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Is Warren Buffett Correct About Gold?


All indictors point toward yes. Over the next 20 years, expect stocks and income-producing real estate to significantly outperform the yellow metal.

Warren Buffet has recently presented a case that stocks will outperform gold. Is he correct? Since it is a new year, this gives us a good reason to update our annual gold indicators and introduce a new one to see if gold is overvalued.

Inflation-Adjusted Gold Using Year X as a Base

Let's start off with inflation-adjusted gold using year X as a base. This one requires a bit of explaining. You often hear about inflation-adjusted gold. This chart shows what the inflation-adjusted price of gold is using the year on the X-axis as the base. The chart is also exactly the same as the gold/CPI ratio except the numbers on the Y-axis are the inflation-adjusted prices of gold rather than the gold/CPI ratio.

For the inflation data we are using How Much Is That In Real Money? by John J. McCusker (which has US currency data from 1665-2001) and the CPI for 2002-2011. All gold data is from, which has annual gold data starting at 1718 for those interested. As you can see we aren't too far from the December 31, 1979 peak of $1,742. The reason this figure seems a bit low is the gold bugs invariably use the January 21, 1980 peak number. This is an annual indicator so only December 31 is counted. The average inflation-adjusted price of gold is $523. While many would consider such a number to be laughable, as recently as 2004 gold closed the year at $438 which inflation-adjusted equates to $520. That wasn't too long ago. Since 2004, the S&P is up only 12%, housing is down over 20% while gold has quadrupled. Gold's inflation-adjusted price using 2001 as a base is $352. In any event, you can see the key variable in the inflation-adjusted price of gold is what year you decide to use as the base. Undoubtedly the gold bugs will respond by saying CPI numbers are fixed by the government and cannot be trusted. This ignores the fact that we are using McCusker for the overwhelming majority of the data. Let's keep this in the back of our mind and move on to other indicators to see how they compare to this one.

The Gold/Real Estate Index Ratio

The real estate data is from Robert Shiller. While the gold price is as of December 31, 2011, the real estate data has only been updated through the third quarter of 2011. However, chances are we aren't talking about too big of a difference in real estate prices over three months, probably +/- less than 1%.

The line you see, which looks to be a little less than five, is in fact a trendline. Interestingly enough, the average reading for this series is 4.80. So the trendline is extraordinarily close to the average in this data series. Such a remarkably steady correlation between two assets is very rare.
The gold bugs will point to the 1980 high of 13.58 and say it can go higher. If the ratio would equal the 1980 high of 13.58 gold would be at $1,770. Note how similar this is to the inflation-adjusted price of gold high which is $1,742.

So what is fair value? If the index were to trade at its historical average of 4.8 gold would need to go down to $625.

What about the downside? You know how in all those finance books they talk about paying attention to risk? Well on December 31, 2001 the ratio traded at 2.38. This would equate to $310. Interestingly enough, this is fairly close to the inflation-adjusted 2001 price of gold of $352.

A central tenet of the gold bugs is that the Fed can print an unlimited amount of money but they can't create any more gold. Well the Fed can't print land, either. By all accounts, this is a very solid indicator and one that should not be ignored. Expect real estate to significantly outperform gold over the next 20 years.

Gold/Stocks Trendline

We are running out of space here and we want to go over a new indicator, so for those interested in the calculations of this indicator, click here. As of December 31, 2011 this indicator suggested fair value for gold to be $664. This is by far the best indicator I have seen when it comes to the gold vs. stocks debate. Look how nicely the indicator oscillates around the trendline for 212 years. Expect to see an ounce of gold trade for less than half of the S&P before the end of next decade.

Gold as a % of Average Wages

Here is an indicator that we haven't looked at yet: the price of gold as a percentage of average annual wages. The data is from the Social Security organization. For example, the price of gold at the end of 2010 was $1,420 and average wages were $41,674. So an average person would have to work for 3.61% of a year to buy an ounce of gold. We don't know what the average wage for 2011 was, but the SS people estimate a 4% increase. The estimate was used for the 2011 denominator so this chart above isn't 100% official but it should be within a few percent. Anyway, from 1951 (when the Social Security data starts) to the 2011 estimate, an ounce of gold was, on average, 1.63% of an annual salary. That equates to $706. The indicator peaked in 1980 at 4.97%. That would equate to $2,151. As for the few people left who are still concerned with risk, in 2001 the percentage was 0.84% which equates to $364. The bottom line is, gold is simply too expensive for the average person.

Indicator Fair Value
Inflation $523
Real Estate $625
Stocks $664
Wages $706

So is Warren Buffet correct? All indictors point toward yes. Over the next 20 years, stocks and income-producing real estate will significantly outperform gold.

(See also: Buffett Mischaracterizes Gold's Bull Market)
No positions in stocks mentioned.
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