Gold/GWP: Why Gold May Still Have Further To Fall

| About: SPDR Gold (GLD)
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Gold (NYSEARCA:GLD) produces no income and, unlike other commodities, little of the gold that is produced each year is consumed by industry. Some gold is used in jewelry and the rest is accumulated as an investment. Since the gold used in jewelry and even industry can be viably salvaged, it can be assumed that close to all of the gold that has ever been produced continues to exist.

Without a future stream of earnings to estimate, pricing gold is typically an exercise in comparison. One looks to the past prices of gold under past conditions and considers a variety of factors such as real interest rates, equity risk premium, the real price of gold, the cost of production, and the Dow-gold ratio. In this article, I will explore the ratio between the market capitalization of gold and the gross world product (GWP).

I calculated the market capitalization of gold for each year from 1950 to 2012 by subtracting annual gold production from a starting point of 165,000 tons at the end of 2011 and multiplying the resulting figure in ounces by the 2010 adjusted year-end price gold for each year. I then divided the market capitalization of gold for each year by the base 2010 GWP of each year.


Over the entire 63-year period displayed above, the average gold market capitalization/GWP ratio was 6.61%. The average ratio remains fairly stable when it is measured over different time periods. For example, the average ratio since 1970 was 6.9% and the average ratio since 1990 was 5.48%.

If the gold market capitalization/GWP ratio is mean reverting then there are a number of interesting implications. For one, this would mean that investors could earn a positive long-run real return by investing in gold. If gold were merely a long-term inflation hedge, as some have suggested, then one would expect to see a clear downward trend in the ratio, as gold became a smaller and smaller part of a growing world economy.

Another implication is that the ratio can be used as a useful tool in pricing gold. Below I have plotted the gold prices that would have occurred at a number of market capitalization ratios against actual gold prices in 2010 dollars.

In terms of inflation-adjusted gold prices, it is well known that gold prices reached extreme highs in 1980 and 2011. However, interestingly, the gold market capitalization/GWP ratio at the end of 1980 was much more of an extreme than the ratio at the end of 2011. At the end of 1980, the market capitalization of gold was over 18% of the world's annual economic output. While still well above average, the market capitalization of gold at then end of 2011 was between 10 and 11%.

The chart above suggests that extreme gains in gold, such as prices over $2000, are unlikely to occur and unlikely to last. A gold price above $2000 (in 2010 dollars) would require a gold market capitalization/GWP ratio of over 14%. This has only occurred twice at year-end over the last 63 years. If gold prices were to reach such levels in the near term, it would likely be the product of inflation and would not result in real gains.

Below I have displayed the distribution of gold market capitalization/GWP ratios over the last 63 years.

Another implication of the foregoing is that a simple model for long-run real gold price growth can be derived: [X%GWP] * [(1+G)/(1+S)], where X%GWP is a percentage of the world's economic output, 1+G is the rate of growth of GWP, and 1+S is the rate of growth in the supply of gold. As long as GWP continues to grow faster than the supply of gold, then an investor should expect to see a positive long-run inflation-adjusted return to owning gold. Over the last 63 years the growth rate in the supply of gold has been surprisingly consistent, ranging from a low of about 1.25% to a high of 1.95% and averaging 1.63%. Below I have compared model gold price growth to actual gold price growth since 1955 using a base of 100. Note that in 1955 the gold market capitalization/GWP ratio was 6.76%.

So what about gold prices today? From a year-end 2012 standpoint, assuming a gold market capitalization/GWP ratio of 6%-7%, gold should be priced between $880 and $1026 in 2010 dollars. Adjusting for 3 years of inflation, gold should be priced between approximately $940 and $1096. As of July 10, 2013, GLD closed at $120.95. This suggests that current gold prices still have further to fall and that it would not be wise to begin buying gold until prices have fallen below at least $1100 or $950.

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. I have no business relationship with any company whose stock is mentioned in this article.