GOLD – a welcome safe haven

Gold is Fulfilling Its 5,000-year Safe-haven Status in These Difficult Times With Large Physical Metal Sales. As the Main Driver of Gold Stock Prices, What is Gold’s Real Value?

by Rod Blake

Is gold undervalued? That question came up on multiple occasions in my 30+ years in the brokerage business. As I write this piece, the precious metal’s price has just run-up to a new seven-year high of US $1,717/oz. Is the current price undervalued? It could be except that less than a year ago the price of gold was hovering around US $1,350/oz. Was US $1,350 undervalued?

Looking back with the added benefit of hindsight, gold was undervalued at that time. Now, with this added dimension in mind, is US $1,717 still undervalued? Or could it be fairly valued or even overvalued? The value of gold may be based on one’s time horizons or market parameters. Let’s look a little deeper into this short but very dynamic question.

Most commodities, including gold (and yes, gold bugs – gold is a commodity as well as a currency), are volatile in their pricing due to their underlying cyclicality. That is, the price of a commodity will generally rise or fall based on the current or perceived future demand. Some cycles are short or seasonal while others are longer, even generational.

An example of a short cycle commodity is the price of gasoline. We’ve all watched in wonder and muttered under our breath as the price of gasoline seems to magically rise every spring ahead of the summer driving season, only to drift lower once again as fall approaches. And even though the whole petroleum industry, from producers to refiners, knows there is an annual rise in demand for gasoline, it cannot seem to produce and store enough gasoline ahead of time to offset this increased demand – leaving consumers to pay more for the privilege of driving in the summer months.

Now this is a very simplistic example to make a point, and to be fair to the petroleum industry, there are other factors involved in the pricing of gasoline such as the additional cost of refining cleaner burning summer gasoline that come into play. But the overall synopsis is correct in that gasoline prices seem to go up every spring.

A similar short term example is the price of natural gas rising sharply ahead of an anticipated period of cold weather and falling just as quickly once the cold snap passes. As we’ve previously experienced, the price of gold often reacts violently to short term issues such as unexpected changes to US Fed key interest rates. So, in a short term reactionary situation, the price of gold could be either underpriced or overpriced. In the recent Coronavirus/crude oil induced run-up to US $1,717, I would suggest that the price of gold was probably overpriced.

Now let’s take a look at the price of gold over a longer term or economic cycle from early 2016 to the end of 2019. I pick this time frame as many commodities, including gold, bottomed in early 2016 and tended to rise over this period.

A commodity that closely follows the economic cycle is copper. Copper is used in so many products that it is often referred to as having a PhD in economics. In the past four years the price of copper rose from about US $2/lb to US $2.80 for a gain of some 40%.

Another commodity that tends to follow the economic cycle is crude oil. Although hated by environmentalists, crude oil still powers the world’s economies. In the same four-year cycle, the price of crude oil rose from about US $50/bbl to about US $63 for a gain of about 36%.

In comparison, in the same time frame, the price of gold bullion rose by about US $400, from about US $1,100 to about US $1,500, for a gain of about 36%.

Again, commodity prices can move violently short-term, but this longer time reference tends to smooth out some of that volatility. Based on this longer term economic cycle it would seem that gold bullion is neither undervalued nor overvalued, but relatively fairly valued in that the percentage gain of the yellow metal was in line with the gains of two commodities that closely reflect that cycle.
Let’s now change course (and make the gold bugs happy) and take a look at gold as a currency. Go back further to a time that most remember well – the global financial crisis of 2008 – which by most accounts was the greatest financial collapse since the Great Depression of the early 1930s. The 2008 financial crisis was widespread and affected most every asset from banking to housing to securities, and was the last time that gold bullion was considered more of a currency than a commodity.

The big difference of the two great financial crises was not the collapse itself, but the recovery from such. Back in the 1930s most central governments let the economic cycle work itself out which, looking back, resulted in the long depression and suffering that followed.

Fast forward to 2008 and central governments, not looking to repeat the mistakes of the past, flooded the money markets with funds and lowered interest rates to stimulate the economy into a swifter recovery. This injection of money was best represented by the United States and its M3 money supply. The M3 money supply figure prior to 2008 was about US $7.5 trillion. Post-2008, it shot up to about US $9.5 trillion in mid-2011 which was the catalyst for the long term economic expansion cycle we’re still experiencing.

The price of gold bullion anticipated more to come and actually exceeded the expansion in the money supply by more than doubling in price from about US $850 to its all-time high of US $1,900 – no doubt a little too far, too fast. But then, as gold corrected back down to a much more reasonable price of US $1,100 in 2016, the M3 money supply continued to steadily rise to exit 2019 at about US $15.3 trillion, and is currently passing up through US $16 trillion.

By comparison, as noted above, gold bullion ended 2019 at about US $1,500. By doing the math, we have the American money supply rising by almost 205% from the beginning of the great recession to the end of 2019 while the price of gold bullion rose by about 175%. This would make gold bullion underpriced compared to the US dollar by about 30% going back over the past 12 years. And even with the current spike up to US $1,675 gold bullion is still undervalued in the currency terms by some 13%. Long term, gold bullion would seem to be undervalued to the world’s reserve currency – the US dollar.

To review, short-term, it would seem that the price of gold accelerated higher in early 2020 to an overpriced position. Taking a longer time horizon, it would seem that the price of gold is moving up in step with other economic cycles and key economic commodities such as copper and crude oil.

This seems reasonable in that the price of gold – taken as both a commodity and a currency – represents the average value of the products that power the world’s economies. Midterm, the world’s economies are expanding and the price of gold bullion would seem to be mirroring that expansion. Long-term, the price of gold is lagging the expansion of the world’s money supply, particularly when compared to the currency printing machine that is the United States Federal Reserve and its M3 money supply.

Gold bullion, as a currency, should mirror this expansion of the world’s funds. And in reality it is doing just this as in most currencies the price of gold is trading at record highs. Gold is lagging in US dollar terms because the American dollar is widely held as a reserve currency so a lot of those dollars are not out in circulation. Also, as the world’s reserve currency, US dollars are bought and hoarded in time of economic uncertainty. Long term, the price of gold, even after the recent run-up, would seem to be underpriced by some 13% to 30%.

Now, back to the question posed above. Is gold underpriced? To me, there is no simple answer. Rather, the answer would seem to depend on one’s perspective. Short-term momentum suggests gold bullion may be overpriced. Midterm, gold bullion would seem to be fairly priced based on world economics.

However, long-term is quite different. The price of gold, as the world’s only true global currency, should mirror the worldwide supply of money, but seems to be lagging by quite a large margin, especially in US dollar terms. Over time this differential in price should resolve itself.

And if 2011 repeats, gold bullion may even foretell of another increase in the supply of money and move up to new all-time highs. Is gold underpriced? I think that based on one’s perspective the price of gold bullion may be overpriced, fairly valued, or indeed underpriced. Establish your parameters and position yourself accordingly.