On Wall Street, a falling price often leads investors to do two things. The first is to rationalize the decline, and the second is to assume that the decline is set to continue. This is precisely what happened with gold in 2013. The price fell 28 percent in 2013, and the media is filled with so-called “experts” justifying the decline and claiming that it will continue.
Take, for example, an article published on the morning of December 31 by CNBC’s Matt Clinch entitled Gold Sees Biggest Annual Loss in Three Decades. The first sentence reeks of rationalization: Gold fell because investors sold their gold to buy equities. No evidence is given that such transactions took place.
The article continues to argue for lower gold prices. Clinch cites two bearish analysts. The first, Nick Hungerford of Nutmeg, claims that gold will hit $1,000 per ounce because the aforementioned trend will continue. The second, Roger Nightingale of RDN Associates, believes the price can fall as low as $500 per ounce because it has no yield and because those who bought gold in order to sell it at a higher price will feel trapped in their positions and be forced to sell.
These arguments amount to little more than momentum-driven rationalization characterized by circularity — “the price will go down because people will sell, and people will sell because the price is/has been going down.”
People are especially willing to accept such arguments for the price action in gold because they fail to comprehend its economic function as they can with other commodities, and they fail to understand its role in their investment portfolios because they cannot value it according to the metrics that they use to value other assets (e.g. earnings yield, dividend yield, revenue or earnings growth, etc.).
Quite simply, gold is a store of value — over long periods of time, similar amounts of gold can be exchanged for similar quantities of goods. This function of gold has been lost to us, especially in the United States, as we tend to think of our dollar holdings as our savings, as our store of value. But over long periods of time, dollars lose their value because the Federal Reserve continues to create more of them. Naturally, as the supply of dollars increases, it follows that the number of dollars needed to purchase gold or any other marketable good increases.
Thus, we should ignore the aforementioned momentum-driven rationalization and look at gold supplies and dollar supplies. James Turk, one of the most sober and clear-headed minds on this subject, decided that in order to determine whether gold offers good value, he should compare the amount of gold held by the United States to the amount of dollars, asking a hypothetical question: If the dollar were still backed by gold (as it was until 1971), at what gold price would the quantity of dollars equal the value of all of America’s gold (about 287.5 million ounces)?
While Turk looks at the broadest measure of money supply — M3, which includes money and credit — we might get a better idea of how to value gold by looking at the monetary base. This is the case because both in the 1930s and in 1980, the value of America’s gold peaked at just more than 100 percent of the monetary base. In fact, the 1980 peak in the gold price coincided with the value of the U.S. gold supply reaching about 130 percent of the monetary base.
While I don’t like to invest according to broad generalizations, a general rule of thumb is to sell gold when the value of the U.S. gold supply exceeds the monetary base. If the value of America’s gold is substantially less than the monetary base, then gold is worth buying — e.g. in 2000, the value of America’s gold was about 10-15 percent of the monetary base.
What about now? The monetary base is $3.75 trillion. America has 287.5 million ounces of gold. At $1,200 per ounce, America’s gold is worth $345 billion, or just 9.2 percent of the monetary base.
Given the Federal Reserve’s ultra-loose monetary policy of the past five years or so and given the weakness we have seen in the gold price since September 2011, gold actually offers better value then it did when it traded at $300 per ounce at the beginning of the century.
This doesn’t mean that the price of gold can’t or won’t fall further — shorter-term markets are driven by speculators and traders who operate on momentum. But they are selling to value investors, including yours truly, and eventually the fundamental value of gold, along with the fear of a rising money supply, will overcome the ongoing negativity and drive prices sharply higher.