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Why It's Extremely Risky to Hold Gold Now


Like all commodities, gold offers no yield which is why historically it offers such dismal returns. Plus, the gold/real estate index ratio is an extremely telling long-term indicator.

It is rather difficult to spend time on a financial website these days without stumbling across yet another bullish gold article. A not-so-small cottage industry has emerged with respect to commodities and precious metals in particular. This is reminiscent of the tech mania back in 1999. However, there is trouble in paradise. One reliable and robust indicator suggests that gold prices in 2011 are the second-most overvalued of any year since at least 1890. History suggests a reversion to the mean will take place and gold will trade at much lower levels over the next couple of decades.

Gold is historically a rather mediocre investment. provides gold and CPI data going back to 1257 and 1264 respectively. If one splices a few data series together and crunches some numbers, one would find that inflation goes up by 0.75% a year while gold goes up by 0.77% a year. It is difficult to find another asset that comes as close to inflation as gold does. Do not interpret this to mean that gold and inflation match in any given year. It just means that sometimes people love gold (2002-2010) and it goes up a lot. And sometimes people have little interest in gold (1981-1998) and it goes down a lot. Over decades and centuries everything more or less evens out.

So gold does indeed do a remarkable job of holding value. However, don't forget about those pesky storage and security costs which are not factored into the price of gold. Every year you have to trim a little sliver off your gold bar to make sure you aren't going to get robbed. So 30 years from your purchase, you may not even be able to buy what you could buy now due to security costs.

Inevitably the gold bugs will make some comment in reference to gold being superior to the worthless paper dollar. Have you ever met anybody who has suggested that you should take a wad of $100 bills and put it in the bank safety deposit box for decades? Everybody knows those dollars will depreciate. This is not exactly a bold prediction since the United States has had inflation every since year since 1954. After 56 consecutive years in a row, most people "get" the pattern. The competition for gold is not the US dollar but rather all other asset classes.

How do you value gold? Like all commodities, it offers no yield which is why historically it offers such dismal returns. What you can do, however, is to compare gold to an asset that should theoretically be one of those entities that you can exchange gold for in 30 years. Real estate appears to be an excellent comparison vehicle since it also follows inflation pretty well. Since transaction costs are so high, real estate is usually very stable and goes up a little bit each year. Yes, we recently have had real estate bubble, but nothing is perfect and it really is a rare occurrence.

The real estate data used in this study is from Dr. Robert Schiller of the S&P/Case-Schiller Housing Index fame. Dr. Schiller has an index of nominal real estate values going back to 1890. This is pretty close to exactly what we are looking for. Mr. Schiller's dataset is not an "average price of house" like some real estate datasets, but rather an index. So keep that in mind.

Without further ado, let's take a look at the chart.

In 2011, the gold/real estate ratio is the second-most expensive out of 122 years. No doubt, the gold bugs will note that in 1980 the index went even higher. For those curious, if gold would reach 1980 levels it would trade at an average price of $1,868 for a calendar year.

As for 1890-1979 and 1981-2010, the gold/real estate ratio traded at a lower level than it has thus far in 2011 in every single one of those years.

The gold/real estate ratio is robust; it does not appear to have any major secular trend creep issues and it offers both great buy and sell signals.

The lowest three readings are as follows:

#1 1970 -- From 1970 to 1980, the average price of gold went up 1,582%.

#2 1971 -- From 1971 to 1980, the average price of gold went up 1,384%

#3 1967
-- From 1967 to 1980, the average price of gold went up 1,650%.

If you see this indicator trading a good amount below its average and median levels it might be a good idea to take a serious look at gold.

Let's look at the highest three readings:

#1 1980 -- From 1980 to 2001, the average price of gold went down 55%.

#2 2011 -- ???

#3 1981 -- From 1981 to 2001, the average price of gold went down 40%.

It is also interesting to note that the average price of gold did not reach either 1980 levels again for over a quarter of a century.

Another interesting aspect of the gold/real estate data is the average and median are exactly the same number. That number is 4.71. What is the significance of this? One interpretation is that gold tends to oscillate around that number pretty well. What would the 4.71 equate to? If gold would immediately decline to its average and median value relative to real estate since 1890 it would trade at $614.

At the low end of the spectrum, if gold would trade at the 1970 ratio it would trade at $242. If gold were to trade at the 2001 ratio level (which is the low of the post gold standard era), it would be at $324.

In summary, gold offers no yield and historically it is a mediocre investment. Furthermore, the gold/real estate index ratio (a highly reliable long-term indicator) is at the 99.18% percentile. While it is possible that gold can get even more overvalued, the risk of holding gold can now be categorized as extreme.

Lasting through April 15, 100% of the donations made to The Ruby Peck Foundation for Children's Education will be channeled to the children of Japan as they attempt to find their footing following this natural disaster; and to kick off this drive, we'll pledge $5000 to get it started. Please do what you can, as it will add up, and thanks.
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