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Gold's Average Price Is Second-Most Overvalued Since 1791

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The inflation-adjusted price of gold is a valuation technique that remains one of the more brilliant carnival-barker efforts in the annals of Wall Street. Here's why.

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The four prior articles in this series have presented a case that commodities are near a secular top. In the last article, Why It's Extremely Risky to Hold Gold Now, the "fair price" of gold as valued by the gold/real estate index ratio was calculated to be $614. In an effort to provide more evidence to the crowd skeptical of the bearish thesis, this article will take a look at another measure of gold: the inflation-adjusted price.

Over the last couple of decades there have been an increasing amount of creative valuation techniques perpetuated by Wall Street. The concept of "operating earnings" is a classic example. Then there was the infamous "eyeballs" technique of valuing dot-com companies.

Also in the Internet era, a stock's crazy valuation was often justified by comparing it to other dot-com stocks which were also ridiculously overpriced.

This provides a nice segue to our main topic which is the inflation-adjusted price of gold. This valuation technique is one of the more brilliant carnival-barker efforts in the annals of Wall Street.

The epitome of ridiculousness is when you read "gold is still trading well below its all-time high." While this is not as common as other quotes you will soon see below, you do come across this more often than common sense may dictate. It is not even mentioned that what the author considers to be an all-time high is, in fact, inflation-adjusted.

A more common quote goes something like "gold is still trading below its inflation-adjusted high." While not quite as bad as above, it still is another doozy. The question is…using what year as a base?

Moving closer to respectability is "gold is trading below its 1980 inflation-adjusted high." While such a measure is fundamentally flawed, the author is not being misleading as he mentions the phrase "inflation-adjusted" and also mentions which year he used as a base. This is equivalent to when you hear an analyst say "the S&P operating earnings yield is 6.3%." While it is really 5.8% based on reported earnings, he at least gives you a fair warning that he is using biased data. Often you hear somebody mention "earnings yield is 6.3%" without even mentioning they are talking about operating earnings.

So what IS the inflation-adjusted price of gold? Well that all depends on what you use as the base year. MeasuringWorth.com has the New York Market Price of gold going back to 1791. The following chart will look at the 2011 price of gold but using different years as an inflation-adjusted base.



First of all, this chart is not a chart of the price of gold since 1791. It is a chart of the average price of gold in 2011 but inflation-adjusted with each year since 1791 as a base. As you can see, the inflation-adjusted price of gold is all about what year you pick as a starting point.

As mentioned in the previous article in this series, the gold/real estate index ratio is currently in the 99.18% percentile. Well the inflation-adjusted price of gold is even worse. By this measure, gold is currently in the 99.54% percentile. Gold's average price in 2011 is the second-most overvalued since at least 1791. Like the gold/real estate index, only in 1980 was gold more overvalued. For those who are curious, the inflation-adjusted cost of gold back then was $1,556. This number is considerably smaller than the $2,000 to $2,200 values you see brandied about because this study looks at the average price of the year rather than the January 21, 1980 top which was a mere blip in time.

After the January 21, 1980 top, gold proceeded to go down over 70% over the next 19 years. This was clearly a bubble. So people are taking what is known to be a bubble price and adding inflation to it for good measure! The gold bull is a house of cards built on quicksand. While the Internet-eyeball technique seemed questionable in 1999, at least people did not have the gift of hindsight that we do today. Do we use March 10, 2000 dot-com valuations as a primary means of valuating stocks today? Do we use 1989 Japanese real estate as the benchmark for valuing real estate? But for some reason gold gets a free pass when it comes to this. One reason for such bizarre behavior is that since gold offers no yield, it allows for more "creativity" amongst the now seemingly endless salesmen pitching its virtues.

So what IS the inflation adjusted price of gold? Well rather than cherry-picking the best year or the worst year, a considerably more reasonable way to value gold is to take the average inflation-adjusted gold price. The answer is $550. The median is $536. It is interesting that the average is very close to the median. This was also the case with the gold/real estate index ratio as well.

Undoubtedly, the gold bugs will try to figure out a way to discount the message of this important indicator. One possible rebuttal is to ignore all readings before 1971 because the US was on an international gold standard back then. If you want to do that, than the average then becomes $662 and the median then becomes $626. Any which way you slice it, the current reading is still the second highest of all time no matter how many years you throw out.

It is difficult to value commodities because they have no yield. Because of their lack of yield, commodities should NOT be given the benefit of the doubt. In fact, they should be substantially undervalued before your interest is even provoked. In fact, the exact opposite is the case now. While gold may or may not have a final blow off top phase, clearly at this point the greater-fool theory of investing is in full effect.




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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No positions in stocks mentioned.
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