Is Gold Overpriced?: A Macro View

A recent Business Insider article implicitly touted the utility of gold as a storehouse of value, pointing out that measured in ounces of gold, the price of college tuition, postage for a first-class letter, gasoline, and food -- among other things -- has actually held steady or even declined over time. For example, a postage stamp today (45¢) would cost you less gold than at almost any time in the past 110 years. Tuition and room and board at Yale would set you back just about the same quantity of gold today as in 1900. And even with the recent increase in nominal dollar price per gallon, gasoline is still pretty much the cheapest it has been as measured in gold since at least 1995.

Of course, the price of gold is up sharply of late: roughly 5% so far this year, 10% in 2011, 30% in 2010, and 24% in 2009. Gold has clearly been appreciating in value faster than the dollar has been declining for the past few years. So, even taking into account the risks of a default in Europe, a war with Iran, a recession in the U.S., a growth slowdown or worse in China and India and so on... is gold overvalued here?

According to the efficient market theory, of course, something is worth what folks are willing to pay for it, so by definition, gold cannot be overpriced -- or underpriced, for that matter -- so long as it can be freely traded. However, those of us who remember tulip bulbs, dot-coms, and "irrational exuberance" may have a different view.

One way of looking at this question is to examine the change in the nominal dollar price of gold and determine how much of that change is due to the depreciation of the value of the dollar and how much is due to market demand (or lack of it). Theoretically, if gold is a perfect store of value, you would expect 100% of the change in its dollar-denominated price to be due to fluctuations in the value of the dollar. To that end, the following chart illustrates the "expected" change in the price of gold given fluctuations in the value of the dollar -- mostly down, but not invariably so -- from 1913, when the average cost-per-ounce was $18.92, to 2011:

Source for CPI data (Dec. to Dec.): U.S. Department of Labor.

What this chart shows is that given that the year-end 2011 dollar was worth about $0.03 in 1913 dollars, all things being equal, we would expect the price of gold in 2011 dollars to be around $610. In fact, the average price of gold in 2011 was around $1,570. Thus the decline in the value of the dollar accounts for about 38% of the increase in the price of gold and market demand (or something else) accounts for 62% of the increase. Has this big differential always existed, or is it relatively recent (keeping in mind the recent surge in the price of gold)? Here is the same chart with the actual price history of gold overlaid:

Source for actual gold prices: National Mining Association (link opens PDF file).

Clearly big discrepancies are a fairly recent development, although of course the apparent stability for the first 60 years is undoubtedly a function of the fixed price of gold per ounce -- $20.67 until 1934, and then $35 until the end of the Bretton Woods arrangement in 1971, since which the dollar has "floated" (some might say "sunk"). Indeed, for some 30 years starting with the early '40s, the actual price of gold was (slightly) less than the expected price because the fixed price pulled the absolute value of gold down along the inflating dollar.

But after 1971, when the dollar-peg-to-gold was eliminated, the picture has been different. In the late '70s and early '80s, when runaway inflation threatened to upset the financial applecart, the price of gold skyrocketed, but then came back to the "expected" trend line. After another brief run in sympathy with the S&L crisis in the late '80s, gold actually lagged its expected value significantly during the dot-com boom, when tech shares were all the rage.

Then we had the 2008 meltdown. The big differential we are seeing now is approaching record territory: Since 1913, the only year in which market demand accounted for more of the increase in the price of gold than 2011 (62%) was 1980 (66%). The average percentage of the increase attributable to market demand in any given year since 1913 is only 8% -- that is, on average, 92% of the increase in the price of gold is attributable to the decline in the value of the dollar -- but of course that is deceptive due to the peg that persisted for so many years, artificially depressing the differential. Since 1971 (post-peg), the market-demand share has been 15%... still a far cry from 62%.

So gold is definitely worth more relative to the dollar than it "should" be, and that discrepancy is definitely near the historical all-time high. But does this prove that gold is overvalued?

We can certainly find folks who will object to that conclusion. Fans of collective intelligence (including many Motley Fool CAPS players) would argue that there is momentous meaning inherent in the price signal we are getting from gold: The sky really is falling, or at least in danger of falling.

Gold bulls would argue that the CPI data from the Feds is cooked, understating the extent of inflation and thus exaggerating the discrepancy between the actual price of gold and where it "should" be... in other words, it is not gold that is overvalued, it is the dollar. (Interesting theory, but we would have needed inflation of 10% a year every year since 2001 to get the "expected" price of gold up near where the actual price was in 2011, and no one believes real inflation has been that high.)

The bottom line is that -- sorry! -- there is no one definitive answer appropriate to everyone.

If you buy gold now, you are paying a higher risk premium than you would have three or four years ago, and possibly higher than you would in a year or so, if we continue to dodge bullets successfully for that long. But whether you conclude that gold is overvalued here probably turns on your own investment situation: age, family circumstances, net worth, current disposition of assets, whether or not you already own some gold, etcetera, as well as on your assessment of the macro risk factors out there. Obviously if you expect we are likely to muddle through over the next year or so, gold at these levels is less attractive than it is if you conclude too many eggs are being juggled and one or more is likely to drop soon with potentially unpleasant consequences. And if you do decide to take the plunge here, these factors will also figure into your choice of investment vehicle: buying physical gold in the form of coins or bars to store in your basement or deposit in a storage facility, or purchasing a gold ETF such as the SPDR Gold Trust (NYSE: GLD  ) or Sprott Physical Gold Trust (NYSE: PHYS  ) or perhaps investing in gold mining stock Goldcorp (NYSE: GG  ) , Barrick Gold (NYSE: ABX  ) , or Newmont Mining (NYSE: NEM  ) , or a gold mining ETF such as Market Vectors Gold Miners.

Even some investors who generally eschew precious metals are reconsidering now given the confluence of macro risk factors. And it is conceivable that someone could determine that gold is relatively overvalued but, on balance, decide to buy anyway. Nevertheless, you should certainly not eschew the due diligence of determining your best guesstimate of a fair value for gold before buying some (or more).

Brad Hessel currently owns shares of Sprott Physical Gold Trust and Market Vectors Gold Miners. He has no position in any of the other equities mentioned; however, Brad's clients may have such positions. The Fool's disclosure policy includes certain trading restrictions that apply to Brad. However, his clients are not subject to our disclosure policy and thus are free to trade any such equities. Motley Fool newsletter services have recommended buying shares of Market Vectors Gold Miners ETF. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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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 March 30, 2012, at 2:41 PM, ouchtouch wrote:

    The big giant factor that you fail to analyze is interest rates. Historically (meaning over the last 500 years) real interest rates are the biggest factor in gold price movements. When the issuer of a currency tells you that it will hold down nominal rates near zero for years to come, gold buyers take notice. Then they notice that if the Fed allows interest rates to rise, the U.S. government won't be able to pay the interest on the national debt. Pretty easy to predict what comes next. The dollar price of gold may well dip a bit as deflationary forces overwhelm the Fed, but at the end of the day the Fed will print print print and gold will go up up up. (Unless Ron Paul gets appointed dictator and fixes everything.)

  • Report this Comment On March 30, 2012, at 5:46 PM, CaptainWidget wrote:

    Dead on, it's all about interest rates

    Gold prices didn't drop until Voelker announced he was going to raise interest rates to a whopping 18%. Until that drastic announcement, they kept going up.

    Contrast to now, Bernanke is absolutely unwilling to even think about raising interest rates for years, and every few months he buys a few hundred billion dollars worth of T-Bills, creating new notes.

    Until there's at least a HINT of rising interest rates (and trust, we'll get a "hint" long before it actually happens) then gold prices will RIGHTLY go up. Gold price is the barometer to America's inflation flu.

  • Report this Comment On March 30, 2012, at 6:29 PM, ETFsRule wrote:

    "Until there's at least a HINT of rising interest rates (and trust, we'll get a "hint" long before it actually happens) then gold prices will RIGHTLY go up. Gold price is the barometer to America's inflation flu. "

    You seem to be saying that interest rates are related to inflation, and inflation of course is related to the value of the US dollar. And the value of the US dollar is related to the price of gold. I agree with all of this.

    Now, please explain what the major difference is, between what you describe and what was done in this article? Why is looking at interest rates so much more valid than looking at the value of the US dollar?

  • Report this Comment On March 30, 2012, at 7:14 PM, xetn wrote:

    I believe you overlook at least two other factors:

    counter-party risk; there is none with precious metals (especially gold). The only reason that fiat money has any value is because it is mandated by government for payments.

    The biggest problem is that government should have nothing to do with money. It should be a free-market with many competing currencies to determine the safest one. (Demand vs Mandates)

    Lastly, please explain why many central banks around the world have been increasing their gold reserves (including China; who have mandated that all Chinese production must be sold to government). It seems that the Chinese are trying to accumulate enough gold to make the RMB a gold backed currency and replace all other currencies as the new currency for international settlements.

  • Report this Comment On March 31, 2012, at 1:25 AM, ArizonaSnow wrote:

    In 2007-2008 the University of Texas alumni fund invested $1 billion in gold and took physical delivery. The price rose from $700 to $1100 during this period. When you buy this much gold and take physical delivery you create a ripple effect throughout the market. More people get behind the run-up and soon you have a market rising on follow-the-leader speculation well after the original big buy is finished.

    Certainly there are other factors involved at different times since 2008, including the Glen Beck/ Goldline promotion, but I think monetary policy and perceived inflation is one of the least important factors in the gold price right now except where it influences the decisions of gold buyers and sellers. Gold should have actually dropped during the recent world-wide recession.

  • Report this Comment On March 31, 2012, at 1:54 AM, whereaminow wrote:

    I realize that writing for Motley Fool (or Business Insider) bestows upon you a certain level of "credibility" in the eyes of your average readers. However, on the topic gold prices, I see the same mistakes made in this article that knowledgeable readers have pointed out in other Gold articles on Motley Fool.

    First, you are comparing apples and oranges. From 1913-1971, gold was the monetary metal, and although it was not a true classical gold standard, the monetary rule was designed to keep gold priced at $35/oz.

    Post 1971, there has been no rule. So comparing gold prices using the two periods as if they are one whole macro view is incredibly foolish.

    In order to understand gold, one needs to understand markets, money, and the State. The classical gold standard was a check on the expansion of the State. It had to be destroyed. Thus, as Mussolini once said, "we have buried the putrid corpse of Liberty."

    Gold is the market's money - when the market is free to choose. Paper is the State's money. While gold has been in demand in every country, in every century, since the earliest markets, paper must be forced upon the people through law.

    The gold price in paper will continue to go up, since there is no natural demand for paper money.

    As far as the CPI, not all gold bulls feel it's a conspiracy. In fact, on several of Motley Fool's CPI articles I have objected on the grounds that the BLS uses Objective and Cardinal utility functions in determining substitution effects. Those complaints fall on deaf ears to MF journalists, who continue to chant "conspiracy theorists!" because they do not understand basic economic theory. I don't think you would do any better, judging by this "macro view".

    The correlation between interest rates and gold prices is interesting, as I have been in agreement with ETFsRule on this point before. However, I have also noticed an excellent 11 year correlation between gold and US debt held by central banks. Since we know that number is not getting any smaller, it's unlikely that gold prices will fall anytime soon.

    And let's play Devil's Advocate. How would gold prices fall? Well we'd need another round of extreme price falls. But don't forget, unlike 2008, banks have $1.5 Trillion sitting in excess reserves to "flood" the system should prices fall sharply. That was not available four years ago. Once again, any price declines we see will be short lived thanks to the magic of the printing press - the State's favorite piece of machinery. More beloved than the tank and warship.

    David in Liberty

  • Report this Comment On March 31, 2012, at 8:56 PM, CaptainWidget wrote:

    <<Now, please explain what the major difference is, between what you describe and what was done in this article? Why is looking at interest rates so much more valid than looking at the value of the US dollar?>>

    Because value is subjective. A dollar may buy you the same amount of eggs as it did 50 years ago, but the cost of production of those eggs has probably dropped by 1000% in that same time period.

    The end user gets the same value for his dollar, 6 eggs (or whatever the number is) but the actual cost has skyrocketed because the CPI inflated out the advances in productivity in egg production.

    By contrast, if you look at the price of gold relative to the federal funds rate since 1971, you'll see a pretty much direction inverse coorelation. Troughs in the gold price perfectly coorelate to peaks in interest rates. That makes valuing gold in interest rates much more objective than in the value of the paper dollar. IMHO

  • Report this Comment On March 31, 2012, at 11:19 PM, ETFsRule wrote:

    "The correlation between interest rates and gold prices is interesting, as I have been in agreement with ETFsRule on this point before. However, I have also noticed an excellent 11 year correlation between gold and US debt held by central banks. "

    In theory this correlation could make sense to me, but in my opinion the numbers don't support it.

    At the start of 2000, the Federal Reserve owned $481 billion worth of US treasuries. Now they own $1.67 trillion worth... so that's an increase of 247%.

    Over that same period, the price of gold increased from $279/oz to $1668/oz, an increase of 498%.

    I still haven't come across a reasonable, quantitative analysis that didn't show gold as being extremely overpriced right now.

    "By contrast, if you look at the price of gold relative to the federal funds rate since 1971, you'll see a pretty much direction inverse coorelation."

    The relationship between interest rates and gold has been looked at quite a bit, and it opens up a lot more questions.

    For instance, if interest rates are going to be the ONLY factor in your analysis (which seems to be what you are saying), then, for example, you should always expect the gold price to show the same yearly increase as long as the interest rate is held constant. And in reality, this isn't the case.

    Also, if high interest rates cause gold to drop, and low interest rates cause it to rise - this implies that there is a "breakeven" interest rate, somewhere in the middle, where the gold price won't change at all. And I don't think this has ever been observed.

    Lastly, if there was a direct correlation between the *current* interest rate and the *current* yearly increase in the gold price, this would mean that the market for gold is NOT forward-looking. But, it's generally accepted that all markets are in fact forward-looking. Wouldn't gold investors try to predict what the interest rate will be tomorrow, instead of just what it is today?

    I don't want to put words in your mouth, and you may have been hinting at a more complex type of correlation between interest rates and gold. Regardless, I haven't been convinced by any of the correlations that I've seen.

    My opinion is that Paul van Eeden is 100% correct with his analysis of gold vs the money supply. His theoretical price is the true, "fair price" of gold, and over a long enough time frame he will always be right.

    In the short-term, gold is like any other asset (including pet rocks, beanie babies, etc) ... its price is equal to whatever people are willing to pay for it.

  • Report this Comment On April 01, 2012, at 1:09 AM, CaptainWidget wrote:

    <<In the short-term, gold is like any other asset (including pet rocks, beanie babies, etc) ... its price is equal to whatever people are willing to pay for it.>>

    True, I was cliff-noting the fair price of gold for dummies analysis. Yes, there are a lot more factors involved than just the price of money, but it's pretty strongly correlated to the price of money.

    I don't think there's a "break even" interest rate, or at least not one the fed can find. I'm sure the interest rate, like prices for all commodities, in a free market would fluctuate. That's why there's never been a plateau for interest rates that keep gold prices stable. If the two did happen to cross equilibrium at some point, some other factor threw one or the other commodoties into an overvalued/undervalued state temporarily, and without a free market to adjust the relationship between the commodities, the imbalance created a bigger imbalance ect gold explosion and so on and so forth...

    But yeah.....there's a causal, but not direct, correlation between the federal funds rate and the price of gold.

  • Report this Comment On April 01, 2012, at 1:36 AM, whereaminow wrote:

    -->At the start of 2000, the Federal Reserve owned $481 billion worth of US treasuries. Now they own $1.67 trillion worth... so that's an increase of 247%.<---

    ETFs, I'm talking about total US Debt held in central banks worldwide.

    I had a pretty chart. Now I can't find it. I know I posted it on Fool a couple months back. Oh well.

    David in Liberty

  • Report this Comment On April 02, 2012, at 2:36 PM, bhessel wrote:

    @ouchtouch & @CaptainWidget,

    I agree that the correlation between the direction of interest rates and the direction of gold prices as measured in dollars is useful with respect to the question of vector, but I am not yet persuaded about how helpful it is in measuring amplitude. The focus of the article is on the question of whether or not gold is overpriced, which is a question of amplitude.

    I appreciate that one can take the position that the artificial manipulation of interest rates by the Fed renders the "reserve currency" less useful as a yardstick for measuring value. From this perspective, the disconnect between the dollar and gold shown in the second graph says more about the sickness of the former than any supposed “mis-pricing” of the latter.

    Be that as it may, most of us are still using the dollar as our measure of value, and my main point—that gold now is unusually highly valued in terms of dollars here—is therefore of interest.

    Obviously (as the article states), this does not necessarily mean that gold is “overpriced.” In fact, depending on one’s interpretation of what is happening, it could be a signal that gold is *underpriced* in terms of dollars. Right now, for example, US government bonds are still benefitting from a “safe haven” effect, and folks are standing in line to buy them at incredibly low rates of interest…but it is not hard to imagine a scenario where that confidence gets shaken, and the Fed is forced to raise interest rates not to cool down a too-hot economy but rather just to sell enough new bonds to roll over the portion of the debt that comes due and pay the interest on the rest of it. That could conceivably spiral into money printing once the market for Treasuries dries up… and what happens to the value of the dollar and the price of gold in that scenario (not to mention the inverse relationship between interest rates and the price of gold)?

    Anyway, thanks for your insightful comments. :-)

    Brad Hessel

  • Report this Comment On April 02, 2012, at 4:17 PM, bhessel wrote:

    @whereaminow,

    Thanks for your efforts to correct “mistakes” in my article. I found your comments interesting and particularly appreciated the suggestion that a correlation exists between US debt levels and the price of gold. Intuitively, it makes sense that such a correlation should exist.

    However, in preparing a response, I am hard-pressed to identify where you have specified more than one mistake: your “apples and oranges” comment lamenting the inclusion of both pre- and post-1971 on the same graph contrasting the dollar-inflated theoretical and the actual price of gold. Evidently you missed the part of the article that stated, “the apparent stability for the first 60 years is undoubtedly a function of the fixed price of gold per ounce…. But after 1971, when the dollar-peg-to-gold was eliminated, the picture has been different.”

    I do see where you predict that I *would* have made another mistake had I attempted to analyze the CPI. Perhaps that plus the apples plus the oranges is how we get to plural “mistakes.”

    Brad Hessel

  • Report this Comment On April 03, 2012, at 3:15 PM, whereaminow wrote:

    Brad,

    You're other mistake would be the really big one ;)

    But that was a question of methodology and since I wasn't sure if that was going to be a worthwhile discussion, I tabled it. Probably should updated my comment, but I suck at editing =D

    David in Liberty

  • Report this Comment On April 12, 2012, at 1:56 AM, rfaramir wrote:

    "this implies that there is a "breakeven" interest rate, somewhere in the middle, where the gold price won't change at all. And I don't think this has ever been observed."

    Yes it has been observed, although, no it is not a fixed rate. It's called the natural rate of interest and occurs when interest rates are not manipulated and the money supply is tied to gold (and fractional reserve banking is outlawed).

    The tying to gold fixes the price of gold, so, obviously, it doesn't change. With no change in the money supply, the free market interest rate IS the equilibrium rate. Our problem, since 1971 at the least, is that we do not have a free market in money.

    That's one of the first things Ron Paul would give us, and it would be a huge boon to our economy.

  • Report this Comment On April 13, 2012, at 5:40 AM, Vidyasagar2009 wrote:

    While the western world is only high lighting issues in the US, and its interest rates as reasons for the Gold Price rise, the real direction to look is eastward, namely India, China, Russia and a whole lot of smaller countries in Asia.

    I come from India, and I know for a fact that we consume more than 900 tons each year. Gold is integral to our marriage, dowry, and all family functions.Our young population which is larger than the entire US population are also investing in Gold ETF "s like there is no tomorrow.Our Gold Imports Bill is so large that is next only to the oil bill. In India you can buy the physical Gold quietly with out an invoice and hoard, there will be no questions. Gold is the biggest beneficiary of all black money generated in India.Once purchased most of it will never come out of the vaults, but will get passed on to future generations.So much so that for any urgent money Gold mortgages and short term pledges are the most popular ways of availing liquid cash in say 15 minutes. you can repay the loan with-in a year and reclaim your gold back. The attitude in India is when in doubt buy Gold, when you want to save buy Gold, Gold is our goddess of wealth.

    With such an attitude ingrained in us over centuries Gold will never lose its lustre, so any fall will be bought into. All paper shorts on the comex are at great risk. also with the kind of double-digit inflation that we are experiencing, due to endless money supply, there is going to be no bear market in Gold in this decade.

    At best prices may be range bound for a few months before they head higher, only to be range bound at higher levels. So please don't listen to the western world's concept of Gold being a dead investment, or their call that the bull market is over. Indian Black market generated cash is worth several billion dollars and the only place to hide that cash is Gold,otherwise by simply keeping plain cash, inflation will erode its purchasing power.

    please feel free to ask my opinion from India at my e-mail ID: jv_sagar2003@yahoo.co.in

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