Yesterday, I promised to provide you with a logical, real-world price target for gold.
So is gold undervalued or overvalued? Turns out the question is much easier to ask than answer.
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You see, there’s no good way – and definitely no universally accepted way – to determine a “fair value” for gold. Unlike a stock, gold doesn’t have a price-to-earnings ratio that we can easily compare to the market.
The valuation problem stems from the fact that gold serves different purposes for different investors…
To some, it’s a hedge against inflation, or against low real interest rates. To others, it’s a hedge against a currency crisis.
Then there’s a whole camp of investors who consider it an “oh crap” asset. By that I mean, it’s an asset they want to make sure they already own when every other investor is saying “Oh, crap!” in response to a sudden collapse of the entire financial system, or the onset of a nasty bout of hyperinflation.
In the end, the price of gold fluctuates based on the varying expectations from people in each of these camps. And how do we reasonably quantify that?
Turns out, we can’t. A recent study published by the National Bureau of Economic Research finds that each of the motivations mentioned above only explains a small portion of the short-term price swings.
Nevertheless, let’s try to answer the question at hand because, well… it is an important one. Instead of providing you with a clearly defined and justified price target, though, I think it’s more instructive to understand how low (and how high) gold could go. You’ll understand why in a moment…
The Floor is Set
On the heels of the yellow metal’s precipitous 14% decline in June, I shared three reasons why gold prices could go even lower. How low exactly? Down to $900 per ounce by year’s end, based on the most bearish prediction coming out of ABN Amro Group.
Of course, ABN Amro’s price target is just an educated guess. One, I might add, that’s based on the most recent trading history.
If we take into account a longer history – say, 2,500 years – the bottom for gold could be as low as $800 per ounce, according to Duke University’s Campbell Harvey.
“Right now we’re way above the mean,” says Harvey. “[The fall] might not be tomorrow. [But] the cycles go in 10 to 15 years, and we’re well into one of these cycles.”
So $800 per ounce is the absolute bottom, according to Harvey, which makes today’s going price of $1,289 per ounce seem expensive.
Or is it?
Again, the answer depends on how you view gold as an investment…
Time Horizon Matters
If you’re looking to be a short-term trader, then yes – the fundamentals point to gold heading lower in the near future. So I’d avoid trying to play a bounce off the recent lows.
Or as John Goldsmith, Deputy Head of Equities with Montrusco Bolton Investments, cautions, “Gold may have gotten oversold and was due for a bounce, but a bounce doesn’t a bull market make.”
On the other hand, if you’re a long-term investor, gold might be dramatically undervalued. Here’s why…
Gold At $6,000?
Remember yesterday’s chart that showed the level of U.S. gold reserves for the last century or so?
Well, here it is again. Only this time, it also shows the amount of national debt, which has blasted off in recent years.
Now, I’m sure we can all agree that the number one concern facing global markets is sovereign debt levels. The examples of Greece, Cyprus, Portugal and Spain (the list goes on) confirm that too much of something can, indeed, end badly.
Accordingly, I’m convinced that the most compelling reason to own gold now is to protect against the U.S. government’s troubling debt levels.
I’m not alone, either.
“There’s still a very large debt situation with no credible solution. Until the countries put in a credible solution to [reduce] debt burdens, we will look to gold as a currency hedge against that risk,” says Will Rhind, Managing Director at ETF Securities LLC.
And that’s where the chart above comes in…
As you can see, back in the 1920s, the U.S. government was virtually debt free. (Imagine that!) Accordingly, the ratio of national debt to an ounce of gold stood at about 0-to-1.
At the end of 2012, though, that ratio stood at $61,796 of debt per one ounce of gold owned by the U.S. government.
Does that mean gold is worth upwards of $60,000 per ounce? Not a chance! I say that because a one-to-one debt to gold coverage ratio is completely unreasonable.
So what is reasonable? Well, at the outset of the Bretton Woods Agreement in 1944, debt coverage stood at 10.9%. So if we go with that as a rough benchmark, we’re talking about a gold price target north of $6,000 per ounce.
Again, that’s based on the alleged amount of gold held by the U.S. Treasury. If it’s less, all bets are off. Trust in the central bank would evaporate immediately on any such revelations. And unlike paper money, we can’t mint gold reserves out of thin air to calm the market.
Bottom line: It’s always prudent to own some gold in your portfolio. “It’s a strategic asset class [that] serves a purpose,” says Russ Koesterich, Global Chief Investment Strategist at BlackRock Inc. The problem is, that “purpose” varies from one investor to the next.
If you’re absolutely convinced that the U.S. government is on a crash course with a default, I’d be loading up at these levels. If, however, you’re after a short-term profit, I’d look to be more opportunistic and wait for a pullback below $1,000 before adding to my positions.