Why is Gold Overvalued?

 

I wrote this third article on gold in December 2010 with gold at $1400/oz. It was published shortly at seeking alpha. In December 2011, I wrote another article explaining why there are much safer inflation hedge choices than precious metals at nosebleed prices. 'Follow' me at seekingalpha.com to be notified when I post new articles there.

There are many theories regarding how to tell whether a hot asset class is bubble-priced or not. One theory is to assume the asset's price will reach the same peak, inflation adjusted, as it did in its prior bubble. Another theory assumes that the price must gravitate to some benchmark, such as “one ounce of gold equaling a fine suit of clothes".1  I suggest forgetting all these old wives tales and instead going by the tried-and-true valuation method called "fundamental analysis". FA has always served me well in steering clear of bubbles. Fundamental analysis for investing in any kind of asset involves estimating its inherent risks, and also estimating the probable return the asset will generate. Note that "return the asset will generate" means return that is organic to the asset itself—separate and apart from any change in the asset's market price.2 If you do forecast this organic return accurately, sooner or later its market price will follow. As Ben Graham said, market price is short term "a voting machine" but long term "a weighing machine." If the market stubbornly refuses to adequately price your asset, you can simply hold on to it and collect its income stream while you wait. Better yet, buy more. An estimate of organic return includes the elements of growth, income, or both. A gold bar cannot grow (unlike a business) and will not produce income (unlike a bond, bank CD, or dividend-paying stock). Because of this, I've heard gold bulls say "you cannot determine a value for gold based on fundamentals—that gold is different." Gold is unique, sure. But on the contrary, you still can and should look at gold's investment prospects from a fundamentals perspective, and frankly gold (at today's $1400 per ounce) looks terrible that way. Instead of attempting to estimate gold’s future income and organic growth rate, you already know them. You simply enter zeroes in your calculation. Zero income, zero growth, guaranteed forever. To illustrate the wealth-multiplying power of real fundamentals (positive growth and income), let’s look at ultra-long term performance. This will even out data that over shorter periods could be very skewed by bull and bear market cycles.  Let’s compare gold with stocks over 100 years. Gold and Stocks Compared as Investments Gold, over the whole of the 20th century, rose from $20.67/oz in 1900 to about $300/oz in 2000. That’s a fifteen-fold increase in 100 years. However, if you sold a few years earlier or later you could have gotten $400/oz, so allowing the benefit of the doubt let's call it a twenty-fold appreciation over 100 years. That is equal to about 3% compounded annually which, coincidentally, was almost exactly the average rate of inflation for the century. So if you bought gold in 1900, you only broke even after inflation 100 years later. Your ounce of gold still bought you a suit of clothes. That is all that can be expected in the very long run—that a non-growing, non-income producing commodity such as gold is unlikely to appreciate much beyond keeping up with inflation.3 On the other hand, let’s see how stocks, which do possess growth and income characteristics, performed over the 100 years.  Actually, an investment in 1900 in the Dow Jones Industrial Average grew a whopping 175-fold over the 20th century (from 62 to 11,000), far surpassing inflation.4 Additionally, a $20.67 investment in the Dow in 1900 would have been rewarded with about $1300 in dividends over the century. What’s more, those dividends could have all been reinvested in the Dow, compounding all along and growing the $20.67 investment into a grand total of nearly $10,000. So a long term investor with $20.67 to invest in 1900—faced with a choice between buying a basket of stocks or an ounce of gold—had a tremendous difference in outcome riding on that decision. Stocks did 25 times better than gold. In hindsight we know the best choice by far was the Dow, and the reason it was superior was because stocks possess the fundamentals of income and growth while gold does not. Warren Buffett's recent commentary that gold is not a "productive" asset to own is another way of saying the same thing. Without organic growth or a dividend, a gold investor’s only hope is purely price growth, which means to be at the mercy of supply and demand. This is a much trickier and more speculative situation than owning a solid, growing business that in most years will maintain or grow its profits. And since gold is not consumed, unlike other commodities, gold's global supply continually grows larger by accumulation. Coins, bars, jewelry, and industrial scrap gold can all return to the supply stream quickly and easily. Gold chart weakness could trigger fear and thereby a large dump onto the market of this ever-accumulating supply. Gold is thus potentially riskier than consumed commodities, like crude oil or wheat. And nobody needs gold—not the way they need to drive or eat. For all of the above reasons, I consider it virtually certain that the current gold price boom sooner or later will be followed by a terrible bust. Once gold price deflation has clearly become established as the new trend, many gold investors will switch from confidence to fear and sell. Gold buyers at these historically high prices are momentum investors, not 'contrarian' value investors, so many will be fickle once the momentum is clearly downward. Gold’s lack of growth or income fundamentals will fail to encourage buying support as the price trends further south. This is what happened as gold fell from its peak of $850/oz in 1980 to nearly $250/oz by 2002. Imagine how much greater the loss after adjusting for 22 years of inflation! And there was no dividend for those 22 long years. Of course gold buyers today pushing the price up to $1400 an ounce (from below $500 five years ago) aren’t looking at gold’s lack of organic fundamentals. Their views have a different focus. Many see gold as a safe haven in a coming financial crisis that is building steam pressure. They expect paper money to lose tremendous value in a plague of runaway inflation.  But they are wrong about these things as I discuss in my book. And buying gold at inflated prices is risky, not safe. Gold now being surely overpriced fundamentally (in the overarching decades-long picture) means that the gold ETFs and gold related stocks are also too high. Gold mining stocks’ profits are leveraged to the price of gold, meaning that if gold rises x%, their profits rise by more than x%. Conversely, when gold falls x%, gold mining stocks can expect to fall greater than x%. If you own gold ETFs or gold miners, I'd suggest taking some profits now at record gold prices. Nobody knows how long this gold party will last. Personally I'd be avoiding all gold ETFs and gold miners such as GLD, IAU, GDX, GDXJ, SGOL, PHYS, ABX, NEM, AEM, AU, GG, GOLD, DGL, EGO, DGP, UBG, UGL, RGLD, GBG, GFI, GRZ, GSS, IAG, HMY, CDE, HL, RBY, RIC, NGD, KGC, AUY, NG. The gold bull may charge considerably higher yet, but it's just too risky for my blood without the fundamentals to support the price. 1 It’s been often said that gold has held its value steady over the ages, and that its price will gravitate to “the price of a fine suit of men’s clothes." But this should come as no surprise. Many things tend to hold their value and thus to more or less track inflation (provided their supply and demand balance doesn’t change). Is it really any different to say “an ounce of gold should equal a suit of fine clothes” versus saying “a gallon of milk should equal a bag of good cookies”?  Another mythical comparison is certain pundits' claim that some cosmic force will ultimately push the Dow Jones Industrial Average and the price of an ounce of gold to their "correct balance" of parity, i.e. Dow 9000/Gold $9000, or Dow 5000/Gold $5000, etc. 2 The exception is assets whose supply cannot grow, e.g. a unique Picasso, location-specific land, or antiques. These assets can be good investments even though they generate no return organically. 3 Of course as demand for commodities leaps from expansion of the global middle class, commodity prices should rise. However, commodity price increases are a key component of inflation, and so owning commodities is still just "keeping up with inflation" in that sense. Notwithstanding, an investor with foresight might still make good money by getting in early enough on a commodity boom cycle. Even so, such participation in commodity price inflation does not enjoy the geometric multiplier of organic growth. (In his book "Hot Commodities", commodities guru Jim Rogers repeatedly says commodity prices are strictly a matter of "supply and demand", implicitly recognizing that they do not reflect any organic growth.) 4 By the way, the remarkable 175-fold gain for stocks versus 20-fold for gold does not represent added risk if the stock portfolio is well diversified. And while gold averaged a 3% annual return, the 175-fold gain of stocks represents only a 5.3% average annual return. The 2.3% difference in returns looks small, but when compounded over many periods it becomes huge.