Is Gold Dead?

Adam Hamilton    October 20, 2000    4025 Words


In these times of wild and reeling markets, it is prudent for every speculator and investor to take a step back, turn off the cacophony of noise echoing forth from a world drowning in information, and take a hard look at our portfolios.  With virtually unlimited demand for speculators’ and investors’ hard-earned money, we are faced with a bewildering array of global choices for capital deployment.  No matter where one’s capital is parked at the moment, the markets seem to be at an inflection point, perhaps balanced on the edge of razor-sharp ridge straddling a vast chasm.  American tech stocks, long the object of many an investor’s affections, have taken a brutal 40% thrashing in a mere six months.  Traditional blue chip stocks have fared better, but have still been trading sideways for over 18 months.  Anyone with capital at risk in the US equity markets needs to do some serious research and soul searching before deciding on future capital deployment strategies.  Some Wall Street pundits believe the indices are ready to roar back with a vengeance, while others believe they are still many, many times overvalued and due for a grinding bear market or even a crash.  Will one camp be proven right, or will the markets trade in a disgustingly monotonous sideways range for the foreseeable future?  Speaking of disgustingly monotonous sideways trading ranges, gold investors have also been kayaking through class five rapids in the last few years.  So many hopes and dreams ride on the yellow metal, but it has, as of yet, let down its supporters and filled its detractors with glee.  Is gold dead?  Is it truly a “barbarous relic” destined to spend its remaining days in the side show of financial history?  Or is it the ultimate contrarian play on the verge of a great renaissance?


Whether one is playing the NASDAQ, the Namibia Stock Exchange, or the gold market, it is very important to periodically reassess the opportunity that was originally believed to exist.  Has the outlook for the investment changed?  Should capital be redeployed to take advantage of higher potential opportunities?  We believe there are three critical dynamics that must be examined periodically for any existing investment holding and also analyzed for any new potential investment opportunity.  These dynamics include current valuation, supply and demand fundamentals, and exogenous factors. 


Valuation is the first and most critical piece of information for ANY investment.  The ultimate return realized is a mathematical function of the original price paid for a particular investment.  If the entry price is too high, the possibility of a world-class return dwindles dramatically and the probability of a large loss looms as an investment ultimately regresses to its true value.  Supply and demand fundamentals are also crucial for predicting expected future price movements.  In free markets, the perpetual and intricate interaction of supply and demand determines the current price of asset.  If a larger quantity of a particular investment is demanded than is supplied, the price will rise.  Conversely, if a smaller quantity of the same investment is demanded than is supplied, the price will fall.  Finally, it is always wise to attempt to factor potential disruptive exogenous events into any investment analysis.  We live in an inherently unpredictable world, and it definitely pays to be aware of potential events which could dramatically alter the fortunes of a particular investment or speculation vehicle.  We will briefly examine these three critical dynamics for physical gold in this essay, and attempt to determine if gold is really dead as a viable investment.


Valuation IS the single most important factor in any investment decision.  If one pays $100 for a share of stock that is really worth $1000, they are a hero, and will make fantastic profits as the market eventually nudges the investment to its true value.  If one pays $100 for a share of stock worth $10 they are a goat, and stand to lose most of their capital when the inevitable regression to true value occurs.  Virtually all assets tend to have cyclical valuations through history.  Sometimes they are worth more than they should be as greed drives up prices, and sometimes they are worth less than they should be as fear precipitates overselling.  The ultimate goal for investors and speculators is to snatch up assets that are in the undervalued leg of their endless valuation cycle, and sell them later when they become overvalued as ever increasing amounts of capital chase them once the value is widely recognized.  The principle is ancient and wise!  Buy straw hats in the winter when no one wants them to sell in the summer at a nice fat premium.  If gold is currently overvalued, there is no sense buying it.  The only available exit strategy after the purchase of an overvalued investment is the Greater Fool Theory.  The Greater Fool Theory states that it is acceptable to buy an overvalued investment, as long as one can find a greater fool to sell it to at an even higher price in the near future.  This strange doctrine has been the foundational speculative strategy undergirding the stratospheric NASDAQ in the last few years.  Valuation for any asset is best established from multiple and quasi-independent perspectives.  Zooming in on gold, the more angles from which one can view the gold price, the better the analysis is likely to be.  By looking at the current gold price in light of historical gold prices, in relation to equities, in relation to commodities, and in relation to oil, we can attain a good solid idea of whether gold is undervalued (a buy) or overvalued (a sell) at this moment in time.


This first graph shows the price of gold over the last thirty years, in inflation adjusted dollars.  With the relentless growth of fiat paper currency since the early 1970s, comparisons in nominal dollars are very distorting, whether one is looking at equities, gold, or any asset valued in dollars.  By adjusting the gold price for inflation (as measured with the CPI, which is a conservative measure of inflation as it is probably intentionally lowballed through hedonics and statistical wizardry for political reasons), we gain a much more accurate perspective on its past price action and current valuation situation…



In real terms, gold is currently languishing at a 28 year low.  The last time this real gold price has been observed was WAY back in June of 1972, soon after Columbus discovered America.  The average price of gold over the last thirty years, in today’s dollars, has been $506 per ounce, almost double the current gold price level.  In terms of its own historical performance, gold is very undervalued at the moment, a good sign for contrarian gold speculators and investors.  Technically, the chart itself is very interesting.  Line “A” marks the base and line “B” marks the top of a massive descending wedge chart formation.  Descending wedges are powerful formations in technical analysis.  When an investment enters a descending wedge with a strong upside move, there is a very high probability there will eventually be a major price break-out to the upside when the apex of the wedge is reached.  The probability is also strong that the upside breakout at the apex will retrace or exceed the major rally of the asset when it initially entered the wedge formation.  Gold has been locked in this formation for over 20 years, and the price is relentlessly nearing the apex of this huge wedge.  As gold entered the descending wedge in a behemoth rally, the inevitable breakout from the wedge has an extraordinarily high probability of being a similar massive rally in the yellow metal.  Some technicians believe line “C” is really the top of the wedge, as it connects several major gold tops since 1980.  They believe the major 1980 spike above line “C” was a speculative blowoff, and the wedge is really bound by lines “A” and “C”.  Whether the AB wedge or the AC wedge is more appropriate, both formations are nearing their apices and a large technical rally is expected when the lines converge in the near future.  Relative to its own modern historical performance, gold IS undervalued.  An encouraging start in a comprehensive valuation analysis…


By examining the complex relationships between diverse markets, the relative valuation of an asset to another important market can be analyzed.  This is very useful in providing other perspectives on the current gold price.  Is gold over or undervalued relative to the gangbuster US equities market?  We divided the price of gold by the S&P 500 to create the graph below…



Over the last three decades, the price of gold divided by the S&P 500 index level has averaged 1.47.  When the ratio gets high, gold is in investment demand and tends to be dear.  When the ratio gets low, gold is cheap and unwanted, a potential contrarian play.  The ratio is currently at 0.20, which is the lowest level in history!  The S&P 500 index, the broadest measure of the best public companies in the United States, was formed on March 4, 1957.  In November 1997, the gold/S&P ratio eclipsed its all time low of 0.33, and it has traded well under that level ever since.  In S&P 500 equity terms, gold has never been priced more attractively than at this moment in time.  Another very encouraging perspective on the current valuation of gold.  Thus far, we have seen that gold is undervalued in its own historical terms and VERY undervalued in relation to the broader United States equity markets.  What about the gold valuation relative to general commodity prices?


The Commodities Research Bureau (CRB) index is the most widely followed comprehensive commodity basket index in the markets today.  It was also created in 1957, and currently contains 17 commodities important for our global economy.  The ratio in the graph below is simply calculated by dividing the price of gold by the CRB index level… 



On average, the gold/CRB ratio has hovered around 1.31 over thirty years.  Since the gold standard was abolished in 1970, there has been an enormous fundamental change in commodity and general pricing.  The gold/CRB ratio has averaged a significantly higher 1.61 since 1980.  Currently, gold is very undervalued relative to general commodity price levels.  The gold/CRB ratio is presently near 1.18, a level that has not been observed since July of 1979, soon after America won its independence from imperialistic Great Britain.  The gold price relative to general commodity prices joins the historical real gold prices and gold relative to equity valuations as a third witness to the currently very undervalued gold price. 


In one final exercise, we will review the gold price relative to the price of oil.  Like the previous ratios, this simple ratio is calculated by dividing the price per ounce of gold by the price per barrel of crude …



Oil, without a doubt, is the king of the industrial commodity realm.  Oil is absolutely ubiquitous in the modern world, and our global economy would grind to a halt almost immediately without the vast quantities of oil supplied to the voracious market each day.  Gold and oil have historically had a very strong positive correlation.  When oil is up, gold tends to be up.  When oil is down, gold tends to be down.  Since 1970, the ratio between the price of gold and the price of crude oil has averaged around 16.4, indicating an ounce of gold on average cost 16.4x as much as a barrel of crude oil.  Incredibly, the gold/oil ratio is currently plumbing the depths of an abyss never before seen at around 8.0.  We calculated the ratio all the way back to 1950 (around the time when the Magna Carta was written), and in the last half century, this ratio is the lowest ever seen.  It is most likely the lowest ratio in all of history, as the gold price in dollars was relatively constant before 1933, and between 1933 and 1950.  Markets abhor valuation extremes, as capitalists tend to sell assets overvalued to extremes, lowering their prices, or buy assets undervalued to extremes, raising their prices.  In terms of oil, gold is as cheap as it has ever been.  As this current gold/oil ratio level is unprecedented in history, there is a very low probability it will last.  Either gold will have to rise dramatically in price, or oil will have to drop dramatically in price to bring the ratio back in line.  Note the sharp “V” shaped bottoms in the past when the ratio has approached or exceeded 10.  Historically, it is very highly probable that the current gold/oil ratio anomaly will be extremely short lived.  With the current oil supply and demand situation, it is obvious oil is not going down dramatically this winter, leaving a big leap in gold as the only potential resolution.


Remembering our three criteria of valuation, supply and demand fundamentals, and exogenous factors, gold is extremely undervalued relative to its recent history, to equities in general, to commodities in general, and to oil in particular.  A particular viewpoint or analysis is buttressed considerably with the addition of multiple vantage points from which to view the data.  With gold currently trading far below historical norms relative to most other major asset classes, the valuation criteria is met.  Gold is CHEAP at the moment.  Markets detest anomalous situations, and cheap gold will not last forever.  From a contrarian perspective, it is always best to buy cheap and out of favor assets early.  Then one can sell them later at fantastic premiums to the following throngs trying to get in later.  From a pure valuation perspective, the case that gold is currently massively undervalued is virtually unassailable.  The ancient secret to stellar returns, buying cheap and selling dear, is still possible with gold.


Although gold is undervalued, it makes no sense to speculate or invest in it if supply and demand fundamentals point to further price declines.  Global gold supply, demand, and inventory levels are critically important for attempting to divine the near future price direction of the yellow metal.


From a supply and demand perspective, fresh gold mined each year has grown relatively slowly over the past fifteen years.  Several different private organizations publish global gold supply and demand data, and the amount of gold mined in the world that they report this year is likely to be in the 2,800 ton range.  2,800 tons is a LOT of gold!  At current market prices, this represents around $25b worth of the yellow metal.  Mined supplies are heavily augmented by the dishoarding of central bank gold.  Global central banks have been liquidating steadily increasing amounts of gold since 1995, and that gold is sold on the physical gold market, increasing supply on the bleeding edge where real world supply meets real world demand.  As everyone who has taken Economic 101 is well aware, supply and demand determine price.  If supply is lower than demand, the price of an asset rises.  If demand is lower than supply, the price of an asset falls.  Although the amount of gold mined each year is large, gold demand dwarfs newly mined and refined supply.  Global gold demand has been fantastically strong in recent years, and is growing stronger all the time.  Total gold demand this year is likely to exceed 5,000 tons, and could even double global mined supply.  With the gold price so undervalued historically, gold demand is very high, as people around the world rapidly snatch up the metal with its price so low.  With freshly mined supply vastly lower than current demand, the supply and demand picture is very bullish for the future price of gold.


With very high global demand, and relatively low supply, why has the price of gold languished in recent years?  Other supplies of gold have filled the demand gap, meeting demand at the current price level.  Official sector gold selling, scrap gold, gold loans, and forward sales have so far collectively provided adequate supply to meet the burgeoning demand.  How long can this artificially augmented stream of gold to the market last?  This is a very important fundamental question that leads us to global gold inventories.  Virtually all the gold mined in the history of the world still exists.  A few modern applications for gold are destructive, including certain electronics and space vehicles, but 99%+ of the gold ever mined is still around.  Amazingly, it would fit into a small cube a little over 60 feet on a side!  Total global gold inventories are very large, representing the equivalent of decades of modern production of the yellow metal.  The critical issue for gold investors is trying to discern what percentage of the global gold inventory is likely to be sold onto the world market while prices remain anomalously low.  The largest culprits for dumping gold on the market to keep the price low are a few western governments.  The gold price is the ultimate check on fiat currency.  If gold rises in price, fiat (paper, unbacked, created by government decree) currency decreases in value.  With most governments growing money supplies at historically unprecedented rates (now more than 8% to 10%) annually, there is a huge incentive to sell gold into the market to lower the gold price so gold is unable to perform its traditional role of providing an early warning sign for increasing monetary inflation.  Very encouragingly, government gold inventories are dwindling, as smaller and smaller central banks are bullied into selling their entire gold supplies to keep up with global gold demand.  Also, as public sellers sell gold, strong private hands are buying it, folks who are unlikely to part with their gold unless at a very high price (or not at all, as many want to keep the gold indefinitely).  Even some governments have grown weary of gold selling and leasing, as evidenced by the Washington Agreement last year.  Some trading day, there will not be enough physical gold for sale to meet demand, and the gold price will begin rising to establish an equilibrium.  Since inventory numbers are so sketchy in the secretive and incestuous gold market, the exact day of reckoning is unpredictable, but more and more signs are pointing to it occurring in the near future.  As an added bonus on the demand side, gold shorts must be considered.  It is estimated that, worldwide, organizations collectively owe 5,000 to 12,000+ tons of physical gold.  This is the equivalent of 2 to 5 years TOTAL mined production.  When the shorts start buying the gold they owe back in the open market, demand will go through the roof for the metal, and it could happen VERY rapidly if the mother of all short squeezes is initiated…  For a much more in depth discussion of global gold supply and demand fundamentals, please take a look at some past essays we have written on the topic, Gold Shorts DOOMED Part 1 and Part 2


From a supply and demand fundamental perspective, gold is in great demand, yet relatively lesser and lesser fresh supply is created each year.  This is a fantastically bullish omen, as the price of gold will be forced to rise as the available for sale non-mined supplies of the yellow metal dwindle in the near future.  Extremely undervalued, demand greatly exceeding new supply…  the first two criterion of examining a potential investment are very favorably exceeded by gold.  The final factor we will briefly examine is exogenous factors and their potential effect on gold prices…


It can be potentially lethal to make linear assumptions in a non-linear world.  As humans, we all tend to make the assumption that tomorrow will be just like today, that the status quo is sacred, and that there will be no major discontinuities.  For a speculator or investor, this assumption is false and can soon prove fatal.  Investors should always perform a virtual stress test of their portfolio, examining what would happen to it if different highly disruptive exogenous events occurred.  Amazingly, virtually all the exogenous events that can be conceived will have positive effects on gold.  What if the overvalued US equity markets implode?  Gold is traditionally a safe haven that investors flee to in times of financial crisis.  Any violent disruption of the US equity markets for more than a few days is likely to greatly increase gold demand and rapidly drive up the price of gold.  What if the US dollar drops from its lofty perch?  Gold would SOAR if the dollar dropped, as it has soared in the terms of other currencies as they fell.  Gold is the only asset that maintains its value for millennia, through all different governments and currencies.  A drop in the dollar would yield commensurate gains in the price of gold.  What if oil prices continue to rise?  No problem for gold.  Higher energy prices are highly correlated with gold, and gold thrives in energy crisis conditions.  What if there is a war in the Middle East, or China invades Taiwan, or India and Pakistan start lobbing tactical nukes at each other?  In any case of international strife, gold demand tends to increase dramatically.  The gold price would ascend rapidly in these scenarios, if history repeats itself.  (and it always does!)


Are there any exogenous events that could hurt the price of gold?  The primary possibility is political mucking around with the gold price.  We have seen a LOT of that in the last five years, though, and frantic announcements of central bank selling happen all the time.  They have lost their shock value and effectiveness.  Governments all throughout history have fought gold, and every single one has lost.  The global free market is vastly more powerful than any group of governments.  Gold is held in very high esteem by virtually every culture in the world, and it is bought and sold in back alleys in every major and minor city on the planet.  Gold is the ONLY substance instantly and universally recognized to have enduring value, and it has always been the metal of kings.  If an asteroid slammed into earth and wiped out 99% of human life, the gold price would probably plummet!  Out of the conceivable array of real-world events with any probability of happening, however, the vast majority of these events would be incredibly positive for the languishing gold price.


We have briefly examined gold valuation, gold supply and demand fundamentals, and potential exogenous events that could affect the gold price.  All three critical areas are very positive for gold.  Gold is undervalued, demand greatly exceeds fresh supply, and large discontinuities have an overwhelming preponderance of having large positive affects on the gold price.


The bottom line?  The road for gold investors has been long and parched in the last five years.  They have wandered through a seemingly endless desert, occasionally tempted by what proves to be an illusory mirage.  Many have fallen beside the sun-cracked path, their white bones picked clean by buzzards and gleaming in the sun.  Nevertheless, a brave contrarian core continues to march forward.  They have studied history, currency, gold, investments, economics, and finance.  They understand the timeless value of gold, the cyclical nature of the markets, and the vagaries of human psychology.  They realize it is darkest before the dawn, and the journey most difficult right before the homestretch is reached.  Gold is in an INCREDIBLE position, and it will have its day.  Nothing goes up in price forever, and nothing goes down in price forever.  Investments are cyclical.  Gold is NOT dead, it is simply biding its time, waiting for its next earth-shattering mega-rally.  The spoils that go to the few remaining gold investors when that day inevitably arrives will be fantastic.  The stunning victory will quickly blot out the painful memories of the long struggle…


Keep the faith, fellow gold investors.  Our day draws nigh!


“Gold has worked down from Alexander’s time … When something holds good for two thousand years I do not believe it can be so because of prejudice or mistaken theory.”  -  Bernard M. Baruch (1870 - 1965), famous speculator, financier, statesman, and advisor to several United States Presidents


Adam Hamilton, CPA     October 20, 2000