Is gold undervalued or overvalued? The question is all the more relevant
now that the precious metal is trading at $1,200 an ounce, having shed
$700, or 38%, over the past two years, including nearly 14% during June
alone.One study stirring much controversy among gold enthusiasts suggests it has more to fall.The study titled “The Golden Dilemma” — was published earlier this year
by the
National Bureau of Economic Research, a nonpartisan think tank
in Cambridge, Mass. Its major finding is that regardless of how you
define gold’s “fair value,” gold sometimes trades well above it and at
other times well below. An ancillary finding: Whenever bullion deviates
significantly from fair value, it eventually returns to trade at that
level.
Campbell Harvey, a finance professor at Duke University and one of the
study’s co-authors, concedes that there isn’t one agreed-upon definition
of gold’s value. But he says that he and his co-author closely analyzed
all the criteria of which they were aware.
The list they studied included defining gold’s value as a hedge against
inflation,
currency fluctuations, or low real interest rates, or as an
insurance policy against hyperinflation or collapse of the financial
system. They found that each definition was unable to explain more than a
small portion of gold’s price swings over the shorter term. While this finding is frustrating to traders who want to forecast gold’s
shorter-term moves, gold is hardly different in this regard than the
other major asset classes.
Consider the price/earnings ratio, a popular valuation metric for
equities. According to research conducted by Cliff Asness, co-founder of
AQR Capital Management, which oversees $80 billion, the P/E ratio
historically has been unable to explain more than 5% of the variation in
next-year stock-market returns.
The situation improves when we focus on the very long term, however,
according to Harvey. When measured over many decades, gold is a decent
inflation hedge, maintaining its purchasing power. His study therefore
provides confirmation of the conclusion reached by a seminal book that
enjoys almost biblical status among gold enthusiasts: “The Golden
Constant,” which was written in the 1970s by the late Roy Jastram, a
professor of business at the University of California, Berkeley.
Gold bugs need to be careful drawing the proper investment implications
of Jastram’s conclusion, however, according to Claude Erb, a former
commodities portfolio manager at TCW Group and the other co-author of
the National Bureau of Economic Research study.“For Jastram, the short run was the next few years, and the long run was
perhaps a century,” Erb said in an interview. “And over the short term
of a few years, both Jastram as well as our recent study found that
gold’s track record as an inflation hedge is quite poor.”
Consider: Investors who bought gold at its January 1980 peak of $875 an
ounce are today still below water in inflation-adjusted terms. They even
were showing a loss two years ago when gold was trading for more than
$1,900. The investment implication is to pay careful attention to gold’s
longer-term cycles before buying gold — or be willing to hold it for
many decades.
So how should you decide where gold is in its long-term cycle? As a rule
of thumb, the researchers urge investors to calculate a ratio of gold’s
price to the level of the consumer-price index. This ratio’s historical
average has been about 3.4 to 1, so it is a good bet that gold is
overvalued whenever the ratio is well above that level.
When
gold hit its high over $1,900 an ounce in September 2011, for
example, the ratio was more than 8 to 1. In January 1980, the ratio
stood at more than 11 to 1. Unfortunately for the gold bugs, the current gold/CPI ratio — 5.3 to 1 —
is still above average, even in the wake of gold’s plunge over the past
three months. To be in line with that average, gold would have to trade
for $780 an ounce. “Note carefully,” Erb says, “our research doesn't
provide a basis for predicting when gold will once again trade at fair
value, however — only that it will eventually do so.”
Michael Bordo, an economics professor at Rutgers University and director
of its Center for Monetary and Financial History, also is not surprised
by gold’s pullback. Referring to the statistical tendency for high or
low readings to eventually move back toward the longer-term average, he
said in an email: “My research has shown that there is a lot of mean
reversion in the nominal price of gold, reflecting the relatively steady
very long run behavior of the real price of gold.”
Erb acknowledges that his study’s conclusions are controversial. But
that is at least partly because the “gold bugs believe bullion has some
exalted status that exempts it from the price fluctuations that cause
every other major asset class to sometimes trade well above or below
fair value,” he says.
Also controversial is the suggestion that a gold/CPI ratio can be
helpful for determining if gold is undervalued or overvalued, since many
believe the CPI understates inflation. But gold will fluctuate wildly
relative to whatever inflation index you choose, Harvey says, and it
will inevitably regress to the mean following any period of extreme
undervalue or overvalue.
If you believe, like the study’s authors, that gold is still overvalued,
you might consider an exchange-traded note that gains in price to the
extent gold declines: PowerShares DB Gold Short
DGZ
-2.25%
, which carries an expense ratio of 0.75%, or $75 for every $10,000 invested.
If you instead believe that gold is undervalued, or just due for a rally
following its recent plunge, you might consider the SPDR Gold Trust
GLD
+2.73%
, an exchange-traded fund with fees of 0.4%. Another gold-oriented ETF is the iShares Gold Trust
IAU
+2.92%
, with fees of 0.25%.
Still, there are more conservative — and cheaper — ways to hedge against
inflation than by investing in gold. Investing in the U.S. Treasury’s
inflation-protected bonds, or TIPS, is one example; an ETF that does
that is Schwab U.S. TIPS
SCHP
+0.24%
, with fees of 0.07%.
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Here is another blog that provides regular news and information and is very useful for Forex Signals.
