Is Gold Overvalued?
by Michael S. Rozeff
by Michael S. Rozeff
In this article, I will make a case that gold's value is significantly less than its current market price of $735. Not being omniscient, I will not consider every factor that now or in the future may impact upon gold's price. But I will examine a few factors that, by themselves, suggest that gold is overvalued.
If gold is overvalued now, it could become even more overvalued. It could rise in price. I am not providing investment advice about whether or not you should buy or sell. I am merely providing some straightforward analysis that may or may not be of value to those of you who are players or potential players in the gold market.
Certainly there are scenarios in which the dollar disappears and gold is one of the last men standing that preserves wealth. Gold is insurance against being wiped out in these catastrophic scenarios. Anyone who thinks that these scenarios are imminent or even highly likely can disregard my comments. If the economic world of the dollar is going to end anytime in the next few years, then the difference between paying $735 for gold and paying $500 for gold will be irrelevant. I am making no comment about the likelihood of these scenarios, other than to say that they are more likely today, in my opinion, than ever before.
If, in your mind, the dollar already is a worthless piece of paper, then you will be thinking about gold in terms of a different metric than its dollar price. The dollar price will be irrelevant to you. You will be thinking about gold as a precious physical item because of its rarity, the difficulties and costs of finding sources and extracting it, and the long history of gold's purchasing power over goods. An ounce of gold will be your metric rather than the price in dollars of an ounce of gold.
Recently, I remarked to someone that gold bullion was in a bear market and had been in a bear market since last March when it hit just over $1000 an ounce. Although a degree of hostility was the reaction, the fact is that gold is now around $735. A decline of 27% qualifies as a bear market in my book.
As long as inflation remains a fact of life, gold will at some point make a bottom and renew its longer-term major uptrend because gold keeps up with inflation. I don't know when that will happen or even if it will happen, and if it happens I do not know how much inflation there will be. I am not predicting any of these things. I don't predict turning points. I wait until the market speaks and provides concrete signals that turning points have occurred. I do not predict. I observe. I observe that gold is currently trending down.
Markets do not know what we think. They can do anything. If I deny the downtrend, that won't change it. If I root for gold, the gold market won't hear me. If I hope for the dollar to flame out, that won't do anything.
This article does not analyze the shortage of coin for immediate delivery. If these coin shortages mean that gold bullion is going to wake up and start rising, then the bear market will cease and all those who have bought bullion on the basis of this discrepancy will profit. It is possible that mints will buy gold bars at $735, mint them into coin, and resell them at $1000 an ounce. This may hold the price of gold up. It may also be holding up bullion's price now, so that if and when the coin demand abates, bullion will fall. There are many such factors that are beyond my scope.
The case I will make for gold's being overvalued rests on its relations to other goods. I compare it first to consumer prices. I began this work in a roundabout way. Years ago my family had a meat market and grocery store. One of our suppliers published a weekly list of items and their prices. My brother recently came across one of these lists from 1967. I wondered how inaccurate the government's consumer price index might be, so I extracted some items from the book and compared their prices with today's. The idea was to find as nearly as possible the same exact items, holding constant the weights of the product. The following ten items are a sample (with some prices rounded.)
Apple jelly was $0.40 and is now $2.48. Up by a factor of 6.2.
Red raspberry preserves were $0.55 and are now $3.00. Up by a factor of 5.5
Jif peanut butter was $0.60 and is now $2.37. Up by a factor of 4.
Skippy peanut butter was $0.61 and is now $2.71. Up by a factor of 4.4.
Mazola was $3.07 and is now $13.59. Up by a factor of 4.4.
Pompeiian olive oil was $0.49 and is now $4.08. Up by a factor of 8.3.
Crisco shortening was $0.95 and is now $5.18. Up by a factor of 5.5.
Carnation evaporated milk was $0.19 and is now $1.17. Up by a factor of 6.2.
Borden condensed milk was $0.42 and is now $3.04. Up by a factor of 7.2.
Nestle's morsels were $0.55 and are now $3.21. Up by a factor of 5.8.
The average inflation factor of these items is 5.75.
The CPI calculator here shows that $1 in 1967 is $6.15 in 2007. This is not far from the small sample of groceries. In fact, I paid something like $3,000 to $3,200 for a new 1970 Plymouth 4-door sedan, and very nearly the same inflation-adjusted price for a new 2003 Toyota Camry 4-door automobile. The Toyota is a better quality vehicle.
We can argue all day long about inflation being more than what the government says. It is a very difficult matter, especially when there is quality variation and when no two persons have the same market bundle. There are all sorts of arguments that can be brought in to this debate. There are hundreds and thousands of new products. There are products whose prices have dropped dramatically, and others that have gone up by a factor of 10 or more. In the end, I believe that the CPI figures are not so wildly inaccurate that they should be discarded. I will use them. You can always adjust them for yourselves, in which case your gold price estimates will differ from mine.
The general idea of the first estimate I will do is to establish what seem to be equilibrium prices of gold at two dates in the past (I use 1975—1978 and 1994), and then to apply CPI inflation factors to those prices. I need to explain why I choose these dates.
After Nixon took the U.S. off gold completely in 1971, gold started to rise. We really can't take the 1967 price, which was under $40, as being a good measure of the free market price of gold back then. Gold rose steadily. By 1974 to 1977, the price had stabilized. Its annual average prices were $159 in 1974, $161 in 1975, $125 in 1976, and $148 in 1977. This stability suggests to me that prices had equilibrated.
I will use a price of $148 in 1977 as one equilibrium price.
Gold then embarked on a price rise replete with fluctuations of significant size. In 1980 it soared briefly to $800 only to fall quickly back to $500 on its way down to $300. This huge volatility can't be used to extract an equilibrium price. But a price chart from 1982 to 1996 reveals a very interesting thing. Gold at first oscillated between $300 and $500. Gradually the oscillations died down and by 1994—1996, gold had settled down to a very stable price. It averaged $384 in both 1994 and 1995 and $388 in 1996.
I will use a price of $384 in 1994 as an equilibrium price.
The fascinating thing is that the 1977 and 1994 prices, both of which are periods of gold price stability, are in accord with the rise in the CPI over that period. The CPI went up by a factor of 2.45 between 1977 and 1994. If we multiply $148 by 2.45, we get $362.60. This is very close to gold's actual price of $384.
Now we can project a 2008 price. There are several ways to do this. Start with $384 and multiply by the inflation factor between 1994 and 2008 of 1.43. This gives a 2008 price of $549. Alternatively, start with gold's $148 price and multiply by the inflation factor of 3.50 between 1977 and 2008. That gives a 2008 gold price of $518.
Gold was $159 in 1974 and $125 in 1976. If we use those as starting points, we get 2008 prices of $687 and $467.50. These average $577.25.
We now have estimates of $518, $549, and $577. These average $548.
Rounding, I take $550 to be an estimate of gold's 2008 price that is consistent with the CPI index. This calculation is supported by the fact that the rather stable price of gold in 1994 grew from a stable price in 1977 and that the growth rate tracked the growth rate of the CPI index between 1977 and 1994.
Another very simple approach that does not use the CPI at all is to find a linear or arithmetic trend between 1977 and 1994 and project that trend forward. Gold rose from $148 to $384 in those 17 years or $13.88 a year. Over the next 14 years, similar increases would add up to $194. That gives a projected 2008 price of $384 + $194 = $578.
The next approach I use is to relate gold's price to the prices of base metals. Copper, zinc, nickel, aluminum, and lead all rose substantially along with gold between 2003—2005 and 2008. They were all part of the commodity price rise. Now all of these metals have fallen back sharply. They are either back to their 2003—2005 levels or getting quite close. If gold mimics their behavior, then gold will return to its 2003—2005 level. That level is about $400.
Silver is back to its early 2006 level. Gold was $550 in early 2006.
Now, of course, we can bring in all sorts of other bullish and bearish considerations. The base metals and silver have industrial uses and they may be falling more because of that. Gold may be unique in its response to the credit breakdown. We may argue that the deflation will be so severe that it will bring down gold's price. We can argue that the severe drop in gold-mining shares suggests a much lower gold price; however, that requires much more analysis since gold and gold-mining shares often diverge in price.
My analysis here is incomplete. I am not providing bottom-line advice for gold investors that weighs all the possible arguments. I am sharing input to the gold decision that is, as far as I know, unique among published reports in both results and methods used. The findings differ from my first article on the subject wherein I estimated a price of $656 using M1 money supply and $1,099 using the monetary base.
I have found that a value of gold of $550 for 2008 is both reasonable and consistent with the rate of increase in consumer prices over long periods of time. A long-term arithmetic linear trend suggests a price of $578. Gold's recent relation to silver suggests a price of $550. Gold's recent relations to other base metals suggest a price of $400.
Since gold is now $735 and in a bearish trend, it seems to me that it is going down for good reason and that the price decline can go further based on the fundamentals considered here. What new events may transpire tomorrow that may affect gold's price are not guessed at here.
October 30, 2008
Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.
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