On Which Basis to Value Gold?

By: Ned_W_Schmidt

Market metrics, like a thermometer, simply reflect the conditions in a market. They do so without opinion or emotion. Metrics such as valuation do not cause market prices to change. Valuation, however, is often a precursor of change as investors, individually and then collectively, respond to price relationships, altering their buying and selling. Valuations of markets will not make you rich anytime soon, but they could make you poorer if they are ignored.

Valuation of $Gold is particularly difficult as we have no income statements or balance sheets. We simply have the price of $Gold relative to the price of other assets with which to work. That might be made simple if we knew what time frame to use for the comparison. In the above chart is plotted the ratio of price of $Gold to the S&P 500 back to 1945. It includes two periods of serous over valuation for $Gold as well two of serious under valuation.

Black line in that chart above is average of that ratio. Green line is the average of that ratio plus one standard deviation. Probability of the ratio being above the green line is about 1 out of 6. Such values will be achieved only during periods of high emotional demand for Gold, as was the case in the two previous periods of  extreme over valuation.

Implications of that ratio are shown in chart to the  right. Using  average of the ratio, implied values for the S&P 500 and $Gold can be calculated. Those calculations favor neither market at this time.

What happens when we change the time frame? Remember, the relevant time frame has not been provided on a clay tablet. In the chart below is plotted that same ratio for the period 1989 through the present. Here the picture is somewhat different.

As was done above, the mean of the ratio can be used to infer valuations for the S&P 500 and $Gold. Results of those calculations are presented in the chart below. As is readily apparent, in this case the game is perhaps now not so favorable for $Gold. A little time with your calculator will also demonstrate that forecasts of $5,000 Gold are dangerous delusions.

In 1999, as shown in both charts, $Gold was like “shooting fish  in a barrel.” Today it is more like a dolphin in your bath tub. Investors must decide which historical framework provides the best basis for valuing $Gold. If one is not a U.S. dollar-based investor, a second step is required. What will happen to investor’s currency relative to U.S. dollar?

Given that politicians will continue to run governments for as far out as one can dream, Gold has a long-term role in all investment portfolios. The issue with which investors must deal is whether or not it should be bought today. Valuation may not be the perfect guide, but it is certainly better than the musings of trend thumping journalists, or hedge fund managers, having over exposed their clients to Gold, now pray gullible public will bail them out of those positions.
               
Valuation considerations and speculative trading activity should serve perhaps as cautionary warnings for most investors. Extreme level of speculation in Silver and small Gold mining shares suggests that investors give more attention to valuation than is normally the case. Level of risk in MVGDXJ is at an unstable high level. See: http://valueviewgoldreport.com/files/Spec_Bar_10_Sep_2010.pdf

By Ned W Schmidt CFA, CEBS

GOLD THOUGHTS come from Ned W. Schmidt,CFA,CEBS, publisher of The Value View Gold Report , monthly, and Trading Thoughts , weekly. To receive copies of recent reports, go to www.valueviewgoldreport.com

Copyright © 2010 Ned W. Schmidt - All Rights Reserved

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