Thursday, October 7, 2010

On the Value of Gold

I've been a gold bull for a while now (see my post Ready to Ride the Golden Bubble from March 2009), but my rationale was more behavioral in nature. But now, Crossing Wall Street has a fascinating post on a possible model (or at least a framework) for the price of gold, which indicates we are nowhere near the peak.

I highly recommend reading the full post as it provides a nice background for why the model may work, but to the magic formula:

Whenever the dollar’s real short-term interest rate is below 2%, gold rallies. Whenever the real short-term rate is above 2%, the price of gold falls. Gold holds steady at the equilibrium rate of 2%. It’s my contention that this was what the Gibson Paradox was all about since the price of gold was tied to the general price level.

Now here’s the kicker: there’s a lot of volatility in this relationship. According to my backtest, for every one percentage point real rates differ from 2%, gold moves by eight times that amount per year. So if the real rates are at 1%, gold will move up at an 8% annualized rate. If real rates are at 0%, then gold will move up at a 16% rate (that’s been about the story for the past decade). Conversely, if the real rate jumps to 3%, then gold will drop at an 8% rate.
I wanted to see for myself, so I took Eddy's model and updated real T-Bill rates with historical T-Bills rates and historical CPI figures going back to 1950, then sized it so the output matched the current price of gold.

And while he is not trying to explain 100% of gold's movement, but rather the factors that drive that movement... the result in itself is rather impressive to say the least.

Log Scale

His six takeaways (summarized):
  1. Gold isn’t tied to inflation, but rather tied to low real rates (not always one in the same)
  2. When real rates are low, the price of gold can rise very, very rapidly
  3. When real rates are high, gold can fall very, very quickly
  4. Gold should not (and does not) have a long-term relationship with equities
  5. Low rates are likely to last for a long period of time
  6. Gold price is political; central bankers can crush the price if desired (i.e. raise rates)
This last point intrigues me. There is so much capital wasted (i.e. invested) in gold that my question is what would happen if central bankers did just that and raised rates?

The common thought (mine included) is that would kill the economy as we do live in a "credit economy" (i.e. there are lots of assets that are priced based on cheap credit, such as housing). But what if that forced capital away from gold and into goods and/or services that actually benefitted someone / something in the economy?

Data Source: Measuring Worth
Model Data (column K): Google Docs