The Path to $5,000 Gold

Ever since I showed that gold is wildly overpriced on a historical basis, I have been looking for ways to demolish the conclusion that we are in a gold bubble. Why? That way, I could either reject the notion or achieve greater certainty about it. Now, the ongoing turmoil in Europe has spurred my imagination into constructing a crisis scenario to try to justify today's inflated gold prices.

Turning somersaults
As the Greek debt crisis has continued to fester, European officials and bankers are coming up with contrived stop-gap plans to put off the day of reckoning. Slowly, ever so slowly, we appear to be headed toward a fork in the road: On one side is Greek default and an ignominious exit from the Eurozone; on the other, Greece becomes a permanent ward of the European Union/northern European nations.

Under a default scenario, the Greek banking system becomes insolvent and would require a recapitalization. As a result, National Bank of Greece (NYSE: NBG  ) shareholders would be wiped out. Not surprisingly, the huge ambient uncertainty has done nothing good for Greek citizens' confidence in the safety of their assets. On Monday, credit rating agency Moody's reported that Greek banks had lost 8% of their deposits since the beginning of the year.

The case of the vanishing bank deposits
Where are these deposits going? Roughly half of the drop is a response to declining incomes, but the other half is "confidence-sensitive depositors ... transferring funds abroad and converting their deposits into gold coins, while others have been placing their cash into bank safety-boxes."  (Emphasis mine.)

The U.S. is insolvent, too
Greece is emblematic of a wider problem: the massive accumulation of sovereign debt in many developed countries coupled with low growth prospects. Need I remind readers that the U.S. faces a debt crisis of its own? The uncertainty concerning the extension of the debt ceiling is the tip of the iceberg; once the total liabilities relating to Medicare, Medicaid, and Social Security are added to existing debt, the U.S. is technically insolvent. Despite the U.S.'s huge advantages, it's no longer possible to rule out a dollar crisis entirely, despite what our irresponsible politicians' behavior suggests.

In its annual report on U.S. economic policy released last week, the International Monetary Fund warned against the possibility of "a sudden increase in interest rates and/or a sovereign downgrade if an agreement on consolidation does not materialize or the debt ceiling is not raised soon enough." In that context, here are two possible scenarios for the U.S. and their potential impact on gold prices:

 

Scenario 1

Scenario 2

Description

Crisis

Mounting concern regarding the inability of the U.S. government to address the long-term sustainability of the country's finances reaches a tipping point. Concern gives way to fear, then panic, spurring a dollar crisis.

U.S. government bonds lose status as the global risk-free benchmark and the reserve asset of choice. Surplus countries and other investors reduce their exposure to the dollar, selling U.S. assets at an accelerating pace and driving Treasury yields significantly higher.

The U.S. banking system, including too-big-to-fail institutions like Citigroup (NYSE: C  ) and Bank of America (NYSE: BAC  ) , comes under intense stress, and without a safety net this time (there is no lender of last resort).

Recovery/Muddle-through

U.S. government addresses its fiscal position to put it on a sound footing for the long term.

The U.S. economic recovery achieves "escape velocity," led by multinationals like Caterpillar (NYSE: CAT  ) , Procter & Gamble (NYSE: PG  ) , and Boeing (NYSE: BA  ) . Employment improves, the housing market stabilizes, and consumer confidence improves.

China engineers a soft landing of its economy and allows the renminbi to appreciate. Global macroeconomic imbalances decline.

Hypothetical price impact on gold market

The price of gold explodes to $5,000 per ounce

Investors are desperate to own any asset regarded as a safe haven. Unprecedented demand overwhelms limited supply and the clearing price for gold shoots up to $5,000 per ounce.

Gold declines to $500 per ounce

The Fed raises interest rates, thereby raising the opportunity cost of holding gold.

As investors discount the possibility of another financial crisis as increasingly unlikely, they reduce their exposure to gold. The metal's price reverts back to its historical average price (approximately $500).

Probability

Unknowable/Small (but rising)

Unknowable

Now, for the sake of argument, let's assume we assign odds of 25% to Scenario 1 and 75% to Scenario 2. Under those assumptions, a fair price for gold is (.25)*(5,000) + (.75)(500) = $1,625, a slight premium to current prices. Let me emphasize that I have no idea what the price of gold would be in a crisis of extreme severity, but the number seems plausible and I'm not trying to predict what will actually occur. I constructed this very simple model to get a sense of the assumptions that are necessary to justify today's prices.

"Possible" doesn't equal "probable"
As the analysis shows, it is possible to justify $1,500 gold under a specific set of assumptions. In the follow-up article, I'll explain why I remain unconvinced and why investors who own bullion or gold-backed ETFs such as the SPDR Gold Shares (NYSE: GLD  ) almost certainly misunderstand the nature of their position.

With gold prices at historic highs, one little-known gold miner is minting a fortune. Click here to find out which miner it is: "The Tiny Gold Stock Digging Up Massive Profits."

Fool contributor Alex Dumortier holds no position in any company mentioned. Click here to see his holdings and a short bio. You can follow him on Twitter. The Motley Fool owns shares of National Bank of Greece SA. The Fool owns shares of and has opened a short position on Bank of America. Motley Fool newsletter services have recommended buying shares of Procter & Gamble. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (14) | Recommend This Article (20)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 06, 2011, at 4:57 PM, unthoughtknown wrote:

    ok.. two things..how can you say it is expensive historically? historically the dollar was tied to gold.. one ounce was 35 dollars or whatever..if we go by "history" and back the dollar by gold (which will happen someday as there will be no choice) gold would be a shitload higher than 1500 an ounce..also, how can you say the Fed raises interest rates? yeah, may they raise it .5 percent? maybe.. but doesnt mean anything..do you think the fed would raise rates to 5%??? they do that the US is bankrupt, the dollar worthless and gold is a lot higher than 1500 an ounce... your arguments are weak at best..

  • Report this Comment On July 06, 2011, at 6:33 PM, xetn wrote:

    Here is the deal, gold is priced in various currencies including the dollar. If the Greek or Italy (other PIIGS) were the problem, you would expect other currencies to disregard gold. So, how do you account for this:

    http://www.the-privateer.com/chart/g-multi.html

    The simple fact is all countries that can (have a central bank) have been creating money out of thin air for years to pay for wars, social programs, and expansive governments. These are some of the major issues being reflected in the "currency" value of gold.

    And, by the way, it is not just gold, look and many other commodities (including food) and see if they have been declining.

  • Report this Comment On July 06, 2011, at 8:15 PM, TheDumbMoney wrote:

    Scenario 3: I think your "Scenario 2" is really two distinct scenarios. That is because it is very possible we continue to have a modest recovery and 'muddle through' for a long time, EVEN without the U.S. addressing its long-term fiscal issues. (Maybe I'm just reading what you said wrong.)

    So if this happens, this "Scenario 3," I could easily see gold staying at the same level, or rising somewhat, but not shooting a ton higher. That is because even if GDP grows, until the U.S. is on a more sustainable long-term path, concerns (right or wrong) about fiat money and sovereign default of the U.S. will persist. I may disagree with some of these concerns, but keeping my objective understanding out of it, the concerns will persist and rise, period. This is especially true in light of events in Europe, and in light of the fact that aside from Europe and the U.S., Japan is really the only large-scale currency game in town and they ain't so hot either. (Why only these three? -- Swiss market is too small, as is Nordic, the Chinese currency market is too manipulated and politically motivated, Australian dollar is too dependent on China, as is Brazil probably, and India is too unstable and "developing" (it's currently facing a Maoist insurgency in its own borders ferchissakes -- can you imagine?).) So there ain't a lot of "trustworthy" currency games in town and once people started freaking out about the dollar and the Euro, and with Japan at 200% or more of debt/GDP, gold started to be and will continue to be a large part of major players' asset allocation decisions. John Hussman's main fund is something like 18% gold miners. Grantham is recommending commodities. What a world!!! But that's just the way it is. We can rail against it, or we can accept it. In such an environment, gold simply does not drop too much.

    Finally, there is a "Scenario 4", whereby gold hits $500/oz again, or lower, as another late-2008 style liquidity crisis causes massive "risk-off" selling of non-dollar asset classes, PRIOR to something like your "Scenario 1" taking place. Catalysts might be Spanish or Italian default, or maybe failure to raise the U.S. debt ceiling, who knows. If this happens, I actually may buy gold, as I think Scenario 1 will be much more likely to follow shortly thereafter.

    In my view, Scenario 3 is most likely for the foreseeable future, and Scenario 4 is the second-most likely to happen in the next year or two.

    But whatdoIknow!!!

  • Report this Comment On July 06, 2011, at 8:53 PM, burlybull1 wrote:

    Two years ago my financial adviser once told me that he didn't deal in commodities like gold because the risk-to-reward ratio was too high for his liking. So for a year I let him handle half of my wealth while I dealt in the purchase and sale of gold and silver. He did well, but not as good as any of the benchmarks. Guess how I have done? I now control all of it myself and have increased my gold and silver holdings. There is going to be a world financial meltdown. Be prepared!

  • Report this Comment On July 07, 2011, at 1:35 AM, dividendgrowth wrote:

    TMF front page throwing out $5000 gold target is actually bad for gold bulls.

  • Report this Comment On July 07, 2011, at 3:04 AM, name7865 wrote:

    You think there's a 75% probability that US politicians will 'address its fiscal position to put it on a sound footing for the long term'?

    I can't believe that any adult can think that. Where have you been the last 30 years? When have you ever seen politicians do anything 'sound' or even sensible? Politicians will do whatever it takes to get big campaign donations and get re-elected. The good of their country is a quaint, old-fashioned notion that went out of style at least 50 years ago.

    You think there's only a 25% chance that 'Surplus countries and other investors reduce their exposure to the dollar'? They are ALREADY DOING THAT.

    I think that the gold price may have risen too far, too fast; but not for the reasons in this shallow article.

  • Report this Comment On July 07, 2011, at 1:16 PM, 94hokie wrote:

    The main, overwhelming thing that makes me discount the entire argument of the serious "gold bugs" - what do you really think will be the best metal to own if the financial sector melts down as bad as you predict or we have a medical epidemic etc...gold or lead?

  • Report this Comment On July 07, 2011, at 2:54 PM, plange01 wrote:

    the path t gold even getting n ear $2000 leads to dreamworld .....

  • Report this Comment On July 07, 2011, at 4:50 PM, moneyman35 wrote:

    "There is going to be a world financial meltdown. Be prepared!"

    If that happens what good will gold be??? The only reason you would want gold in a world meltdown would be if everybody decides to agree that gold has value to everyone.

    You're a dreamer! I like that. But, If the world has a meltdown and you think you're just gonna go pickup the gold in the car you can't get gas for, from the bank that no longer exists and go trade it for food at the store with run by the guy who is miraculously still selling food even though the world as we know it has come to an end... You're nuts.

    If there is a meltdown of epic proportions like some are predicting. We are all effed and there aint nothing anybody can do to prepare for it.

    So be like be me and live in ignorant bliss in hopes that it doesn't happen!!! I'm having a blast!

  • Report this Comment On July 08, 2011, at 1:06 PM, JaysRage wrote:

    This is actually your best article yet on the topic. You've articulated that there are two possibilities of fiscal policy....one that causes deflation.....one that causes inflation. The deflation scenario, however, could very well result in depression, so gold would be a good bet there too.

  • Report this Comment On July 08, 2011, at 2:21 PM, whereaminow wrote:

    Alex,

    I really liked this. You performed the kind of thought exercise that I can follow and enjoy.

    I won't be writing any rebuttals, and even though I disagree with your estimate of likelihoods of the vairous scenarios, I certainly respect the willingness to look at possibilities that could cause price movements beyond the standard models employed by gold skeptics.

    Great work.

    David in Qatar

  • Report this Comment On July 08, 2011, at 2:29 PM, jerryguru69 wrote:

    Ha, Ha, Ha, LOL, LOL, LOL

    your equation kinda reminds me of that cosmic calculation of a couple of decades ago about the possibility of advanced civilization in the universe. It was publicized by Carl Sagan in relation to the PBS series 'Cosmos'.

    For the record, the author of said equation withdrew it in light of the publicity.

  • Report this Comment On July 08, 2011, at 3:15 PM, buffalonate wrote:

    I hope gold does goes to 5000 so I can double short it.

  • Report this Comment On July 08, 2011, at 3:57 PM, TMFAleph1 wrote:

    David,

    You wrote:

    "[...], and even though I disagree with your estimate of likelihoods of the vairous scenarios..."

    Just to be clear: These aren't my estimates of the probabilities of these scenarios. I'm simply making explicit the assumptions that you need to make in the context of this simplified model to justify the current price of gold.

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