Gold has always been a reliable asset class for investors throughout history as it provides stability to portfolios. Today, gold's role as a hedge and portfolio stabilizer is as important as ever. With worldwide monetary policy occurring at unprecedented levels and many securities/indices trading near or at record highs, it is imperative that investors have exposure to gold in order to diversify asset classes. Gold is usually treated as a commodity but acts as a currency in our economy and should be thought of in that manner. By enabling this mindset it assists in creating a monetary perspective to golds valuations and as money is used in primary economic functions so is gold. This is essential to understand and when making the analysis for gold, a more informed decision.
The Price of Gold and the USD
The price of gold can be perplexing sometimes and even if market conditions are favorable, the rise in the price of gold may not always materialize. This could be due to the fact that Gold is priced in USD. Even if the price of gold rises, if the value of the USD rises more Gold will be negative. This, however, doesn't change the fact that you can still compare the price of gold to other currencies or other asset classes in which the price of gold should have risen relative to that asset class. Gold current prices are an indication of its value but will sell at premiums when the physical metal is purchased.
The chart below shows how the gold price moves against major currencies and change's relative to floating currencies valuations moving against each other.
Gold vs the S&P 500
One of the most common ways to value gold is by comparing it to the price of the S&P 500. This can help investors decide, especially by looking at a historical picture if the S&P 500 is overvalued compared to gold. If you look at a historical chart of the S&P 500 to gold ratio (how many ounces of gold to buy the S&P) back to pre-1929, you'll see that Gold is trading today at pretty favorable prices with only 2 other cycles in that time with cheaper relative gold. Comparing gold to the S&P doesn't necessarily make the case to buy gold, however, coupling this with golds depreciation against other assets will make a stronger case for why now, more than ever, investors should have a 5-10% (depending on your market views) weighting in Gold.
Gold vs The U.S. Monetary Base
The monetary base is essentially all liquid money in an economy. It encompasses all circulating money plus cash in the central bank's reserves on behalf of commercial banks. The monetary base is important to understand because central bankers will influence the money supply in order to spur an economy. After the global financial crisis, the Federal Reserve increased the money supply by,
- Lowering interest rates to almost zero, and
- Quantitative easing which included buying Trillions in assets (United States QE). The graph below shows just how cheap gold has become relative to the monetary base. With gold at these lows and compared to the monetary base this should be a major sign that it is undervalued.
The monetary base relative to gold at such lows brings about other questions regarding where has the expanding monetary base went when the economy has only seen moderate inflation numbers and golds' averages have significantly dropped.
Gold vs The U.S. National Debt
Government debt is usually thought to be relatively low risk, however, there are plenty of times throughout history when we have seen sovereign debt crises (Greece and now Venezuela). As government debt grows, naturally it becomes riskier even if only marginally, forcing investors to look for other assets to find reduced risk. This is why Gold and the U.S. national debt level have been correlated for so long. As the national debt rises, more people take notice and buy gold. A quick look at the chart comparing gold to the national debt shows just how correlated gold and the U.S. debt are. In recent years the price of gold has retreated moderately while U.S. national debt continued to rise. This makes it clear that gold has become undervalued again relative to national debt. The decrease in the sentiment of gold increases the sentiment in government securities and other equities pushing consumer confidence, allowing the government to take more risk.
The ratios above are important gauges to use when evaluating prices of gold. The price of gold can show how gold moves against world currencies, the other ratios depict how gold is valued in comparison to other major factors of the economy and 2 of the 3, are at the most relevant levels ever. As recent monetary policies have created more national debt, increased valuations of the S&P 500 and excessive money supply increases, this should highlight how gold may react in the future if market conditions become unknown. Explained in our article regarding monetary policy and through gold's comparison to (monetary base and national debt), ratios this help illustrate how it can protect against unknowns created by policy. Gold works as an insurance policy more than ever since the capability of telling the future of the economy is unknown. With the ratios at these levels, today the importance stands between economic fundamentals and the future viability of money supply and other asset valuation increasing at the same pace.
The allocation of gold in an investor's portfolio is as important as diversification. Gold is one of the few assets that have intrinsic value, so owning some gold is essential as a store of wealth. With current global economic and market conditions, it is evident that now more than ever gold should be owned not just as a defensive position, but also with expectations for price growth because of the misalignment to the monetary base. Price appreciation should not be the first focus with gold, rather it should be viewed as an instrument to protect true wealth with historical relevance. Like equities, you could lose valuation in the short term on your investment but short-sightedness should always be avoided.
Disclosure: I/we 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.