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
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
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
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
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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