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Is Gold Overvalued?

By Richard Baker      Printer Friendly Version Bookmark and Share
Aug 8 2011 1:46PM

The price of gold has soared recently in terms of currencies but is gold becoming overvalued with respect to key commodities? The Eureka Miner’s Gold Value Index© (GVI) addresses this question - the answer may surprise you. The GVI is updated daily in the Eureka Miner’s Market Report .

The commodity ratio is a simple way to determine the value of one commodity relative to another. “How many pounds of copper buy an ounce of gold?? is the question answered when the dollar price of gold is divided by the dollar price of the red metal. The ratio removes currency from the value comparison which is indeed helpful given the recent instability of the major reserve currencies. It is also reassuring to know that mankind has used this technique for millennia. Ask any Phoenician trader.

The Eureka Miner’s Gold Value Index© (GVI)

The Eureka Miner’s Gold Value Index©(GVI) computes the relative value of gold against a basket of commodities in much the same manner as the US Dollar Index® (DXY) determines the value of the dollar relative to a basket of foreign currencies. It is important to note that the Kitco® Gold Index also measures the price of gold not in terms of US dollars, but rather in terms of the same weighted basket of currencies that determine the DXY. Both metrics lend important insights into the movements of gold value and price.

The GVI was designed with metal markets and mining companies in mind. The basket includes gold-referenced commodity ratios for oil, copper and silver for these reasons:

  1. Derivatives of crude oil are a common cost element for all miners
  2. Copper has proven to be a reliable proxy for global growth
  3. Silver is both a precious and industrial metal that now competes with gold for investment and as a hedge against fiat currencies.

The DXY was assigned a value of 100 in March 1973 after the U.S. dollar became a full fiat currency. I gave the GVI a value of 100 on June 7th 2010, the day the DOW closed below the intraday low of the so-called “Flash Crash? which occurred one month earlier.

For either index, values greater than 100 denote increased value form the benchmark date; less than 100, decreased value. During the Great Recession, the GVI rose above 120 in early December 2008 as copper prices dropped below $1.50/lb. COMEX gold was in the mid-$700/oz range during that dark month - the memorable days of $35/bbl oil and $9/oz silver.

The “Flash Crash? redux was one of the worst days for metals and miners in 2010: the U.S. dollar hit its high for the year, many mining equities tanked and gold, although trading in mid-$1200/oz territory, achieved a very high value in relation to oil, copper and silver.  Below is a chart of the GVI from that date through Aug. 5, which closed a week of similar tumultuous market decline.

Eureka Miner's Gold Value Index (08-07-2011) 5

Gold value (magenta line) slowly bounced down from the “high-value? benchmark (blue line) until it found a bottom 10 months later on April 11, 2011 of 67.7 – an amazing 32.3% loss in composite value. The one-month average (dark blue line) shows the general downward trend. The gold value lows for each of the three GVI components are:

Gold:Oil 4/28/11 low down 24.5%
Gold:Copper   2/07/11 low down 34.7%, COMEX copper record $4.6375/lb
Gold:Silver  4/25/11 low down 54.1%

My July 28th Kitco commentary identified Nov. 26, 2010 as an important date between the benchmark and the gold value low. This date lies roughly in the middle of a six-week interval when key commodity ratios returned to near historical norms and enjoyed a halcyon period of rock sold stability. Arguably, the GVI of 83.6 on Nov. 26 represents a reasonable “market norm? (shown by the extended black line). If the GVI is above this line of equilibrium, gold is considered “overvalued? with respect to the basket of commodities; and considered “undervalued,? if below.

Starting in May, gold gained relative value then moved sideways to finish the month of July. The escalating sovereign debt crisis in Europe and the debt ceiling debate in Washington served to surge gold euro and dollar price as well as relative value. The GVI of 89.5 at Friday’s close (Aug. 5, 2011) was only 10.5% below the high-value benchmark and a healthy 7.1% above the GVI market norm.

Gold is presently overvalued but…

Holders of gold should be pleased that gold has recently risen so dramatically in currency price and relative value. They don’t have much company from other investors stung by the recent equity and commodity carnage reminiscent of mid-2010. The fall of the S&P 500 from its 2010 closing high to the GVI benchmark date was 13.7%. Friday’s close was only marginally less severe, down 12.0% from the S&P 500 April 29 high of 1,363.61. With the U.S debt downgrade and escalating worries in Europe there may be further downside to go.

By my definition gold ended the week overvalued with respect to the GVI market norm but its one-month average is still below the equilibrium line. After some of the present market volatility subsides, don’t be surprised to find gold value converge to near historical commodity norms if the western economies return to muddling along and don’t fall into a double-dip recession. Falling oil prices and the resilience of copper price to remain above $4/lb-level are hopeful signs.

The wild card is further central bank intervention to prop up debt-laden western economies. There is eerie coincidence if the descent of gold value below the market norm in this commentary’s example is juxtaposed with the second round implementation of U.S. quantitative easing (QE2, November 2010 through June 2011).

Although other factors such as “Arab Spring? served to drive oil prices, the alarming commodity price inflation due to QE2 over this period is supported not only by the fall in the U.S. dollar but also the significant drop in the relative value of gold. As commodity prices now deflate, our Phoenician trader would remind us that gold remains the ultimate arbitrator of value.

By Richard Baker, CP Analytics



Disclaimer: The prices of precious metals and physical commodities are unpredictable and volatile. There is a substantial degree of a risk of loss in all trading.