The Long-term Prospects for Gold

Recently, I claimed that gold is far from being a bubble and that it is possible to value gold. So, following on from these claims, I thought I’d explore the long-term prospects for gold and present a few interesting (& long-term) charts on the subject of gold as it relates to the dollar.

 

You don’t have to be a freak to own gold anymore:

 

After a decade full of popping bubbles, it seems that quite a few people have been spooked by the increasingly positive sentiment towards gold. Put bluntly, you don’t have to be a freak to have a decent holding of gold these days. That’s a drastic change from even 5 years ago, when it was often considered the crazy guy’s favorite asset. The knee-jerk conclusion is that gold must therefore be in a bubble.

 

I have misgivings with this notion, and I think that such sentiments are a function of the popularity of bubble-watching these days. We should note that, in the Federal Reserve System, long-term cycles seem to last roughly the length of one working generation (i.e. 20-25 years). At the risk of putting too much faith into the generational cycle, it would seem that gold is only 10-11 years through its up-trend. [Chart from Kitco]

 

Chart of Gold Since 1995

Click to enlarge. Source: Kitco.com

 

That being said, it cannot be denied that people have become more friendly towards gold and silver in recent months and years.

 

Valuation Metrics:

 

In a previous article, I proposed a roundabout method of valuing gold. That is – given that the gold price is as much about dollars as it is about gold – that one should seek to value dollars rather than gold. The chart below shows the degree to which the dollar is backed by gold:

 

Gold Covering/Backing the Dollar

Click to enlarge. Source: FRASER & World Gold Council

 

[The blue line shows the ‘Market Price of the Federal Reserve’s Gold’ divided by the ‘Total Size of the Balance Sheet of the Fed’. I have included this chart on the Federal Reserve Balance Sheet Chart page of greshams-law.com. I will be updating this chart (along with all of the others) on a weekly basis.]

 

Federal Reserve notes (and Federal Reserve balances) are liabilities of the Federal Reserve. This means that the stock of Federal Reserve notes and balances in existence are some kind of irredeemable claim upon the entirety of the Fed’s assets. In order for there to be a profit-motive in owning Federal Reserve notes (& Fed balances), the entire stock of stock of Fed notes and balances should not buy the entirety of the assets at the Fed (at market prices). In other words, in order to get all of the claims upon the assets at the Fed, you should have to give up less than the assets at the Fed. So, gold is on the balance sheet of the Federal Reserve, therefore dollars are some kind of irredeemable claim upon gold (as well as US Government Bonds, notes, bills, MBSs, Fed agency debt securities etc.). Gold seems to go through these long-term cycles where gold becomes a very significant proportion of the Fed’s balance sheet, and then a wholly insignificant proportion. When it is significant (e.g. at 1913, 1940 & 1981), you want to dump your gold and buy dollar-denominated risk assets (e.g. the Dow). Conversely, when it is insignificant (e.g. 1920, 1929, 1932, 1969, 1999), you want to dump your dollar-denominated risk assets and load up on gold (& physical Federal Reserve notes).

 

With this in mind, it certainly seems like there is a long way to go before the market value of the Federal Reserve’s gold reaches a sizable percentage of the total balance sheet of the Federal Reserve. Moreover, as is evidenced by the movement in the ratio in 2008/2009, the Fed’s repeated monetary debasement exercises will serve to lengthen the bull market.

 

Sizing up Risk & Reward with Gold:

 

This being said, I think it is prudent to size up the risk/reward dynamics for gold. After all, the whole point of the contrarian market philosophy is to attempt to eek something out without exposing ourselves to considerable downside risk.

 

In an attempt to stick with prudence rather than extravagance, let’s suppose that Ben ‘Helicopter’ Bernanke has a sudden change of heart about monetary policy (let’s say that he becomes an avid LewRockwell.com fan!). Let’s say that he decides to keep the Federal Reserve’s balance sheet at its existing size over the next 20 years. Moreover, let’s suppose that this generational trend towards an increasingly gold-backed dollar first tests the 1999 low and then stops at a conservative 40%. Then that would mean a downside risk target at $1000/ounce, followed by an upward target of around $4000/ounce in 20 years time. This is with absurdly conservative premises! If we assume that ‘the Bernank’ doubles the size of the Fed’s balance sheet over the next 20 years (after all, the possibility of a series of QEs is not outrageously contentious), then we would have an upward target of more like $8500/ounce!

 

Even the latter scenario is rather conservative (remember I’m talking about 10-20 years here!). If you take a look at the chart above, it should be clear that the ‘unleashing of the dollar from gold’ has implied progressively wider swings in the ratio. In 1980, the market value of the Federal Reserve’s gold was in excess of 120% of the total Fed Balance Sheet size (and US Government bonds were nicknamed ‘certificates of confiscation’). That represented an enormous discount for the prospect of future money printing exercises and yet Paul Volcker (the renown ‘anti-inflation’ guy) was at the helm of the Fed. It is entirely conceivable that this bull market in gold could end in a similar fashion.

 

George Soros cuts back his gold holding:

 

George Soros recently cut back his gold holding somewhat. As the Financial Times reported:

 

Some investors, including the hedge fund run by billionaire investor George Soros, have cut their exposure to gold amid expectations that the end of quantitative easing in the US could be a turning point for the market.

 

Others have also reported that he did so because of his decreasing fears about deflation (that’s right, deflation). In light of the above chart, this should not seem paradoxical. After all, if he believes that the prospect of deflation remains muted, then he probably also believes that the Fed will not increase the monetary base. This would mean that the upward tendencies in the above ratio would be less pronounced and that the gold price may not perform as fantastically as other things.

 

Conclusion:

 

So, if the above is correct, it should be clear that the long-term potential for gold remains in tact (regardless of the shorter-term price action that George Soros may have been thinking about). Only when the market value of the Fed’s gold is frustratingly high will there be the opportunity to sell (& short) gold. Conceivably, that will also be the time to load up on the Dow Jones Industrial Average, as the subsequent move would leave potential for a long-term levering cycle for the private sector.

See here for our collection of rare historical economic data.

Posted May 25, 2011