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The gold-dollar exchange rate suggests gold is fairly valued [ClearOnMoney]
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The gold-dollar exchange rate suggests gold is fairly valued

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Commentary

The gold-dollar exchange rate suggests gold is fairly valued

9 May 2012 by Jim Fickett.

If you deflate the price of gold and silver by the increase in the number of dollars, instead of by the consumer price index, gold and silver prices are neither high nor low right now.

For a long time I've had mixed feelings about gold. On the one hand, with an ongoing debt crisis in Europe, coming debt disasters in Japan and the US, and negative real rates seemingly a permanent fixture in many countries, it is hard to see the gold price coming under much downward pressure any time soon. On the other hand, as I've said many times, with the inflation-adjusted price far above its long-term average, it is difficult to see any margin of safety in gold.

It would be nice, in this highly ambiguous situation, to have an additional anchor point – some independent way to assign a rational price to gold. Last week Pacific Capital Associates sent out a newsletter with a very useful idea along just these lines (now up as a blog post).

The main idea is to focus on the fundamental debasement of the dollar. In the past, I've looked at the inflation-adjusted gold price, essentially considering what an ounce of gold will buy at any given time, in terms of common consumer purchases. PCA, instead, focuses mainly on confidence in the dollar, related to the risk of losing future purchasing power. Quantitatively, they measure debasement of the dollar not by loss of current purchasing power, but by growth in the money supply.

To get technical for a moment, there are, of course, many measures of the money supply. In our current financial system, people do not pay with seashells, metals, or even (usually) paper dollars. One can get into long and difficult arguments about whether money market funds are investments or money, and whether travelers' checks are money or credit. PCA uses a very conservative definition of the money supply, defined by the Austrian school of economics as the “true money supply” or TMS. This is essentially currency plus accounts from which one can draw cash without anyone having to liquidate an investment – e.g. checking and savings accounts.

Below is a graph of the gold (and silver) price since 1969, adjusted for the growth in TMS. The average values for the two metals over the time period covered is shown by dashed lines.

The main thing to note is that, according to this analysis, both gold and silver are right at their average value for the last four decades. That is, if you deflate the price of gold and silver by the increase in the number of dollars, instead of by the consumer price index, gold and silver prices are neither high nor low right now.

The second thing to note is how high the prices of both metals went during the great inflation. Even adjusted for the increase in the money supply, both metals went up to several times their long-term average price.

Overall, this analysis suggests (1) that gold and silver are currently fairly priced and (2) that if one fears future inflation, a reasonable strategy might be to hold precious metals into the worst of the storm, and then sell them and buy other assets like equities, which will likely have depressed real values.

Peter Bernholz has shown that in many historical cases of high inflation, the gold price rises sooner and faster than the prices of goods and services, so the high value of holding gold in the early stages of inflation is a general feature of history (Bernholz, Monetary Regimes and Inflation, 4).

The overall argument here does not depend strongly on the particular measure of the money supply. In case you don't buy into Austrian views, here is the same graph using the most common measure of the money supply, M2:

With M2, current prices look slightly high, but the main conclusions stand.

There are several caveats to this whole analysis. First, many will argue that the Fed has temporarily increased the money supply more than usual, but will cut it back, or at least slow its growth, once the economy recovers. However, while I do not doubt that it is technically possible for the Fed to slow the growth of the money supply, I think the economy, weakened by globalization, speculation, and long-term misdirection of investment through Fed and government intervention, will stay weak for a very long time, and it will be politically impossible to choose monetary tightening.

Second, one could argue that an increase in the supply of dollars may not lead to loss of purchasing power at all, as long as demand increases with supply. With the value of the dollar rising every time Europe takes a turn for the worse, this point of view is probably quite valid for the short term. However the US is very likely to have its own debt crisis eventually, at which point demand for dollars will fall precipitously.

A third caveat I take more seriously – that the dollar is not the only currency competing with gold. For example, real savings account rates in China are negative, and gold is one of the few options open to ordinary citizens to preserve wealth. But in China, gold is competing with houses and renminbi, as dollars are not available, and so the number of dollars in the world is irrelevant to the gold price, as seen by Chinese savers. A January white paper from Amit Bhartia and Matt Seto at GMO argues that the rise in the gold price in the last decade has been driven mainly by demand in Asia, not the US and Europe:

We believe that gold is an emerging markets asset as much as it is a bet against the Federal Reserve, and that much of the rise in gold prices has been driven by purchases by emerging consumers, who are driven primarily by “financial repression.” …

Gold purchases over the past 10 years have been derived increasingly from emerging markets, especially emerging Asian countries (with India, China, and Vietnam accounting for the bulk of the increase in demand). Whereas in 1999, emerging Asia accounted for only 39% of global gold demand, by 2010 this figure had reached 57% and has increased since then. Exhibit 2 illustrates emerging Asia’s increasing influence: from 1999 to 2010 its share of global gold demand increased from 39% to 57% by 2010 and is concomitant with the rapid rise in gold prices. …

Exhibit 4 shows aggregate demand of gold from 2000 to 2010 based on data from the World Gold Council. A total of 29,342 tons of gold were purchased for both investment and jewelry.

A number of interesting observations can be drawn from the data:

  • Retail purchases from emerging markets totaled over 23,200 tons, a staggering 79% of total demand, far and away the primary demand component over this period
  • China and India alone combined for a total of 9,000 tons, a figure that is more than the developed world as a whole and four times aggregate ETF demand. …

Because of capital controls that severely restrict money outflows, Chinese and Indian residents are essentially forced to either deposit their savings in a bank or invest in local equities. Governments regulate deposit rates, forcing negative real rates. Moreover, local equity markets are often incomplete. The recent dismal performance of these equity markets has not been encouraging either. Gold jewelry and gold bars, along with real estate, are the most prominent among the few alternatives.

Coupled with this “financial repression,” savings in emerging markets rose dramatically in both relative and absolute terms between 2000 and 2010. In 2000, emerging markets accounted for roughly 25% of global GDP. By 2010 this figure reached 40%. Domestic savings in China rose from a 41% average in the 90s to 47% in the 2000s while India’s savings rate rose from 23% to 29%. Consequently, combined gross savings in China and India increased from $557 billion in 2000 to $3.4 trillion in 2010. Essentially, there was an enormous increase of money available to invest and, given the lack of good alternatives, gold was a preferred choice.

Bhartia and Seto make a strong case that demand in emerging markets is one strong driver of the gold price. However it is not the only one. The dollar is still the single more important reserve currency in the world, and many people in many countries keep their savings in crisp US bills. So it is valid to make an argument for gold in terms of competition between dollars and gold for savings. In addition, financial repression in China is quite likely to continue for a long time, also supporting the gold price.

Ten years ago, I had about 10% of my portfolio in precious metals. With the run-up in prices, this percentage grew considerably, and I have reduced it back to somewhere in the 5-10% range again. It is difficult to assign any true dollar value to gold, and hence difficult to take a value investing approach, but the analysis above, against the backdrop of Bernholz' historical studies, makes one good argument for holding some position.

Data footnote

M2 and the underlying data for TMS were taken from the Federal Reserve's H.6 report. Following a summary of the Austrian view by Michael Pollaro, the following components were summed to obtain TMS:

Table 5 (not seasonally adjusted components of M1):

  • Currency
  • Demand deposits
  • Other checkable deposits, total

Table 6 (not seasonally adjusted components of non-M1 M2):

  • Savings deposits, total

Table 7 (other memorandum items):

  • Demand deposits at banks due to foreign commercial banks
  • Demand deposits at banks due to foreign official institutions
  • US government deposits; demand deposits at commercial banks
  • US government deposits; balance at Federal Reserve; general account

For each year in the above graphs, I used the average metal price for the year, as reported by Kitco, and the June figure for the money supply. The adjusted price for any given year is just the nominal price divided by the increase in the money supply from the base year.