Revisiting Gold

Back in 2010, we wrote that we viewed gold as overpriced, but were unwilling to lie down in front of what appeared to be an early- or mid-stage bubble. Good thing we didn’t, as spot gold is up about 40% since. It mght be time to revisit the trade though.

In May of this year, Michael Darda of MKM Partners observed that the commodities rally was getting a bit long in the tooth when compared to earlier bubbles like U.S. housing and the Nasdaq.

In late July of this year, Doug Short provided an eye-catching overlay of the recent gold price run-up on the bubble and bear markets seen in the Shanghai Composite of recent years, the Nasdaq circa 2000, the Nikkei circa 1990, and the Dow circa 1929-1932:

And today, we noticed an Associated Press story on the elevated pace of gold sales on eBay:

For gold sellers on eBay, the recent stock market turmoil has been a boon for business.Gold and silver sales on eBay had already been rising steadily over the past several years — so much so that eBay Inc. created a special area in May to make it easier for buyers to find sellers.

Now, activity on that part of the site, the Bullion Center, is intensifying as consumers unnerved by the economic uncertainty flock to gold in hopes it will be a stable investment.

“When people are coming down to the question, `Do they want to have cash in the bank or gold in their hands?’ the answer is they’d rather have gold or silver,” said Jacob Chandler, CEO of Great Southern Coins, the largest seller of precious metals on eBay.

Of course, a question that the investing public might want to ask is, what do owners of the companies selling precious metals want in THEIR hands?

It all begs the question that investors started asking around 2005—is gold in a bubble, or have fundamentals shifted it to a new equilibrium that is still north of here, as many market participants still seem to believe? Smart people can be found on both sides of the argument.

It motivated me to dust off an old model based on the relationship between foreign official reserves on the Fed’s balance sheet and the price of gold. Although the historic sample is limited to quarterly data since 1975 (with no clear relationship appearing until around 1982, perhaps as markets became confident that a ‘correct’ price had been found for gold following the turmoil of the 1960s and 70s), the logic is compelling. As U.S. dollars go outside our borders, they tend to support gold demand and thus gold prices.

The relationship held up well until 2007, when gold began its parabolic ascent to its current levels. As shown in the first two charts below, a very simple linear regression model based on the relationship between historic foreign official reserves and gold prices implies that gold has between 70-80% downside from here. That seems a bit extreme.

Eyeballing the historic relationship, obviously an even cruder method than simple regression, one might expect to see a gold price closer to $650, as shown in the third chart, implying about a 60% drop from current levels. Of course, that assumes that there has been no change in fundamentals.

If we refer back to Doug Short’s chart, we can trace out approximate changes in value over the entire pre- and post-bubble periods he’s documented. By my estimates, the median annualized change in the Shanghai, Nikkei, Nasdaq and Dow is somewhere around 6.5% from start to finish (though the Shanghai hasn’t technically finished, as it is still short of 1,500 days from its peak).

Using a 6.5% annualized rate of return, and taking June 2007 as a starting point with a gold price of around $650, we would expect the price of gold to eventually settle at approximately $1100, which seems more reasonable. The decline from current levels would be in the neighborhood of 35%, as shown by the yellow line in the fourth chart.

Of course, while that final back-of-the-envelope estimate sounds more reasonable, it ignores both the commodity and monetary features of gold, which could (frustratingly!) be used to argue for both higher and lower prices.

Wherever the price of gold ends up, and whatever path it takes in getting there, is entirely unknown, of course. But for clients in our active mandate, we are considering putting on a position or positions that would be expected to benefit from a decline in the price of gold. 

[2011/08/15 - Another factor that argues for a bid under gold, at least in the minds of most traders and investors, is foreign exchange intervention, which is not going away any time soon judging by recent remarks from Japan's Finance Minister and the Swiss National Bank. Another widely-held thesis (David Rosenberg, for example) is that gold's nominal value should have some relationship to the supply of high-powered money, such as bank reserves and currency (Rosenberg has used this as the basis for a $3,000 upper price forecast if memory serves). However, I think this is a shaky framework as it doesn't adjust for velocity, i.e., the fact that most high-powered money is just sitting in reserve accounts at central banks (a fact that implies that the money multiplier is a myth or at least broken at the moment). The level of foreign official reserves shown in the charts above would seem to support the low-velocity argument. So again, either the fundamentals of gold have changed, or it's in a bubble, or both are true to some extent.]

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (SCM) is a Pennsylvania registered investment advisor that offers discretionary investment management to individuals and institutions. This publication is for informational, educational, and entertainment purposes only. It is not an offer to sell or a solicitation to buy securities, or to engage in any investment strategy. Past performance is not indicative of future results.  This material does not take into account your personal investment objectives, your personal financial situation and needs, or your personal tolerance for risk. Thus, any investment strategies or securities discussed may not be suitable for you.  You should be aware of the real risk of loss that accompanies any investment strategy or security. It is strongly recommended that you consider seeking advice from your own investment advisor(s) when considering any particular strategy or investment.  We do not guarantee any specific outcome or profit from any strategy or security discussed herein.  The opinions expressed are based on information believed to be reliable, but SCM does not warrant its completeness or accuracy, and you should not rely on it as such.  We are considering adding positions in the next 72 hours that would benefit from a decline in the price of gold.

Other Links to this Post

1. Symmetry Capital Management, LLC » Gold Making Us Look Foolish — August 18, 2011 @ 3:17 pm