Gold's theoretical value
March 12, 2004

I will be discussing the current gold price and some of the stocks I am investing in at the Calgary Investment Conference in April and at the London Global Mining Forum in May (take a look at the conference schedule in the left panel). If you’re there please come and introduce yourself.

Last week we looked at the irrational behavior of the gold market during 1979 and 1980. We left off in 1988, after noting that from 1984 to 1988 the actual gold price differed, on average, by only seven percent from its theoretical price.

On the surface, the gold market from 1987 to 1996 was about as exciting as watching paint dry. Yet a lot was happening in the undercurrent.

In 1983 a new financial risk management tool was developed to mitigate the impact of gold price volatility on mining companies: hedging. Total gold hedging increased from four tonnes in 1983 to forty five tonnes in 1986. But from 1987 to 1990 a total of eight hundred and seventy six tonnes were hedged.

Around the same time, between 1989 and 1993, M3 growth increased by only six percent. Gold inflation, on the other hand, was eight percent during that period and so the gold price should have declined two percent over the course of those four years.

This downward pressure on the gold price, coupled to the expansion of hedging, which increases the supply of gold in the market, caused the actual gold price to drop nineteen percent from 1987 to 1993 -- fifteen percent below its theoretical value.

Although gold peaked in February 1996 at almost $420 an ounce, the average price for that year ($388) was fifteen percent less than its theoretical price of $458. It was already undervalued, yet the gold price still declined to almost $250 an ounce in 2001.

Compounding demand for dollars, following a series of currency crises that tightened supply and strengthened the dollar against almost all other currencies, was behind the decline in the gold price. We have discussed this before, but it is worth reviewing again.

Capital flight from Brazil between 1992 and 1994, as the real effectively went to zero, created significant demand for dollars. In response, the dollar increased by about ten percent against the PVE Dollar Index (a GDP-weighted index of thirty five currencies; see “A New Gold Index” – January 16, 2004).

The worst financial crisis in Mexico since the Revolution occurred from 1994 to 1995; the peso lost over fifty percent against the dollar. More capital moved into the United States and this further increased demand for dollars.

The Japanese yen lost twenty four percent against the dollar from 1995 to 1996, and still more capital fled to the United States, but the “Big One”- the South East Asian Crisis - didn’t hit until 1996.

From 1996 to 1998 the Indonesian rupiah lost seventy six percent of its value against the dollar, setting off a domino effect that dragged the South Korean won down fifty six percent and the Malaysian ringgit and the Philippine peso each down by forty percent. A truly massive flight of capital ensued, most of it destined for the United States. The US dollar increased by almost thirty percent against our GDP-weighted index.

In 1998 Russia defaulted on its foreign debt, sending the ruble down over seventy percent in that year alone. The euro’s launch in 1999 was also the beginning of its twenty eight percent decline against the dollar. Back in 1998 the “new” Brazilian real collapsed again, the Turkish lira fell in 2000 and the Argentine peso followed in 2002… you get the picture.

In all these cases capital poured into the United States. As a result, the dollar increased by more than one hundred and ten percent from 1990 to 2002 against our GDP-weighted currency index.

Gold in dollars is inversely related to the dollar exchange rate. Just like any other import, if the dollar gets stronger the gold price goes lower. There is an almost perfect correlation between the decline in the gold price between 1996 and 1998 and the increase in the dollar exchange rate.

Our model shows that accounting for both dollar and gold inflation, gold is worth about $740 an ounce as of 2003. Yet gold is trading for only $400 an ounce. Just as the actual gold price did not deviate from its theoretical price for very long after the Iranian Hostage Crisis, the current gold price cannot remain below its theoretical price.

Were it not for the dollar’s tremendous increase over the past decade, the actual gold price would differ by less than ten percent from its theoretical price. This can be shown by recalculating the gold price in constant 1990 dollars, i.e. keeping the US dollar exchange rate constant since 1990.

You can see the result of this exercise represented in the chart above by the modified gold price line. Notice how well it tracks the theoretical gold price, and keep in mind that these two lines were derived completely independently of each other. The theoretical price is based on gold being $20.67 in 1933 and adjusting for both dollar and gold inflation. The adjusted gold price is merely backing out the exchange rate from the actual gold price since 1990.

The undeniable correlation is no coincidence, and begs the question whether the dollar can sustain its current exchange rate. I have already addressed that issue in a previous article (see “Predicting the Gold Price”, February 6, 2004) and concluded that gold is likely to exceed $1,000 an ounce within five years, regardless of whatever short term volatility we encounter on the way. We should, however, not be too sanguine; a nasty short term correction in the gold price can severely damage one’s portfolio, which is often accompanied by a general sense of humor failure.

Paul van Eeden

Paul van Eeden works primarily to find investments for his own portfolio and shares his investment ideas with subscribers to his weekly investment publication. For more information please visit his website (www.paulvaneeden.com) or contact his publisher at (800) 528-0559 or (602) 252-4477.

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