Gold has been one of the hottest investments over the past three
years, more than doubling in price to $1,700/ounce from
$800/ounce. To many investors, gold remains something of a
mystery. Gold has value, but many investors are unsure
exactly why that value is. Gold doesn't produce cash flow, so
it doesn't lend itself to traditional investment analysis.
Gold also isn't easily categorized. Though slotted in the commodity
section of most financial publications, gold isn't a
commodity. A commodity, properly defined, is a tangible good
that is consumed and removed from market: Agriculture products are
obviously commodities; once consumed, they're not coming
back. Hard commodities - aluminum, copper, iron - are
transformed and difficult to reclaim without destroying the final
good they compose.
Another key characteristic is commodities aren't stockpiled, so
changes in quantities produced or consumed immediately influence
price.
Gold is different. Very little of gold is actually
consumed. According to the World Gold Council, 2,500 metric
tons of gold were produced from mining in 2010. Of that, only
419 metric tons were consumed in industrial production (mostly
dentistry and electronics). The rest was simply added to the
world's existing supply of gold of around 165,000 metric
tons. In other words, mining only adds 1 to 2 percent to
world supply.
This is an important distinction from silver, which is often viewed
as a gold surrogate. It isn't. Silver is a commodity;
much of what is mined each year is consumed each year by industry.
Economically, gold is really more like an asset than a commodity.
Trading gold is like trading stocks or bonds. Buying and
selling volume does nothing to call in additional supply.
Price changes are dependent on the reservation price of the
marginal owner, just like a stock.
This invites an obvious question: how do you forecast future
reservation prices? I'm sympathetic to methodologies that
focus on gold's "moneyness." I view gold as liquidity or the cash
component of an investment portfolio. Cash is a wealth-preserving
asset, as compared to a stock or bond, which is a wealth-creating
asset. I find it useful to focus on gold's relationship to money
supply inflation and purchasing power to gauge where the price is
going.
For this reason, I find research by Paul Van Eeden of Cranberry
Capital especially useful. Van Eeden developed a model for
the theoretical value gold based on historical U.S. dollar money
supply (currency, demand deposits, and small and large time
deposits) and gold supply dating back to 1971, when the United
States officially abandoned the gold standard. Gold is the
constant value, and it is the dollar that changes (losses) value.
Theoretical Gold Value
Source: Cranberry Capital
M2 money supply provided by the Federal Reserve is a good proxy for
van Eeden's money supply measure. The year-over-year growth
rate peaked in November of 2009, but the rate has recently
accelerated to the 2009 high. In fact, M2 money supply has moved up
33 percent in the past four months. This recent spike has
more gold bulls believing gold is back on its upward trajectory.
Does that mean gold prices are set to challenge the August high of
$1,920/ounce in the near future? Of course, it's possible.
But actual price and theoretical gold price frequently diverge on
risk perception. When risk perception is high, the actual price of
gold exceeds the theoretical value. When risk perception is low,
the actual gold price trails the theoretical price.
Risk perception has waned, but the actual price of gold remains
well above the long-term theoretical value of gold. Gold investors
- those measuring there holding periods in years -should expect
gold's price growth to slow or even reverse, particularly when the
economy regains its bearings and cash is drained from less risky
wealth-preserving assets (like gold) and funneled into more risky
wealth-generating assets (like stocks).
Steve Mauzy
Editor
High Yield Wealth
Wyatt Investment Research
Disclosure: None