Valuing Gold

Valuing Gold

January 13, 2008


Unlike most anything else out there that one could invest or speculate in, gold does not have a valuation. It is never expensive or cheap. It might be overbought or oversold, or some such thing, which is really a way of saying that a floating currency compared to gold is oversold or overbought. Gold is money. It is money because its value is stable.

Thus, there can never be a “bubble” in gold. A “bubble”, at the very least, must be a period when people pay far more for an asset than it is worth. What’s gold worth? One ounce of gold is worth….one ounce of gold. It’s money. It’s also true that there are times when it is extremely beneficial to speculate in gold (1971-1980) and times when it is extremely unrewarding (1980-2002). But you could say the same thing about dollar bills in a coffee can (a wonderful investment in 1929-1932, a terrible one in 1970-1980). That’s really just the paper equivalent of stuffing gold in a vault in Zurich. In 1923, during the German hyperinflation, it is said that a hotel was purchased for one ounce of gold. The price of one ounce of gold, in Germany, reached about 84 trillion marks. Yet, in 1923 one ounce of gold was $20 in the US, as had been the case for the past 134 years. Was there a bubble in Germany but not in the US, for the same easily transported, easily traded item?

Most all investible assets can be valued on some cashflow basis. This is true of stocks and bonds, of course, and real estate, which constitute among them the vast majority of assets worldwide. Gold has no cashflow. Other commodities can be valued ultimately on their usefulness. This translates into a demand, which is balanced by a supply, which is closely related to production cost. Gold’s value is ultimately related to production cost as well, but because annual production is a tiny fraction of available holdings (less than 2% these days), changes in production have little effect on gold. If all gold production ceased for the next ten years, nothing in particular would happen. There would never be a shortage of gold, because it is never “consumed.” On the demand side, nobody needs to buy gold either, for industrial purposes. (A tiny amount is used in electronics.) Gold is useful, of course. It is useful as money. One of the requirements of money is that it is not useful (at least at its present value) for anything but money. You can see this is true of dollar bills as well. Nobody uses them as anything but money.

Thus, all the attempts to value gold in terms of oil, or the CPI (“inflation adjusted gold price”), or some such thing, are essentially meaningless. This is reflected in the futures curve for gold. It trades like a currency — on an implied interest rate differential — rather than an industrial commodity.

This makes some people nervous, because investment ideas are typically based on the proposal that something is “cheap,” or, at the very least, that there is a “supply/demand imbalance,” which is to say, a shortage or glut. Neither is ever the case for gold. To the typical stock investor, looking for value or growth (gold has neither), or even the passive index investor content to add a little to their ownership of US industry every month at the going rate, this is counterintuitive behavior. To the bond investor looking for a balance between yield and risk, gold is equally puzzling, as there is no yield (or slightly negative) and the “risk” is hazy at best. And when you have an investment that is “rising in price,” but there isn’t a decent argument that it is “cheap” or there’s a “shortage,” then it sort of looks like a bubble, no?

You have to use some different techniques to invest/speculate in gold effectively. As I argued some time ago, gold is not an investment. It’s money. There’s no return on capital. But, if you’re interested in return OF capital, it is the King of Kings. Gold is an interesting speculation at only one time: when currencies are losing value. And not only that: if one currency, like the Indonesian rupiah in 1998, is losing value, then you can go to a currency that is not losing value, like the US dollar in 1998. That would be more profitable than gold, as it pays some interest. So, the only period in which gold is an attractive speculation is when all currencies are losing value, which typically takes place when the major international currencies lose value. Thus, we need to look toward the currency managers, central banks, to manage our gold speculation effectively. Today, especially in the US, it appears that central banks are not only complacent regarding the worsening inflation, they are outright negligent. Ben Bernanke built his career on the notion that the Great Depression could have been averted by a brisk inflation in the early years of the 1930s. It’s false, and Ben Bernanke is going to prove it today.

Even I am rather surprised at the degree of Fed negligence. I thought there would be a tightening bias, and that Wall Street’s Big Surprise would be Fed rates climbing above 6%. That will happen eventually, but not right away. (Good thing I don’t try to trade this stuff.) Even Arthur Burns, the inflationist of the early 1970s, was tightening aggressively at this point, taking the Fed funds rate to 8% and higher. The kind of total abandonment suggested by today’s Fed raises the possibility not only of a relatively gentle currency slide, like the 1970s, but a collapse.

People don’t have much appreciation for how destructive inflation can be. We are stuck in the Great Depression image of economic hardship — bankruptcy and unemployment, and falling prices. Neither tends to happen in inflation (although it is happening now, something of an exception). What happens instead, is that everyone gets poorer together. Some time ago, I showed what the US stock market, per capita GDP and weekly wages looked like if you adjusted for the dollar’s decline in value against gold since 1970. It’s not a pretty picture.

Click Here for Graphs of the Disaster of 1970s Inflation

It took about thirty years for the US stock market to return to its highs of 1965, measured in gold terms. Per capita income never really reached the highs of the late 1960s (this series is inflated by the temporary rise in the dollar vs. gold in the late 1990s). And weekly wages, measured in gold oz., have been a total disaster. Let me say that again: for the great majority of Americans, even after thirty years their situation did not recover to the level of the 1960s. And it is going to deteriorate again. Maybe thirty years from now, we will say that “even after seventy years, their situation did not recover to the level of the 1960s.” You can see from the graphs that the recovery from the Great Depression was much briefer. Even with World War II intervening, by 1949, or 20 years after the peak of 1929, people managed to recover what they had lost. Life for most in the US will probably take the funny character of a Country That Used To Be Rich, like Argentina (doing better today actually) or the UK in the 1950s, or Italy in the 1980s.

In 1929, the DJIA hit a high of 381, or about 19 ounces of gold when the dollar was worth 1/20th of an ounce of gold. The DJIA had a trailing P/E of 20 at that time, so it was not really a “bubble.” (Perhaps there was a “bubble” in corporate earnings, sort of like today.) Today, the DJIA is at 12,606, with the dollar at $895/oz. You can buy the DJIA for 14 ounces of gold. The DJIA is below its 1929 peak! I’m serious. It’s just the same as the German hotel. Was it worth one ounce of gold (hyper cheap) or was it worth 84 trillion marks (“hyper expensive”)? Maybe the DJIA will rise from today’s 12,606 to 84,000,000,000,000 in the future, and be worth one ounce of gold.

There is sometimes confusion here, because people mistake technological development for prosperity. “But…but…in 1965 people used vacuum tube electronics, and now you can buy a DVD player for $30!” That’s true. But, you can also buy a DVD player for $30 in Burkina Faso, or Zimbabwe. Africans are still poor, poorer than they were forty years ago. Dying of starvation! With $30 DVD players!