The set-up to today's markets is well understood and has been widely documented. Emerging markets have grown increasingly vulnerable this year as USD financing has dried up, making it harder to roll over new debt and finance current account deficits. Meanwhile, U.S. markets have continued showing strength despite a bull market that is in its tenth year. Rising interest rates, a ballooning fiscal deficit and the possibility of substantial trade dislocations continue lurking as an overhang to the aging bull.
With investors becoming mindful of these growing risks, it is reasonable to ask why gold continues to perform so poorly. Since topping in late 2011, the precious metal has underperformed the S&P 500 by a significant margin.
Different factions tend to give different answers as to gold's attractiveness and those factions' answers also tend to have little to do with the current price of gold.
Some assert that gold should always be a substantial part of a portfolio because of the unreliability of central banks and debt-financed economies. Others, while skeptical of gold's long-term investment potential, suggest a 5%-10% weighting in gold as a hedge against market turbulence and inflation. Finally, a third broad group belittles the concept of gold as an investment altogether regardless of its price because it lacks intrinsic value relative to productive assets.
Gold's Fair Value
Investing in any asset requires an ability to place a reasonable value on that asset and investing when opportunity costs favor it. The reason why it is eschewed by value investors, in my view, is that placing a value on gold itself is rather difficult. What exactly gives gold its value?
There are tangible applications for gold in the real world, such as jewelry and in electronics, which give gold commodity-like characteristics. But, gold also derives a substantial portion of its value as a monetary reserve and from investment flows. Since gold tends not to be very reactive with other substances or easily destroyed and the amount of gold in existence cannot be artificially increased, it has served as an ideal source of money.
Assigning a fair value to gold based upon its commodity-like properties and money-like features will produce stark differences. Why? If one views gold as a commodity, it would not be unreasonable to expect its inflation-adjusted value to be rather consistent over time. But, the number of dollars in circulation grows at a rate higher than inflation. Growth in goods and services creates increased demand for money on its own and so in order to create stable prices, one would need to increase the money supply at a rate equal to real GDP growth.
That is not an iron-clad law (other factors such as the velocity of money can play a big role), but it is roughly true in the long run. In the United States, real GDP growth in the post-WWII era has averaged about 3.2%, inflation 3.5%, and M2 growth close to 6.7%.
Growth in nominal GDP and M2 for the United States, 1948-2017. Created by the author from FRED data.
Obviously, a gap that will continue to grow exists in the valuations of gold as a commodity and as a form of money so long as the growth in global gold stocks grows at a pace that is slower than real GDP growth. (The amount of new supply in gold each year has stayed fairly constant, increasing at a rate that is a little less than 2%.) But, where would thinking about gold in each of these ways place its fair value today?
The answer heavily depends upon the starting point one uses to adjust gold by inflation or by the excess growth in the United States' money supply versus gold production.
In 2011, I suggested using a model along the lines just discussed and used 1913 as the starting point. It seemed a natural point to begin at given that it marked the creation of the Federal Reserve System in the United States. As a heuristic, that approach has also worked fairly well over time compared to how gold prices have actually performed.
Gold prices, the 1913 gold price adjusted for inflation, and the 1913 gold price increased at the rate of M2 growth and then discounted by increases in global gold stocks. Created by the author.
Logic certainly supports the model as a rough heuristic of market behavior. As investment flows to gold and it rises as a percentage of financial portfolios, the marginal buyer sets a price for gold as if it were a currency. Periods when gold falls out of favor, and the investment flows that drive marginal demand weaken, its price resembles much more closely that of a commodity.
In addition to providing a hedge against inflation, gold is often touted as a hedge against fear. The evidence for this, though, is somewhat suspect.
The chart below compares the VIX with gold prices since 1970, with key VIX spikes highlighted. Seeing time compressed in this way over nearly fifty years shows pretty clearly that gold moves in its own bull and bear cycle, with little long-term correlation to stresses in the financial system.
Gold prices versus the VIX, 1970-2018 with key spikes in the VIX annotated.
Looked at another way, the correlation between the VIX and gold prices oscillates fairly regularly between positive and negative levels. Recently, correlations have moved positive as both the VIX has stayed low and gold prices subdued. This, however, should not be seen as an indication that a rise in the VIX would necessarily augur rising gold prices.
60-day and 120-day rolling correlations between the VIX and gold prices, 1990-2018. Created by the author.
The evidence, then, suggests that while gold is a very good hedge against money printing and inflation, it is a very weak hedge against rising levels of fear or market selloffs.
If gold is being considered as a hedge against fear or a stock market decline, better options exist. The best options are short-term bond funds or cash, which are finally starting to provide some yield as a trade-off for the patience shown.
The Bottom Line
Gold is finally starting to look attractive again seven years into a bear market that began in 2011, although prices today approximate fair value and Fed policy is working against higher gold prices.
Those worried about the long bull run in equities and looking for diversification would do better purchasing short-term debt and earning a 2%-3% yield for their efforts.
Allocating 5% or so of a portfolio here to gold as a hedge to future inflation would also not be a terrible idea.
Gold's ultimate fate, like so many other assets, is dependent upon the Federal Reserve. The Fed's target rate, or the neutral Fed Fund Funds rate, is in the vicinity of 3% at the moment versus its current target of between 1.75% and 2%. Although this month that range will almost certainly increase to 2% and 2.25%. While it works its way back to a more neutral rate, the data will determine whether it keeps hiking after getting there or not. That data and how it's interpreted will probably determine the course of gold prices over the next few years.
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.