Century Management’s Gold Valuation Analysis
Gold has confounded economists and investors throughout time. Nathan Meyer Rothschild (1777-1836), the top financier of the early 19th century, said, “There are only two people who understand gold: One is a director in the Bank of England, and the other an obscure clerk in the Bank of France. Unfortunately, they disagree.” Today, nearly 200 years later, Ben Bernanke, the former Chairman of the U.S. Federal Reserve, remains equally perplexed when it comes to gold. In a statement to Congress on October 7, 2013, he said, “Nobody really understands gold prices and I don’t pretend to really understand them either.” In addition, Janet Yellen, the current Chair of the U.S. Federal Reserve, stated in her testimony to Congress on November 14, 2013, “Well, I don’t think anybody has a very good model of what makes gold prices go up or down.”
With all the different opinions surrounding gold, there are basically only two different ways of looking at gold: as a commodity or as money. Some believe gold‘s sole value is that of a commodity, where it is most often used in jewelry, industry, medicine, dentistry, technology, electronics, and aerospace. Others believe as financier, banker, and philanthropist John Pierpont “J.P.” Morgan (1837–1913) did: “Gold is money.” Investor demand has served as the biggest swing factor on the price of gold over time, as central governments, institutions and consumers have frequently invested large sums in gold during periods of great uncertainty, deflation or high inflation.
For purposes of our research, we do not need to reconcile whether gold should be viewed as a commodity or as money, or why gold prices rise or fall. The focus of our research is to determine the price at which gold becomes an attractive investment.
After having analyzed gold from five different viewpoints, we summarize our gold price zones in Chart 1. Our research suggests gold, which has been trading between $1,225 and $1,326 per ounce as of the first two months of 2014, is in a fair value zone. We believe the downside risk to gold is approximately $600 to $700 per ounce, and the extreme upside is between $1,800 and $2,200 per ounce.
We believe gold is currently trading in a fair value zone and therefore not at an attractive price to buy as a commodity. However, in our February 21, 2014, newsletter titled Inflation, Gold, and Gold Mining Companies, we illustrated that a number of the 40-plus gold mining companies we researched and bought at the end of 2013 were priced as if gold were trading between $800 and $900 per ounce. While gold is currently trading in our fair value zone and would not qualify under our investment discipline as a buy today, we would recommend the purchase of gold for those who want to own it as a hedge against potential higher inflation or a currency crisis rather than for pure investment purposes.
Century Management Gold Valuation Methodology
To arrive at our gold valuation zone prices sited in Chart 1, we used these five methods of valuation:
- The price of gold over time, adjusted for inflation
- How much gold prices dropped during gold bear markets
- The price of gold compared to the price of oil, housing, and commodities
- The price of gold compared to the U.S. Consumer Price Index
- The actual cost of producing an ounce of gold
The remainder of this report details how we arrived at our gold valuation zones using each method. Comparing each method, some approaches yielded significantly different price ranges and valuation zones. These differences occur because, when compared to gold, other assets do not always reach their peaks or their bottoms at the same time. For example, the ratios of Gold-to-Housing and Gold-to-Oil suggest that housing is currently more depressed than the oil market. However, by averaging these ratios, we gain the benefit of insight from each market.
Method 1: Historical Gold Prices, Adjusted For Inflation
Chart 3 highlights the low and high prices for gold from 1968 through 2013. These prices are historical, meaning not adjusted for inflation. Using this approach, we benefit from observing the market’s determination of gold prices at extremes. Chart 4 also shows the low and high prices for gold, except these prices are adjusted for inflation as measured by the U.S. Consumer Price Index (CPI). Now let’s compare Charts 3 and 4 to see the impact of inflation on gold prices.
The peak gold price was $850 per ounce on 1/21/1980 (Chart 3). Using the same date of 1/21/1980, but now looking at Chart 4, the price of gold is $2,546 in today’s dollars (i.e. adjusted for inflation). The difference in price between these two charts suggests that inflation has averaged an annualized rate of 3.28% over the past 34 years.
See full PDF on Century Management’s Gold Valuation Analysis here.