How to Value Gold
The long-term bull market in gold has been a ‘life saver’ for investors over the past 10 years. Equities have been in a sideways/bear market. Bonds have been all over the place with the peculiar twists and turns of monetary intervention. Commodities have been great, but quite gut-wrenching at times. Yet gold, the elusive metal, seems to have been one of the few assets to proceed upward in an orderly fashion. Now, although I don’t necessarily advocate buying gold just this second, I continue to believe that it is in a long-term bull market. So, to alleviate the fears of some of gold’s antagonists, I thought I’d address one of the most prohibitive complaints about gold: – namely, that ‘it doesn’t yield anything’ and that ‘you can’t value it’. Here, I’ll outline a ‘pseudo-valuation’ method for gold.
A Roundabout Method of Valuation: Looking at the Currency:
Pardon me for stating the obvious, but I must mention that the gold price is as much about dollars as it is about gold. After all, the gold price is merely the going rate at which people swap dollars for gold (and gold for dollars). The reason why I mention this is because I intend to go about the problem of objectively looking at gold by examining the currency itself. Moreover, in doing so, I hope to shed light on the profound interconnectedness of the gold market, the bond market and – these days – even the MBS market.
Fiat Currencies trade at ‘Discounts from Par’:
In The Economics Of Inflation – A Study Of Currency Depreciation In Post War Germany, Constantino Bresciani Turroni noted that the vicious inflation of the Weimar Republic could only stop because the market was (eventually) allowed to function. That is, the paper mark price of gold was eventually ‘allowed’ to rise to a level that reflected the outstanding quantity of paper marks and the quantity of gold backing it. The drastic conditions experienced during the depreciation of the paper mark highlighted a crucial aspect required of any irredeemable fiat currency; that, in order for a currency to be a viable and well-functioning currency, there must be a profit-motive in owning it. I urge you to stick with this, as the relevance to the gold price will emerge shortly. We must ask; what constitutes a profit-motive when it comes to today’s fiat currencies?
Well, a Federal Reserve note (and a Federal Reserve balance) is a liability on the Federal Reserve. So, in order for there to be a profit-motive in owning Federal Reserve notes and balances, the market should - in some sense – reflect the fact that all of those Fed notes and balances are backed by the assets of the Federal Reserve. That is, in order for there to be a profit-motive in owning Federal Reserve notes and balances, only a proportion of the Fed’s assets should have to be paid in order to acquire all of the claims (Fed notes & reserves) upon those assets. Spelling this out a little more, it should be the case that the dollar prices of the Fed’s assets are high enough to imply that the entire stock of claims upon the Fed’s assets (i.e. the supply of Fed notes and reserves) must only buy a proportion of the Fed’s assets.
Despite the – perhaps - convoluted use of language above, I’m really not saying anything complicated at all. Imagine that there existed a ’1 greshams-law note’ that was backed by one troy ounce of gold. Then who in their right mind would pay more than one ounce of gold to acquire that ’1 greshams-law note’ (itself a claim upon one ounce of gold)?
The Implications for the Gold Price Etc.
Gold is on the balance sheet of the Federal Reserve (along with US Government Bonds, TIPS, Fed Agency Debt Securities and Mortgage-backed Securities). So, transposing what was said above to the present-day dollar, we should note that the market will try to price gold, US Govt. bonds, TIPS and MBSs high enough to imply that the entirety of the Fed’s assets cannot be bought by the entirety of the iredeemable claims upon those assets (i.e. Federal Reserve notes and balances).
However, the Market Discounts the Funny Business:
So, going back to the example about the ‘greshams-law note’, let’s consider what the market might do in the face of ‘funny business’ (say, the printing of notes or the consumption of the asset backing them). For example, what might happen if it were expected that only 0.5 ounces of gold would back each ‘greshams-law note’ in the near future? Quite simply, the market may move to reflect that. That is, people might only swap gold for ‘greshams-law’ notes at a rate of 0.5 ounces for 1 note (i.e. 2 notes/gold ounce).
A ‘Valuation’ Method for Gold:
With equities, you want to be buying when the P/E ratio is at generational lows and selling when the P/E ratio is at generational highs. But do we have any such measure for gold? My contention is that we do; you want to be buying gold when the discount from par is low compared to the future level of balance sheet expansions. Conversely, you want to be selling gold when the discount from par is high compared to the future level of balance sheet expansions.
A Rough Measure:
As a rough guide, I include an estimated chart of the degree to which the entire stock of Fed notes and reserves can buy the Fed’s assets:
The End Game for Gold:
Even according to this rough measure, one can see that the bull market in gold has some way to go. At these prices, the majority of the assets backing the dollar are debt instruments (US Govt. Bonds, Federal Agency Debt Securities, MBSs & TIPS). Conceivably, by the end of the bull market, the gold price would have risen to outrageous levels to imply a dominant role for gold (as compared to the other assets at the Fed). Likewise, at such a time it is likely that a Volcker-esque Fed official will emerge to take away the punch bowl. At that time, the market will be discounting huge balance sheet expansions that don’t have a chance of happening. The above indicator will be showing an enormous discount and yet the calls for the printing press will be near their ends. It is at that time, that the contrarian will be able to get out and/or short gold.
As I have mentioned elsewhere on greshams-law.com, the Fed (and everyone else) seems to be intent on preserving the existing supply of ‘IOU money’ (i.e. demand deposits at depository institutions). Their method of preservation is to expand the balance sheet of the Fed whenever markets come under pressure.
Our methods of ‘valuation’ show that the degree to which the market is anticipating these balance sheet expansions has not reached extreme levels (yet!). We should keep an eye on social mood, sentiment towards money printing, policy-making and the market itself. When this bull market is coming to its close, it is likely that these factors will be screaming ‘SELL!’ and yet the pundits of Wall Street will be screaming ‘BUY!’. Then, and only then, should the contrarian investor seek to short gold.
Recommended: Charting the Federal Reserve's Assets - 1915 to 2012