Gold at $635: Buy, Sell, or Hold?
by Michael S. Rozeff
by Michael S. Rozeff
Below, I will provide an interesting calculation on gold. That is my main contribution to this subject that I am willing to make public, apart from the intervening paragraphs. If this sounds as if there is far more that I know about gold that I am not revealing, I doubt it. If I do, it hasn't yet bubbled into my consciousness. I can't reveal what I can't verbalize. My only other effort in this direction is here.
I do not make gold forecasts and very few other forecasts, publicly, that is. It's enough of a challenge for me to figure out how things work. My ignorance and shyness shield me from making very many predictions. I don't want to look like a fool. But I surely appreciate the boldness of those who do make forecasts and lack my character defects. Predictions are great fun. They are useful. We should have them. It's just that I always start wondering what underlies them. I think predictions should be accompanied by some sort of explanations.
Commodity price cycles
This week my banker asked me what I thought the gasoline price would be in September. First I laughed. Then I hesitated. Then I told him it would be the same price as today. Many markets are basically random walk markets. In such instances, today's price is about the best forecast that an ignorant investor can make. That is I. What do I know compared with what the market knows? Very little. Usually.
There are times, however, rare instances in which I make a calculation or two. I thought stock prices were absurdly high in 1999 and 2000. Every valuation model showed overvaluation clearly. Some people wrote books about it. I didn't. Maybe I told a few people. But that's a difficult venture. If you tell them when to sell, then you have to tell them when to buy back in. First thing you know they're depending on you for their portfolio decisions. I have enough worries. Second thing you know is they're blaming you when you make the inevitable mistakes. I let my relatives and friends make their own mistakes.
By the way, I haven't finished about my banker. He insisted that the price would be $4.00 by September and gave me excellent reasons why. These can be found in every newspaper, Chinese demand, the peak driving season, etc. I told him that I thought crude oil would decline at some indefinite point in the future back to $50 or even $25. He began to doubt that the check I was handing him was genuine. I mentioned that the last time around crude had plunged from $40 to $8 to $10. When markets crash, they often drop 80 to 90 percent. If the peak here is $75 or $80 or whatever, a drop of 50 percent or more is quite likely. Oil producers and explorers will do the same they have always done, I explained: find and produce more oil.
You may wish to tell me all the reasons why this time will be different. People always explain things to me. I listen. I may question, even discuss. Then I make up my own mind. Take China's boom. China's boom will go bust at some point. They're inflating their money supply by very large amounts (18 percent a year.) Any Austrian will tell you the boom won't last. As for the yuan, I have 4 Chinese students this year who all told me several times that the yuan is at most 10 percent overvalued. One worked in a bank. Foreign currency is traded by street vendors outside the bank, and the rate is not much different than the official rate inside the bank.
I admit my model for crude oil is crude. Simplicity has its virtues. If I attempted a sophisticated econometric model, it wouldn't work anyway. It can't. So I hold to the simple idea that high prices bring forth greater supply even as they curtail demand. Industries go through capacity cycles.
The bottom line concerning commodity price cycles is that I am reluctant to make a big bet on gold based upon commodity prices. They quite often collapse. Maybe Harry Browne, alev ha sholem (may he rest in peace), was right. Stop worrying about all this and divvy up your money into 4 piles: gold, cash, long bonds, and stocks.
My banker still seemed unsatisfied with my answer, so I told him to put me down for $3.75 in September. He brightened up considerably. I secretly thought, no, the price will decline. If I predict a rise based on my "feeling" or "intuition," then in all probability there will be a decline. Gasoline will decline below $3 by September. I've learned how to "copper" (go against) my own feelings. My feelings tend to extrapolate in making predictions, and that is usually wrong except for those occasions in which it is temporarily right; that is, when there is momentum in a market. By the time I recognize momentum in a market, it's getting ready to reverse, usually after a few months. Mean reversion is what occurs, or what goes up comes down and vice versa, but not until the price move goes much further than one anticipated. Markets make fools of us all. Are there any winners? They don't write articles like this.
Gold and interest rates
Do I know how the gold market works? Absolutely not. I have no special knowledge of the gold market, so don't expect a detailed analysis of the factors that might be influencing the price of gold. I do not know why gold languished for many years. I do not know why it has recently zoomed up. But since I have to decide whether to buy, sell, or hold, I need a theory or two to guide me. I use technical analysis, but without an idea of basic value it is not enough for me. I need to have an idea of what gold's fundamental value is.
There is gold and then there are gold stocks. Let us leave that problem for another occasion. Consider only gold. If there is a flight from the dollar as the gold bugs avidly hope for and predict, gold will withstand the demise of the dollar. If the dollar loses half its value in the next month, gold will probably more than double because speculators will project even more losses in the dollar's value. The cost of gold's insurance against dollar decline is losing a return on dollar assets. Gold pays no interest. It costs to store it, although the costs are low. The issue is whether the return on the dollar assets is high enough to warrant staying in dollar assets even though the dollar is declining. In a world where the dollar declines continuously at a known rate and interest rates are high enough to compensate for the loss, it makes no difference whether one holds gold or dollar assets. The problem is that in the real world we do not know whether interest rates suffice to offset inflation in money. I happen to think they don't. Based on my grocery bills, which is my simple model, I think price increases are higher than the official rates. This means I think interest rates are too low. But my record at forecasting interest rates is miserable. Interest rates have been moving up. This happens during business expansions, and it's happening now.
The bottom line concerning interest rates and gold is that I'm not willing to make a big gold bet on the basis that interest rates are too low or too high. My ability to forecast interest rates is negligible. Harry Browne's four pot strategy is again looking good.
My back-of the-envelope calculation
Now what you've all been waiting for, my calculation. After diligent searching on the web, I find that the gold price was $20.67 an ounce in 1932 and for many years before. It seems like it was too stable, perhaps because of government price-fixing. But lacking a better number, I'll use $20.67. I will not use the $35 an ounce that the government used later in that year because that was a New Deal artifact. I trust the long history at $20.67 more.
Now in 1932 the M1 money supply was $20 billion. The American population in 1932 was 125 million and now it is 270 million. This provides a factor of 270/125 = 2.16. If the old M1 was good enough for Americans in 1932, then perhaps it would be good enough for Americans of today. There are more of us, so I'll multiply 20 x 2.16 = $43.2 billion.
That's a dicey calculation, as any economist will tell you. They'll write books about it. I've assumed that the demand for money is the same today as 75 years ago or that money velocity is unchanged. But we all know it's not. We know that foreigners now demand more dollars than they used to. But do they demand proportionately more dollars? I do not know. We know that payment practices are more efficient, and perhaps people do not want as much M1. We know that interest rates have changed. We know many things, and yet we know nothing. I'll stick with my factor of 2.16. At least you know how I got it. Alter it if you want to.
Next, the amount of M1 today is $1,372 billion. M1 has risen by a factor of 1,372/43.2 = 31.76. I've taken into account the population growth.
Finally, what gold price suffices to monetize this amount of M1? Compute 31.76 x $20.67 = $656.
I confess I was as shocked as you are when I did this calculation several days ago for the first time. I had no idea this would be the answer.
M1 or some other M?
I chose M1 because I've always chosen M1. I've always thought that currency and demand deposits are pretty much what people use for money. They don't use time deposits and money market mutual funds that much for money. I chose M1 because Frank Shostak argues for AMS (Austrian School of Economics Money Supply) and M1 is close to it. He argues against using M2, M3 and MZM as money supply concepts.
The Federal Reserve controls the monetary base. Monetarists focus a lot on the base. It's gone up by a factor of 53.19. That implies a gold price of $1,099. However, the banking system and the public have created M1 to use, not the monetary base. The money multiplier between the base and M1 intervenes. The monetarists know this. They would not define the base as what Americans use for money. It's better to use M1 in my back-of-the-envelope calculation.
Gold bugs fondly point to other M's, like M2 and the beloved M3, because they have risen by factors that exceed M1. They imply gold prices higher than $635 an ounce. M2 was $45.0 billion in 1932 and today it's $6,775 billion. It's up by a factor of 6,775/45 = 151. That makes gold's fundamental price today 151 x 20.67 = $3,121. I think Shostak is correct. We shouldn't use these M's as measures of the money supply. I include M2 here merely to show how a gold bug projects a price of gold of $3,000. If you prefer M2, that's your prerogative. Then you may wish to hold more gold.
Gold is trading near $635 today. I estimate that's about what it's worth. Should you buy, sell, or hold it? A passive investor doesn't ask such a question. He or she holds a well-diversified portfolio. Sometimes an investor is partly passive and partly active, meaning some funds are earmarked for speculative ventures. Such a speculator should, in my opinion, seek out opportunities in all markets, stocks, bonds, currency, commodities, real estate, venture capital, and collectibles. In this view, gold is one possible opportunity whose fate depends on a number of speculative factors that I have taken pains neither to speculate on or elaborate. But I've provided one idea that perhaps gold is neither greatly overvalued nor undervalued at $635 an ounce. This observation will not prevent the gold price from rising or falling markedly after this article is published.
April 29, 2006
Michael S. Rozeff [send him mail] is the Louis M. Jacobs Professor of Finance at University at Buffalo.
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