. The novel theory of gold valuation posited under Required Yield Theory™ is that gold is, and must trade as a global perpetuity with a growing (compounding) real yield. This attribute arises because, unlike fiat money, the total world above ground stock increases more slowly than world real GDP (i.e. real GDP or claims to goods and services, increases per unit of gold). Meanwhile, fiat money supply grows faster than national real GDP, causing inflation and loss of purchasing power. This sets up a GDP-weighted exchange rate between the global realm of gold and the national realms' fiat money-denominated assets that unlike gold, do not obtain real returns inherently but require fiat payment streams of earnings, dividends and interest.

Gold is therefore inversely sensitive to the current:

  1. Rising real yields
  2. Falling U.S. and global inflation expectations
  3. Rising GDP-weighted value of the U.S. $
  4. Declining expectations for world real GDP in relation to the growth of total world gold stock (lower real yield for gold). Though mine supply is slowing and will slow further due to much lower marginal production profitability.
  5. Mining margins are compressing and mine and acquisition write-downs are accelerating which are creating a nightmare scenario for mining stocks if gold moves much toward or below this target.
  6. Physical retail demand is now nowhere to be seen and is likely to reverse in what could become panic selling if the price of gold drops another few hundred dollars.
  7. Recent central bank dovishness, in the author's opinion, is not going to set the clock back much on real rates as "tapering" is now clearly seen as not being far away unless economic growth and employment dive.

Graphically: Fig. 1

(Click to enlarge)

The model in this figure has a 13.4% average absolute variance from actual gold price since 1978; 6.6% absolute variance since 2008 and 5.5% since 2011 (inception of weekly tracking). The raw model did not indicate a fall in gold prices in April because real yields had not begun spiking and inflation expectations falling. However, Bernanke's testimony clearly indicated a coming of tapering, which is very positive for real yields and served as a very negative marginal signal for gold prices. Conversely, gold prices have not caught up (on the down side) yet with the real yield spike and fall in inflation expectations. A reversal of these two factors would mitigate the RYT price target.

Bond Yields

Apart from duration, the major factors comprising yield are real market-required yield, inflation expectations and effective taxation wherein markets target an effective real after-tax return. The long term real after-tax yield must approximate real per capita GDP growth for reasons detailed in my NYU Journal Of Financial Markets, Institutions and Instruments paper. This means that at a currently expected real GDP growth rate of about 2.3%, the real after-tax yield would be about 1.2%. This rate is not just for next year, but long term as projected by this Conference Board research study. Adjusting this rate for taxes brings us to about 1.5% to 1.8% for long TIPS - right about where they are. This would indicate that barring surprising growth evidence, the real yield has about run its course plus a few tenths except for the recent bout of dovish Fed proclamations. (Incidentally, the TIPS yield is not directly the real market-required yield. You have to take out taxes for both the coupon and expected inflation gross-up.)

Why did long TIPS yields surge from some .45% in early 2013? Because an end is seen to excess fiat capital creation by the Fed. In this SA article, I have shown how excess capital creation lowers real yields, hurts employment (the return on labor - real wage; is not going to grow if capital is getting negative real yields), and impairs capital investment. Investment doesn't happen because of low interest expense (the Fed's claim), but rather because of prospects for an adequate real return - which the Fed destroyed too. How much excess capital does QE3 create? About $1 trillion per year at $85 billion per month. And how much is that in relation to total U.S. new stock issuance and borrowing? Let's look at the latest Z1 Flow of Funds Report. Note exhibits L.1 total credit outstanding and F.213 net equity issuance at annualized rates. Capital formation excluding QE is running about $2 trillion. The excess $1 trillion of mortgage and other asset purchases massively dilutes the real return on marginal capital formation on top of the cumulative effect of QE 1 and 2.

Dallas Fed President Fisher called bond markets "feral hogs" Monday, intimating that post-FMOC bond yield spikes are irrational. Sadly, this verbal color smacking of desperation can't hide misunderstanding of the principles underlying markets.

Circumstances That Could Drive Gold Higher

Renewed QE efforts or prolonging would push down real yield and raise inflation expectations as well as push down the dollar. This would change RYT gold price targets. A context of marked economic weakening or very large external threats to growth would probably be needed.

About RYT

I have been short gold (and oil), both indirectly, since Friday as posted on my comments on a prior SA article on gold. RYT is backed by several granted and pending asset valuation patents and journal papers.

At first, the assertion that gold obtains a growing real yield appears to conflict with Roy Jastram's notable "Golden Constant" research. The reconciliation with RYT stems from industrialization and productivity growth (Fig. 2). There was nearly no productivity growth until the industrial revolution. Thus, mined gold often experienced loss of purchasing power until GDP growth came to outpace the rate of new mine supply in relation to existing world gold stock.

(Click to enlarge)

(Robert Gordon; Center for Economic Policy Research)

My forthcoming e-book will disclose the full valuation model and offer a non-exclusive patent license, comprehensive data set and instructions for computer modeling.

Investors should form their own reasoned opinions and act according to personal risk tolerances and portfolio strategies in relation to opening long positions in gold and its derivatives.

Disclosure: I am long DUST, RUSS, BRZS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.