Investing in gold has never been for the faint of heart. Gold was on a ridiculous eight-year run from the beginning of 2005 to late 2012 from slightly over $400 to slightly under $1,800 per troy ounce.
Widespread political and economic turmoil led to projections in late 2012 of gold at $2,000, $3,000, and even higher price peaks over the next few years. Then what? Gold prices promptly fell to a little over $1,200 midway through 2014 and almost two years after the peak, we are hovering around $1,300 per ounce.
Was the eight-year run, or the recent adjustment, a fluke?
There are a few correlating factors that suggest that the gold peak is an aberration. Claude Erb, a former portfolio manager in the commodities field, co-authored a paper for the National Bureau of Economic Research called “The Golden Dilemma” suggesting that gold is significantly overvalued.
Erb discovered a relatively high inverse correlation between the interest rate for 10-year treasuries and gold prices. While there are many factors that can affect gold prices, this particular one has done an unusually good job of explaining recent prices.
The abstract of Erb’s paper suggests that part of the reason for the correlation may be “a bull market in fear” driving both bonds and gold. Fear is often given as an answer to explain and predict gold price spikes – fear of economic meltdown, collapse of the dollar, collective geopolitical unrest, and/or runaway inflation. While the fear of runaway inflation seems laughable at the moment, the others have at least a grain of truth to them.
We wonder if artificially low interest rates, driven by the Fed’s stimulus policy, have accelerated a similar “artificial” valuation of gold. Another possibility is that in times of extremely low interest rates and fears of a stock bubble, gold simply looks like the best investment choice for a larger number of people.
Interest rates are not the only thing to consider. The paper suggests that a good measure of whether gold is relatively overvalued is the price relative to the CPI. The historical ratio averages 3.4 to 1. According to Mark Hulbert in a MarketWatch column from January 2014, the ratio was approximately 5.3 to 1, suggesting that gold should be priced a little below $800 per ounce. Of course, just because something is overvalued doesn’t mean the price will not continue to rise.
Some analysts express cautious optimism with predictions in the $1,400-$1,500 per ounce range for 2014 and 2015. Others believe the imminent removal of the Fed’s stimulus package will finally spur a greater economic recovery, raise interest rates, and make gold less desirable. Theoretically, inflation will eventually kick in and make gold more attractive, but probably not until there is a significant downward adjustment in price.
We are not gold experts, and you should not invest based solely on our opinions. However, it seems to us that some of the rise since 2005 is warranted by economic conditions, but there is still relative overvaluation to be dealt with. Assuming the economy slowly grows over the next few years, interest rates will also rise slowly, and gold will either stay static or drop slowly over that time. Of course, this is an election year, and it is always possible that a rash government policy will have unintended consequences in either direction.
Gold still has a place in many investor portfolios – but if you’re holding bullion, it may be the wrong time to add more. For it appears the biggest gold bull market in recent history is itself now history.