The biggest problem with investing in gold (NYSEARCA:GLD) is determining what 'fair value' is. Gold makes intuitive sense as an asset class, given today's geopolitical risk, fiscal imprudence and monetary profligacy. But at what price?
Looking at the price of gold over the past few decades, one is forgiven for automatically thinking the metal could be overpriced. After all, it has risen about 7x since its low during the early 2000s. While historical price movement doesn't necessarily mean something is over/undervalued, many investors anchor their targets using historical data.
Gold Price in US Dollars data by YCharts
Gold may make intuitive sense, but, because of its price movement, many investors are wondering if it is a good investment. You see, it's a similar problem to what we see with stocks: a good company can be a bad investment and vice versa. While this problem for stocks can be solved by conducting discounted cash flow analysis, since gold doesn't generate a cash flow it can only be valued using relative measures.
Below I show 2 ways to evaluate the price of gold. None of these methods are perfect. In fact, this imperfection is part of the story I'm trying to tell - it is very difficult to value gold. To be frank, there are probably dozens of ways to evaluate the price of gold using different comparisons. Moreover, using the same comparable but different time-frames can yield different answers. An honest gold analyst will remain objective in his outlook, so be wary of those pounding the table with a certain price target.
The first relative measure I used below compares the gold price to the money stock (M2) flowing through the economy. Since the growth in money supply should arguably be reflected in prices of goods and services (i.e. inflation), one might expect gold prices to rise in tandem with money supply. While this is a simplistic view (prices might not rise evenly, for example) it does form a basis for evaluating prices.
Note: All comparisons use the common longest-available data for both measures. In this example, the data goes back to the late 1970s.
According to this measure, gold has caught up to the monetary growth that has occurred over the past few decades. It is quite clear that the deepest discount was in the early-2000s, precisely when gold prices hit bottom. While it is quite possible that the growth of gold prices overshoots on the upside, the compelling valuation gap, relative to M2 money supply growth, no longer exists. In fact, according to this gold may already be slightly overvalued.
US M2 Money Stock data by YCharts
The second relative measure I used tells a different story. It compares gold prices with the growth of total credit in the US economy. Arguably, credit growth is a form of monetary expansion since all credits must be theoretically repaid using real dollars. As with M2 in the previous example, the argument is that money supply growth should be reflected in the price of goods and services, including gold.
Compared to the growth of total credit in the US (government and private), gold prices have lagged. In fact, the move in gold prices during the same period was about 1/2 as strong as the growth in credit. According to this measure, gold is significantly undervalued.
US Total Credit Market Debt Owed data by YCharts
So there you have it. Two contradictory answers to the same question. Personally, I reconcile these valuation uncertainties by simply allocating a portion of my diversified portfolio to gold (specifically ETFs Physical Swiss Gold (NYSE:SGOL)) without getting overly-excited about the asset class.
Disclosure: I am long SGOL. 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.
Additional disclosure: This is not advice. While the author makes every effort to provide high quality information, the information is not guaranteed to be accurate and should not be relied on. Investing involves risk and you could lose all your money. Consult a professional advisor before making any investing decisions.