Preview

In this issue, I review the broad case for buying gold. As a long-term investment, gold tends to underperform other asset classes like stocks and real estate. But there are certain periods in history when gold does exceptionally well. I believe now is one of those times.

At its current price near $900 per ounce, gold has more than tripled since its low of $260 in April, 2001. Gold is in a clear uptrend, but given its price increase, investors should be asking two main questions:

1. Did I miss my opportunity to buy gold?
2. How much higher will gold go and when should I sell?

For Question 1, I believe the answer is no. The analysis below suggests that the bull market in gold is around halfway over, with substantial gains still remaining.

Question 2 is much trickier and will depend on how conditions evolve over time. Today's gold price seems roughly like a "fair value" compared to historical averages, but I expect its long-term momentum to continue for several more years. My personal guess is that gold will reach at least $1500-2500 in the next five years. I would not recommend buying gold much higher than $1000, but at today's price I still think it makes sense to buy some.

The time to sell gold will ultimately depend on how quickly the overvalued stock market and the overvalued housing market become more favorably priced. I would certainly prefer to invest my money in these assets in the long run. My expectation is that gold investments will buy substantially more stocks and real estate in 5-10 years, and investors should return to these asset classes once they are priced more favorably.

Gold as an asset class

Gold is a tricky asset because there is no obvious way to calculate fundamental value. Gold has no earnings and pays no dividend. Let's face it: gold is just a lump of metal. So why buy it?

The first step is to recognize gold as an asset class just like stocks, bonds, real estate, or commodities. And you should be willing to own some at the right price.

Stocks have fundamental value based on future company earnings. Bonds have fundamental value based on future promises to pay. Gold has fundamental value as a means of storing wealth for future exchange. Investors hold gold for many of the same reasons that they hold dollars or other currencies.

Perhaps the most appealing aspect of gold as a store of wealth is that governments cannot easily create more of it. Unlike U.S. dollars which can be printed at virtually no cost, gold must be mined and so the supply is fundamentally limited (the world gold supply has increased roughly 2% per year for the last 50 years).

The only way I can identify fundamental value in gold is to examine its long-term relationship with other asset classes. I will do so in this newsletter relative stocks and U.S. currency.

The case for gold

The last bull market in gold in the 1970s lasted around 12 years. Gold increased 19.1 times in dollar terms and 8.3 times adjusted for inflation. Here is a graph of the historical gold price since 1970:

Click on the image above for a sharper version

Just like long-term stock market cycles, gold goes through bull and bear markets that span decades:

Click on the image above for a sharper version

In the gold "bull market" from 1929-1942, the gold price increased by 70% in 12 years, but stocks fell by 70%. In the 1970s bull market, gold increased 19.1 times while the stock market increased by a mere 20%. The difference between these two bull markets is money supply growth and inflation. In the Great Depression, the U.S. money supply fell since we were on the gold standard, and inflation was -1.9% per year from 1929-1942. In the 1970s, by contrast, the money supply increased substantially and inflation was 6.9% per year.

Holding U.S. dollars and bonds in the 1930s would have been a great investment, but investors would have been killed doing the same thing in the 1970s.

In gold bull markets, the price does not always go up in dollar terms, but it goes up relative to other assets like the stock market. Consider the long run relationship between the price of gold and the S&P 500 (you can find a similar analysis for the Dow by searching for "Gold as an investment" on Wikipedia):

Click on the image above for a sharper version

The above graph plots the S&P 500 to Gold ratio, that is, the total market cap of the S&P 500 divided by the price of gold, since 1870. I plot the y-axis in logs so that the trend is a straight line.

In the long-term, stocks outperform gold from the price increases as well as the dividends they earn (which are not accounted for in the graph). But investors who held gold at the right times could buy substantially more stocks at the end of each gold bull market.

In the 1930s, gold increased relative to stocks by a factor of 8. In the 1970s, gold increased relative to stocks by a factor of 16. In today's bull market, gold has thus far increased relative to stocks by a factor less than 4. There is no guarantee that the above chart will overshoot to the downside, but I expect that it will.

In some sense, gold is a default investment when other assets are expensive. One could alternatively hold cash or bonds, but what guarantee is there that they will maintain their purchasing power? I don't think the yields are high enough to compensate for this risk. Since 2001 holding cash has been the wrong strategy for preserving wealth and I expect it will continue to be so for a few more years.

Long-term investors shouldn't care whether gold goes up in dollar terms, only whether gold is able to buy more stocks in the future. One can just as easily view the above chart as the stock market priced in gold rather than dollars. Think the stock market has recovered since 2003? Think again.

Inflation outlook and the money supply

The real question is whether we are in the midst of a 1930s style deflation, or a 1970s style inflation. Overall, I think the evidence supports an inflationary environment. Here's why I think so.

Exhibit 1: The U.S. trade deficit

Click on the image above for a sharper version
source: NYTimes: Gambling Against the Dollar, November 1, 2006

How are we going to pay back all of this money? Inflating away the dollar's purchasing power seems like the only politically feasible thing to do. The alternative would be a complete reversal of the U.S. from a spending country to a saving country. It's possible that this will happen, but isn't it "easier" just to pay back our foreign creditors with depreciated currency?

Think it's funny how we send China all of these paper dollars in exchange for real goods? Well, it's funny only until they don't want dollars anymore.

Exhibit 2: A dollar based monetary system

Unlike a gold standard system of money where every dollar is backed by physical metal, U.S. dollars are currently backed by, well, nothing but confidence in the system. For better or for worse, the U.S. has decided let the Federal Reserve control the money supply independent of any additional checks and balances. There are advantages and disadvantages of doing things this way, but one consequence of a fiat money system is that inflation is much more common.

Consider this chart of historical inflation for the last 140 years:

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Prior to 1913, inflation oscillated around 0% per year since the government could not create additional currency. Only after the Federal Reserve Act in 1913 do we really see inflation at all. During the Great Depression, the U.S. experienced widespread price deflation since we were still on the gold standard. In 1944, the Bretton Woods Agreement established a fiat money system with the U.S. dollar as the world reserve currency, with the dollar redeemable for gold at $35 an ounce. In 1971, after the U.S. began running massive trade deficits to fund the Vietnam War, the dollar was officially delinked from gold since the U.S. did not have enough gold to cover its expenses.

Also note the relationship between war and inflation. Inflation increases after the U.S. spends too much money without paying for it. Have we raised taxes to fight the Iraq War? No. In fact, we're giving out tax rebates with our latest fiscal stimulus package.

With undisciplined fiscal spending and a lack of resolve to pay for it by raising taxes, I don't see how we get out of this mess without future inflation.

Exhibit 3: Ben Bernanke and the money supply

One writer and investor whom I respect and read regularly made a recent reversal on gold investing based on the Fed's actions with regard to money supply. Gary North has been recommending gold since 2001, but now writes that inflation is gone, at least in the short term:

"There are good reasons to invest in gold and silver. Inflation hedging in 2008 is not one of them...Next time someone rants and raves about mass inflation, sit tight. Be polite. Don't believe it. Someday, yes. Not in 2008 or 2009. Probably not in 2010...

...Deflation has now popped the bubble. I have repeatedly warned my readers that the Federal Reserve was deflating. I have warned for a year that under Bernanke, FED policy had changed, that he was determined to whip inflation, and that the FED was barely inflating – in the range of 1% a year. If you have read my reports, you knew about this shift long ago."

-- Greenspan's Last Bubble Has Popped: Gold, by Gary North, March 22, 2008

North is correct that money supply growth has slowed in the last few years. Despite the recent reports of Fed "bailouts", they haven't been printing money in the literal sense. The rate of money supply growth (M0 at least, which is physical currency) has slowed to less than 2% per year, its slowest rate in decades.

But I do not think the Fed is prepared to let this continue forever. Ben Bernanke has made his academic career studying the Great Depression. As I understand it, the general finding of this literature is that the U.S. failed to increase the money supply to sufficiently counterbalance the massive credit deflation that occurred (sound like a familiar scenario?). Even though Bernanke is not *currently* increasing the money supply, he certainly can and I think ultimately he will.

In Bernanke's famous Federal Reserve speech, "Deflation: Making Sure "It" Doesn't Happen Here", Bernanke makes it clear that he is prepared to run the printing presses to fight off deflation. He does not want to, but eventually he will have to. The political pressure to fight asset price deflation will be enormous.

Even though money supply is not growing right now, previous expansions are already baked into the cake. The following chart demonstrates that the historical money supply to gold price ratio is not outside of historical norms by any means:

Click on the image above for a sharper version

Charts of M1 or M2 look similar. The point is that the dark blue line, which indicates the ratio of the money supply to the gold price, is nowhere near extreme values.

Price targets for gold

I do not believe we are in a gold bubble. Short-term highs and lows occur in any bull market, but I see little evidence of widespread investor acceptance of gold. Very few average investors I know own any. And every article I read in the Wall Street Journal goes like this: "Gold has been going up, but don't forget how risky it is!" These are not the signs of a market top.

The current gold bull market seems too short and too small relative to history. In five years, my most conservative estimate for gold ranges from $1000-1500. This is based on the gold price momentum *not* continuing, so that we have no bubble stage. I obtain this target by adjusting a pre-bubble price of gold ($150-200?) in 1980 by the money supply growth since then.

An aggressive estimate assumes that the gold momentum continues and ultimately enters a bubble stage. Under this scenario, I project gold to reach $4000-5000. I am certainly not counting on such an extreme a valuation, but I think it's possible, especially considering how easy gold investing is these days with ETFs.

My personal guess is somewhere between these two extremes. I expect gold to peak between $1500-2500 in the next five to ten years, but it depends on how aggressively the Fed acts moving forward. It is true that the Fed can stop gold in its tracks by holding the money supply fixed and raising interest rates. But does anybody really think this will happen?

It seems almost incomprehensible to me that I will have to convince people to buy stocks instead of gold if a mania stage ensues. But only time will tell whether we eventually reach such a period.

Conclusion

In summary, I think that we are halfway through a long term bull market in gold. We are getting close to the "hold" period rather than the "buy" period, but I am certainly not close to selling. Investors who do not own any should think about buying some.

I invested in gold in 2006 at $630 an ounce. I was nowhere near catching the 2001 bottom because I wasn't paying attention. But I've been happy so far, and I expect investors will be happy with gold investments made in 2008. If stock prices or real estate prices correct to more favorable levels, I will sell some or all of my gold and buy these instead. I just don't see this happening for another few years.

The ultimate outlook for gold depends on how nasty you view the current credit crisis and how aggressive you think the Fed will act to try to resolve it. As for me, I think the crisis is about as big as they come and that the Fed will do anything and everything in their power to prevent it. And so I own gold.

Disclaimer: I am not a gold analyst or a macroeconomist. I have no formal training examining gold prices, and I am not an expert on the subject. I simply try to understand the economic forces influencing the gold price and examine today's conditions relative to history. Investors should learn more about investing in gold and seek professional advice when making investment decisions.