Physical Gold Investors Will Eventually Be Rewarded For Their Patience

May 23, 2022 4:40 AM ETDBP, JJP, GLTR, JJPFF, GLD, IAU, DGL, BAR, SGOL, OUNZ, GLDI, IAUF, GLDM, AAAU, BGLD, IGLD, GBUG, IAUM, PBUG, WGLD, PHYS11 Comments7 Likes
Anna Sokolidou profile picture
Anna Sokolidou
1.09K Followers

Summary

  • The Fed and other central bankers are getting very hawkish. I appreciate how much it scares gold investors.
  • But don't worry. The stock market is already significantly down from its January 2022 highs. So, it is unlikely the Fed would hike the rates dramatically from their current levels.
  • Even if the base interest rate in the US eventually totals 3%, which is unlikely, the real rates will still be negative. That's bullish for gold.
  • Most of the gold's cheapness is due to "paper gold".
  • I suggest buying physical gold for the long term without investing in "paper" gold.

Золотых слитков на ворсу золотых монетах много

chonticha wat/iStock via Getty Images

Many gold investors are scared right now. Indeed, at the end of February and at the beginning of March, the price of gold per ounce exceeded $2,000, whilst now in May, the price is just slightly above $1,800. Most of the sell-off was due to the hawkish Fed and the record-breaking inflation. The latter was not only due to very easy monetary policies imposed in 2020 but also due to poor logistics. The supply chains were broken because of the coronavirus crisis and after the sanctions were imposed against Russia in March. Geopolitical uncertainty has not gone away, the supply chains will take ages to rebuild, and the Fed cannot do much about currency devaluation. Gold is highly undervalued. But it is uncertain when exactly the gold prices will break their record highs. Let me explain this in some more detail.

Gold's undervaluation

Although the hawkish Fed will probably hike the interest rates several times, I still think the gold prices are ridiculously low. Here is why I think so.

There are several ways to measure if the yellow shiny metal is overvalued or not. Two of them are the Dow/Gold and the Gold/Money Supply ratios.

Dow/Gold

Obviously, it compares the Dow Jones index to the dollar price per gold ounce. The higher it is, the more undervalued the gold is.

Dow/Gold ratio history

Dow/Gold ratio

Macrotrends

Source: Macrotrends.net

Right now, the ratio is quite high, near 20. In the 1960s and the 1990s, it was 30 and 40. Soon after the ratio got high, the gold prices rose considerably, as can be seen from the graph below.

Gold price history

Macrotrends

Source: Macrotrends.net

Very interesting is that one ounce of gold cost as much as the Dow Jones index in 1981 because the ratio was 1. So, in that respect, it is possible the gold prices would surge to unseen before highs, whereas the Dow would fall substantially from the current levels.

Gold/Money supply

US M2 Money Supply and Gold Price
Data by YCharts

The diagram above shows the gold price growth in the last 10 years was nowhere near the money supply growth. This also means the yellow metal is undervalued right now. The graph above suggests gold should cost $2,400.

Macroeconomic indicators and the Fed

There are several macroeconomic indicators that predict recessions. These are ISM's PMI in Manufacturing and Non-Manufacturing PMI, unemployment rate, inflation, and the treasury yield curve. The Fed pays particularly close attention to the unemployment rate, inflation, and the stock market.

Unemployment rate

To start with, 3.6%, the current unemployment rate, is near the levels last seen in 2019, which is a very good indicator suggesting the economy is strong.

Unemployment rate

Trading Economics

Source: Trading Economics

So, if we put ourselves in the shoes of the Fed's Jerome Powell, we will see there is an opportunity to tighten further, especially given the enormous inflation rate.

Inflation

Inflation

Trading Economics

Source: Trading Economics

The current inflation rate, last seen only at the beginning of the 1980s, certainly requires some intervention from the Fed. But the problem is that it is not enough to just decrease the money supply to fight inflation. The problem is that there are shortages of the key goods and commodities resulting from the pandemic-related supply chain problems as well as the situation around Ukraine. So, in that respect, the Fed's measures can only have a limited effect on the inflation rate. Even if the base interest rate reaches 3%, thus triggering a recession, the prices of certain goods will probably still stay high. But the Fed is unlikely to do that since the financial markets will crash.

S&P 500

SPDR S&P 500 ETF price
Data by YCharts

Although the Fed has not raised the interest rates dramatically just yet, the S&P 500 is sufficiently down from the levels last seen in January. Most of the fall was due to the end of the quantitative easing (QE) program at the beginning of March 2022. At the beginning of May, the rates were only raised by 0.50% - not too much given the situation. But the markets are still down sufficiently. A lot more will happen to the stock market if the Fed gets much tougher, which, I think, will probably not happen since central banks do not want to provoke panic. But there is one more reason explaining why Powell will not get much more hawkish any time soon. That is due to the debt level, which is much higher than it used to be during the 1970s.

Debt level

As a friendly reminder, in the 1970s, there was a classical situation of stagflation - high inflation and high unemployment. Right now, the unemployment rate is not high but may go much higher if the Fed tightens. At the same time, if the Fed tightens, the inflation rate won't go down by much. This will provoke stagflation. However, during the 1970s, the Fed was able to raise the interest rates to 20%(!) since the US debt level was not very high at the time. This is clearly not the case right now.

Debt History

Debt history

Trading Economics

Source: Trading Economics

The federal government collected $4.1 trillion in revenue in the fiscal year 2021 (FY2021) — or $12,294 per person but they spent $6.8 trillion in FY2021 — or $20,634 per person. The government has been spending more than they have been receiving for decades. Obviously, this led to a very high debt level. The current US debt stands at around $30 trillion. Let us imagine the base interest rate is at 3%. In order to service it, the government would need $900 billion per annum or almost a quarter of the 2021 budget inflows. This would force the Fed to print even more money in order for the Treasury to pay back the debt, further devaluing the currency.

That is why I think the Fed will tighten from the 0.75% - 1% levels but there won't be a very big hike. That is bullish for gold.

Geopolitics

Geopolitical uncertainty is very bullish for gold. At the end of February, when the situation in Ukraine only started and new sanctions against Russia were imposed, the gold prices popped from $1,800 to about $2,050.

Gold Price in US Dollars
Data by YCharts

Interestingly, the political situation got more tense, but the gold prices fell down as the Fed became more hawkish. In my view, the geopolitical situation will last for a while, whilst the Fed probably won't tighten much more without harming the economy.

With the pandemic and the situation around Ukraine, many analysts and investors completely forgot about China and the US-China relations. The main focus of 2019 stock market analysis was the trade war between China and the US, something everyone forgot. There might also be some volatility in the future due to the news from that front.

Why is gold so undervalued?

But lots of gold's undervaluation is not only due to the Fed but also due to the numerous gold derivatives, namely ETFs and futures. SPDR Gold Shares (GLD) is also part of the ETF market. Earlier on I wrote that buying physical gold is much better than investing in "paper" gold since the former is in limited supply. As a result of high supply of paper gold, the gold market is very large and therefore not very volatile. That is why a piece of very positive news on the gold market does not make the prices of the precious metal shoot up greatly. This does not mean the gold prices don't have any meaningful potential.

There are still asset bubbles in the market.

For example, in spite of the Fed's hawkish stance, the house prices in the US still rose in the first quarter of 2022. After the Fed started printing money in 2020, the house prices surged significantly.

The Federal Reserve

The Federal Reserve

Source: The Federal Reserve

Gold, meanwhile, on average only makes up 2% of investors' portfolios. Not to mention just a few investors hold gold.

Outlook

All that obviously means gold is undervalued. That is why, in my opinion, many assets may crash in gold terms. But I fully admit I cannot predict when and by how much the gold prices would shoot. However, when the market realizes this, it will most probably be too late. Gold is a perfect hedge against fiat currency devaluation and is a good asset to hold when many other asset classes are over-popular in spite of the stock market correction this spring. I suggest buying physical gold for the long term.

This article was written by

Anna Sokolidou profile picture
1.09K Followers
A research analyst and a freelance writer looking for value investment opportunities. I have several years of investing experience. I am mostly interested in writing about bargain stocks of large companies. My interest is not limited to American companies but extends to firms operating in other countries but listed on US stock exchanges.
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.

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