Is Gold Really Expensive?

Perhaps the most common argument right now against investing in gold is that it is too expensive. The price of gold per troy ounce in US dollar terms have hit one high after another, and now hovers around US$1200/oz. And as such, one may be tempted to think that it’s now too expensive to invest in gold. But can you afford to wait, and hope that the price will fall?

The argument of whether it’s expensive or not is a problematic one: price is relative. It depends on what you compare it to.

In currency terms:
• From 1995 to 1998, gold declined 25% in USD terms but, it gained 7% in terms of Japanese Yen, and 20% in South Africa Rand. So, did gold price declined or did it increased in value during this period? It depends on the relative currency, right?

To say that gold is expensive in US dollar terms is to say that the dollar is too cheap. Hence, what we should be taking about is not really the price of gold, but the value of gold. It is a question of valuation, and in order to do so, we need to have some benchmarks to determine whether gold is expensive, cheap of fairly valued.

As famed investor Warren Buffett says: “Price is what you pay, and value is what you get”. If the value is less than the price, then buy; otherwise it is time to sell. Although he was referring to stocks, the same principle can be used to value other assets including gold.

Let’s take a look at how gold prices compare to price of some common asset classes; this would give an indication of whether it’s over-or-undervalued.

1) Gold vs. a basket of currency
Gold is a special metal which is part commodity and part money. And, as money, it’s used as a store of value. But has it been a true store of value? This is an important question for those considering investing in bullion. This is more so since gold prices can fluctuate widely over time. One way of gauging gold as store of value is to compare it against a basket of currencies over time.

Against a broad basket of 29 currencies, gold prices remained more or less constant throughout 1990s. During this period the US dollar appreciated as a result of large investments into the country hence, gold expressed in dollar terms fell. But if we take out the impact of the US dollar, we see that gold as storage of value and a safe haven remain intact; the easiest way to demonstrate this is to compare gold prices in terms of currencies that are subject to financial turmoil like the Indonesian rupiah or Mexican pesos. Investors who had gold in their portfolio were substantially better off.

Example: Mexicans saw gold prices rise by 100% during 3 months during the 1995 crisis. Indonesians saw their prices rise 300% during the 7 months during 1998 Asian financial crisis, as their local currencies lost tremendous value.

But, just because paper currencies have devalued against gold does not tell us anything about whether gold is expensive or whether paper money will lose more value in the future.

So, we will need to compare gold against other tangible assets.

2) Gold vs. crude oil
This is one of the most popular but relevant comparison. However, it does have its flaws as the global supply of oil as we know is diminishing through consumption while the supply of gold is not (as it is never really consumed). Since the dawn of time till now, there’s approximately 166,000 tonnes of gold above ground

(Gold Council estimates).

But, comparing gold prices against oil is still interesting and gives some insights to its long term value:
• The amount of gold needed to buy per barrel oil has been relatively stable over time.
• Since 1900, average gold price / barrel of oil was 0.05 ounces. This is like the long term average.

Currently, the current price is about 0.06 ounces which suggest that gold is slightly cheaper when expressed in terms of oil (or oil is expensive expressed in gold). Not surprising given we know that oil prices is determined by supply which is diminishing through massive consumption in last few years with the emergence of China and India as new super economic powers.

3) Gold vs. house prices
In some countries like Vietnam, you could literally walk in and buy a house, and in exchange pay in gold (based on weight). So, we can also work out the purchasing power of gold in terms of exchange value for property.

Below is the price of an average single family home in US and UK expressed in term of an ounce of gold. There is no noticeable upward trend in the house price index expressed in gold and also the current price would suggest that house prices are already cheap compared to gold (recall that house prices fell drastically from the peak as a result of the sub-prime crisis).

4) Gold vs. Stocks
The Dow Jones Industrial Index (DJIA) is the oldest stock index introduced in 1886 and is very similar to gold in that dividends are not included in its computation (gold also doesn’t pay dividends). It represents a good benchmark to gold for investments.

In 1900, the ratio of gold to DJIA was 2 i.e. it takes 2 ounces of gold to buy the whole DJIA. It remained at below 5 ounces for next 25 years, and shot up to 15 during the bull of 1920s. After the crash, it went down to 3 ounces of gold. By 1950s the ratio was rising and back up to 25 in 1965. In 1970s, it fell sharply and by 1980s when the US economy recession started, it fell to almost one. During the tech bubble of 2000, the ratio was as high as 35 ounces for the entire index.

The current value is around 8 ounces. As the long term average is around 5 ounces, gold is still not overvalued compared to US equities.

5) Gold cover ratio
This is perhaps the most interesting comparison. It is often said that gold is part commodity and part money. But nobody really believes that gold is a commodity like copper which trades at $6,900 per tonne. A tonne of gold would cost $38.5mil so it’s difficult to imagine that gold would be regarded for only its physical properties.

“Gold would never have attained its position as supreme monarch of monetary systems without its unique attributes, yet the demand for gold became so insatiable because it was used as money”

If we regard gold price as continuum ranging from commodity at low-end to full fledged money at the high end, we can work out how much gold will be needed to “cover” the amount of money in the system. Post the 2008 sub-prime crisis, the US Federal reserves has embarked on quantitative easing to ensure that financial system did not crash, and would resume its growth path. What it means is simply, they have printed a lot of money (not bucket loads, but in the trillions).

To cover 100% of all banknotes and coins circulating in U.S: then gold prices should be at $3000/oz. If we included monetary substitutes like cheque accounts; gold prices would need to be around $6,000/oz to cover all the money. If it’s M2 (which includes everything - savings, deposits, and others), the price would jump to a whopping $30,000/oz! And, from the production chart below, it is evident that there is no way that the supply of gold from mines can support this. So in terms of basic supply demand, prices would have to go up.

Summary and conclusion
Valuation of gold is tricky business. No independent measure can tell exactly whether it is cheap or expensive, but the comparisons illustrated here provide some guidance.
Looking at the gold cover ratio, it shows that gold is not at extremely high price level. In comparison to stocks, and oil, gold appears to be inexpensive or at least fairly valued. Gold prices below $1200 per ounce provide attractive entry levels: our 12 months forecast stands at $1500 per ounce. And, any increase in risk from the current sovereign debt crisis in Europe, could propel the gold prices even higher.

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Chris Gan
14 July 2010