Is it too late to buy gold?

2011-SEP-24

For years, the mainstream investment community has snubbed gold. Warren Buffett – perhaps the most famous investor in the world, and one of the richest – famously dissed gold 13 years ago with the line: “It gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”

In similar fashion, on May 9 1999, two days after the UK Treasury announced that the Bank of England was going to start auctioning of more than half of its gold reserves (415 tonnes), the Financial Times commented in its Lex Column:

“It is entirely rational for the UK to seek to maximise the value of Britain’s gold, currently an unjustifiable 43 per cent of net reserves… It is odd that the UK is keeping 300 tonnes. At 18 per cent of net reserves, it will represent a heavy position in a low-returning commodity that has proved to be a lousy investment in recent years, even if it may still serve as a partial store of value in [times of] global crises. So having already unnerved the markets, the Treasury might as well have gone the whole hog and planned to sell the lot.”

A year earlier, The Motley Fool argued against buying gold in one of their investment guides, stating that “If the world’s central banks want to put their faith in them good ol’ boys in the US government (by buying US Treasuries instead of holding gold) rather than an off-yellow metal of indeterminate value, then we’d be fools to argue.”

They were fools all right, but fools not to argue. The gold price stood at under $300 per ounce in 1998, while the Bank of England sales from 1999 to 2002 were at an average price of just $275.60 per ounce. If the Bank had followed the FT’s advice and sold all of its stock, the average price realised on its sales would have been even lower.

But of course, there will come a time when it will make sense to favour other assets – be they stocks, bonds or real estate – over precious metals.

So what should people look out for in deciding whether or not owning gold is a good idea?

When everyone else in the room owns the same asset as you, very often that’s a good indicator that it’s overvalued.

Is gold overvalued, or “over-owned” today? To answer this question we need to look at the ownership of gold and gold related-assets as a percentage of investors’ portfolios. We also need to examine the inflation-adjusted gold price over recent decades. And last but not least, we should compare the stock of US dollars with the value of the US government's gold reserves. One could run similar assessments of money stocks versus gold reserves in other countries, but for the sake of brevity, we'll stick solely with the US example – Uncle Sam does after all remain the issuer of the world's only reserve currency.

Gold ownership among investors

So what are the gold ownership trends among investors? Surely, with the price having soared from under $300 per ounce a decade ago to record-peaks at over $1,900, investors are piling into gold?

Yet as analysis published earlier this year by Sprott Asset Management shows, gold assets remain a meager percentage of investor assets. In their Gold Yearbook 2010, CPM Group noted that in 1968, gold held by individuals for investment purposes represented roughly 5% of global financial assets. By 1980 this figure had fallen to 3%. By 1990 it stood at 0.6%, and by 2000 it had fallen to just 0.2%.

And today? CPM Group notes the figure rose to a mere 0.6% by 2009. Sprott calculates that in 2010, it would have risen by another 0.1% to 0.7%. So despite the big run-up in the gold price over the last 10 years, gold as a percentage of investor assets remains at essentially the same level it was at two decades ago.

Even this overstates public interest in gold. As Sprott’s analysis notes:

“The increase in gold ownership from 0.2% in 2000 to 0.7% in 2010 is also misleading. If you consider the approximate $227 billion that was invested in gold bullion in 2000, that level of investment would have grown to $1.18 trillion, or 0.6% of financial assets, by the end of 2010 – based purely on gold appreciation alone. In other words, the actual amount of new investment into gold since 2000 represents only 0.1% of current global financial assets, or about $250 billion. Although this number may seem large, consider that roughly $98 trillion of new capital flowed into global financial assets over the same period, so gold’s approximate 0.3% share of global investment flows is essentially trivial.”

The gold price adjusted for inflation

Inflation statistics are a political tool. They invariably underestimate the extent to which prices are rising, for the simple reason that governments – as large debtors – have a vested interest in seeing the real value of their debts and “unfunded obligations” slowly diminish. With regards the inflation statistics published by the USA's Bureau of Labor Statistics (BLS), the economist John Williams of ShadowStats.com notes that “over the decades, the BLS has altered the meaning of the CPI (Consumer Price Index) from being a measure of the cost of living needed to maintain a constant standard of living, to something that no longer reflects the constant-standard-of-living concept.”

This of course has interesting implications for gold price targets. On January 21 1980, the gold price hit a peak of $850 per ounce in the London PM Fix. Based on the BLS’s current inflation methodology, this is equal to $2,468 in today’s dollars.

Calculating inflation using the methodology used in 1980, however – stripping out all of the BLS hedonic manipulations that have been implemented since – and the real inflation-adjusted gold price high is $8,593.94 per troy ounce. For silver – which, lest we forget, hasn’t even taken out its old nominal $50 record high – the 1980 price peak of $50 per ounce equates to a whopping $505.53 in today’s dollars, using the 1980 CPI. Even using current BLS figures yields a silver price target of $145.19 per ounce – a 250%+ increase on today’s spot price.

The gold price compared with the money supply

So gold remains below its inflation adjusted record (well below when using older – and some would say more realistic – CPI measures). But of course, whether or not gold priced in US dollars is undervalued or not hinges on the question of the supply of those same dollars.

This is often a moving target, as the supply of dollars can sometimes be expanding at a dramatic rate (as has been the case with M2 in the last few months). Dylan Grice of SocGen recently constructed a chart which shows official US gold reserves as a percentage of the US monetary base over the last 50 years. This was Bloomberg’s “Chart of the Day” on September 15, and shows a "fair value" gold price of $10,000 per ounce.

Similarly, James Turk’s Fear Index measures the value of the USA’s official gold stock against the M3 money supply (which the Fed stopped publishing in early 2006). Thus, the Fear Index equals the US gold stock, times the market gold price, divided by M3; the higher the number that results from this equation, the greater the fear and uncertainty afflicting the global economy.

The Fear Index chart for this month is illustrated below. As with Dylan Grice’s chart, the Fear Index shows that we are someway off the point at which rational observers would consider gold to be overvalued:

Others have come up with altenate ways of measuring gold’s value. Famed gold trader and analyst Jim Sinclair – former Precious Metals Adviser to the Hunt Brothers who is renowned for his accurate gold price predictions over the years – uses an equation that compares US external debt with the value of US gold reserves. This is basically the price at which gold would have to be for the US Treasury to be able to pay off its debts to foreigners with its gold reserves:

External debt/US gold reserves = gold price target

As Sinclair puts it: “In crisis times, the US dollar price of gold ALWAYS seeks to balance the International Balance Sheet of the USA.” Today, putting the correct numbers into this equation gives a gold price target of around $13,664 per ounce. Those interested in watching James Turk’s interview with Mr Sinclair should click on this link.

In conclusion, one would be wise to ignore the myriad cries of their being a “bubble” in the gold market. Gold remains undervalued. No doubt the day will come when frantic buying leads to it being overvalued, but – as this analysis will have hopefully demonstrated – we are some way off that point at the moment.