Putting a fair price on gold - easier said than done

PUBLISHED : Monday, 18 July, 2011, 12:00am
UPDATED : Monday, 18 July, 2011, 12:00am


Gold is on a roll. Last week, with fears growing about possible sovereign debt defaults by Italy and even the United States, the price of bullion climbed to a record US$1,594.45 an ounce.

At that level, gold was up an impressive 134 per cent since the depths of the financial crisis in October 2008, outperforming both the Hang Seng index's post-crisis rebound and the super-charged Hong Kong property market.

But this shining performance poses a problem for serious investors. Given the momentum behind gold's rally, few are willing to bet against the metal's continued rise, at least in the near term.

On the other hand, working out a fair value for gold - how much an ounce should be worth and whether the metal is over or underpriced at current levels - is troublesome.

Other assets generate an income for their owners - bonds pay a coupon, stocks return a dividend, properties provide rent - which makes assessing their value relatively straightforward.

But gold returns nothing, which means calculating its fundamental value is next to impossible.

Still, in an attempt to provide some guidance Julian Jessop at independent research house Capital Economics suggests a number of different ways of assessing the current price of gold.

First, he points out that although last week's high was a record price in nominal returns, gold has set far higher prices in the past if you adjust for inflation.

Factoring three decades of US inflation, he calculates that the all-time high for gold in today's money was hit on 18 January 1980 at US$2,400 an ounce. That means gold could climb another 50 per cent from its current level before setting a new record in real terms.

Another favourite way of putting a value on gold is to compare it to oil. On average over the last 40 years an ounce of gold has been worth 16 barrels of Brent crude.

Today, with Brent trading at a shade over US$117 a barrel, an ounce of gold is worth around 13.5 times a barrel of oil.

In other words, at the present price of oil, gold would have to climb to US$1,876 an ounce - a further gain of 18 per cent - just to regain its historical average.

And if the metal were to retest its past highs of 25 to 30 times the price of oil, then the gold price would have to climb to between US$2,900 and US$3,500 an ounce.

Alternatively, if you regard gold as a form of money, then you can compare its price performance to the behaviour of US money supply. Jessop notes that since the depths of the financial crisis the US monetary base has more than tripled. If the price of gold were to keep pace, it would have to climb another 30 per cent to more than US$2,000 an ounce.

But not all Jessop's valuation methods indicate such a favourable outlook for the gold price. If you look at the broader M2 measure of US money supply instead of the monetary base, you find it has risen only by 20 per cent since the outbreak of the crisis. By that measure, gold is now overpriced by some 50 per cent.

Similarly, if you compare the gold price to the price of US equities, you find that the Dow Jones Industrial Average is currently trading at 7.8 times the price of gold.

That's significantly below its long run historical average of 10 times, which implies that gold is currently overpriced by around 28 per cent.

No doubt gold enthusiasts would argue this is evidence that US stocks, rather than gold, are overpriced.

If you believe, as many gold bulls do, that the US is heading for an economic collapse, then perhaps you should be looking at the relationship between gold and equities not over the long run but rather during the Depression, when the Dow Jones Industrial Average was worth just two ounces of gold or less. At that multiple, even if the stock market were to fall back to its 2009 crisis lows, the gold price would still have to double to US$3,200 an ounce to reach its fair value.

As you can see, the trouble with trying to put a fundamental value on gold is that you can come up with almost any answer you want, depending on what measure you chose. The truth is that the gold price is driven overwhelmingly by sentiment. At the moment that sentiment is powerfully positive, so the price is climbing.

But be warned, sentiment can reverse in an instant. And if it does, the price of gold, with no fundamental valuation to support it, will drop like a stone.