What Is the Fair Value of Gold? Ask Stocks

By James Debevec  SEP 07, 2011 12:00 PM

Stocks and real estate may be mildly overvalued, but commodities such as gold and silver are extremely overvalued. Here's proof.

 


Unlike stocks, bonds and real estate, commodities do not have a yield. So how do we figure out what they are really worth once the hysteria subsides? In past articles we have used ratios of other asset classes and compared them to commodities. Today let’s take a look at gold versus stocks.

Many gold bugs seem to think that gold will trade on a one for one basis with the Dow. Going back to Jan 1, 1900 (where daily data is available), gold has spent exactly one day trading at that level (at gold’s January 21, 1980 top). Around the turn of the new millennium the Dow/Gold ratio spent 171 days above 40. The laws of probability dictate that there is a considerably greater chance of this ratio hitting 40 than 1. Yet it seems you read and hear people predicting a Dow/Gold ratio of 1 a lot more than you hear about it hitting 40.

Rather than looking at the Dow/Gold chart, let’s look at the Gold/S&P chart instead. The reasons for the switch are twofold. The first reason is the S&P is a better index that than Dow because it has more stocks and it's not price-weighed. The second reason is, inverting the chart makes viewing it more intuitive as low means buy gold and high means sell gold.

Usually the Dow/Gold chart is shown back to 1900. Thanks to the stellar historical data of chartsrus.com, we can go back 1800 to get a bigger picture. The data is monthly.



Back in 1802 the Gold/S&P ratio hit 34.33. This would equate to $40,200 gold. Now before you mortgage your house and head on over to the nearest coin dealer, you may want to keep in mind that this graph demonstrates a secular downward trend. The reason for this is because stocks go up more than gold in the long run. Over this time period, stock prices outperformed gold by 1.4% a year. While this doesn’t seem like much, over a couple of centuries it adds up.

So on first glance, this indicator does not appear to have much predictive value. However, if we set the Y-axis to a logarithmic scale, a pattern begins to emerge from the chaos.



You may have seen the inverted Dow version of this chart as a few people have explored this concept before. But we are going to take an extra step here and figure out the formula for the trend line and then calculate how far gold is from the trend line each month.

Here is the new chart:



This chart has a very nice oscillation around the 1 line. It does not appear to have an upward or downward bias. The trend line in this chart runs is so close to the “1” line that you cannot even tell it is there.

If you thought that the 1979 blow-off top started to make the chart have an upward bias, the 2000 bottom set that idea aside as the indicator reached a new low.

Look how the last three bottoms are around the same level. It seems that when the US took itself off the gold standard in 1933 and 1971, it did not appear to change the relationship between the two assets. It just made it more volatile.

The current reading is higher than all prior bull market readings with the exception of October 1978-January 1980.

If you look at the chart, at the end of 1974 this indicator was at the top end of the range up to that point in time. Let’s say you were aware of this chart back then and sold gold and bought stocks at the end of 1974 because the indicator was at the high end of its range. You may have had second thoughts five years later, but if you would have held steady for 25 years, stocks outperformed gold by 1,379% from your 1974 purchase price! That is 11.3% annualized outperformance for a quarter century despite missing the second half of the ‘70s gold bubble.

The main purpose of these articles is to see if commodities are overvalued or undervalued relative to other asset classes. Stocks have their own indicators. What this article suggests is gold is considerably overvalued. Stocks and real estate may be mildly overvalued, but commodities such as gold and silver are very, very overvalued.

How overvalued? The gold/stocks trend line indicator suggests the “Fair Value” of gold is 52.87% of the S&P 500 which equates to $616. The current reading is the 98.0% percentile. This is the fourth article I have written on gold and other indicators have suggested reasonable prices to be $614, $550 and $734. In an article in the August 29, 2011 edition of Barron’s, the metals-consulting firm CPM calculated that if gold were bought only for its industrial and ornamental uses its price would be around $600. Every time the indicator in this article reached these levels, stocks outperformed gold by at least 1,218% in less than 22 years. Every time stocks outperformed gold by at least 11.69% a year annualized.

In summary, we have five different methods of calculating what gold is really worth and they all are telling a similar tale. Gold is extremely overvalued now. I predict over the next couple of decades gold will trade at 52.87% of the S&P 500. Should you buy then? No. Why? The first reason is because since the indicator trends down, by the time gold bottoms, fair value will be a lower percentage of the S&P. The second reason is you want to buy when gold is below fair value, not at fair value. At all the major secular bottoms in the chart, gold traded at least 20% (April 1872) below fair value every time. As for last three secular bottoms, gold traded 66% (September 1929), 67% (June 1968) and 71% (August 2000) below fair value.

No positions in stocks mentioned.

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