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In the absence of cashflow,
judging gold's present "fair value" means analysing it like an
insurance actuary would...
WITH ITS
incredibly constant supply and unsurpassed history as a store of value,
physical gold is the wise choice for retained wealth during currency crises. But
for new buyers, is today's price too high?
From post-war
Austria to Argentina a decade ago, it is clear that holding gold offers
insurance against many levels of currency crisis – something which a
growing number of economic historians, such as Reinhard and Rogoff and Niall Ferguson, thinks increasingly possible in
the developed West today.
Across long periods
of history, from imperial Rome through to Elizabethan London and late 20th
century America, the value of gold in terms of the goods and services that it
can buy has remained remarkably stable. It is commonly noted that one ounce
of gold could buy a good suit of clothes in each of those periods, a base value to which, over the
ultra long-term, it's likely to revert at some point in the future. Gold's
ability to defend wealth in periods of monetary crisis, whether strong
inflation or deflation, can give it a valuable premium above its long-term
base value. But today, this metric would mean gold is around 75% over-valued.
Is today's premium
– over and above gold's long-term base value – excessive? In the
absence of cash flow, we need to judge gold's present value in the way that
an insurance actuary would, pricing it in terms of risk-adjusted outcomes.
That, in turn, means estimating the likelihood of different degrees of currency
meltdown. Doing this, I find that it is hard to push gold's fair value down
to today's market-price of $1,400 per ounce without setting the probability
of a serious inflation or even hyperinflation to zero.
I'm much more
fearful of currency devaluation that the market is, in other words. But
discounting to zero the probability of an event not experienced in our
lifetimes is a classic mistake. Most recently, it caused the credit ratings
agencies to incorrectly estimate the risk of a mass sub-prime mortgage
default. In 1980, this same mistake caused the gold market to anticipate
strong annual inflation rates, just as we'd experienced throughout the 1970s.
Gold's then premium, over its base value, hit 240%. But the market hadn't
reckoned with the shock of strongly positive real interest rates which the
Volcker Fed – in the absence of large, structural government deficits
– could and was about to deliver.
Today, historical
inflation data shows that the risk of a serious
currency devaluation in the next 15 years is most certainly not zero. (Since
WWII, for instance, the Pound Sterling has lost between 80-90% of its
purchasing power in nearly 11% of those time frames.) The historical record
I've included in my Gold Value Calculator also includes the currency collapses of Weimar Germany,
post-war Austria, Peso-crisis Mexico and Argentina's bond default at the
start of this century. Because Western Europe, Japan and the United States
have now accrued a significant level of government debt, and I fear we are
entering the same state of political denial which led those countries to
lurch from crisis to crisis over the last 100 years. I think our future is
likely to look a bit like their past.
Though small, the
risk of severe inflation and currency devaluation is material at perhaps 0.5%
in the next 15 years. Also critical to the Gold Value Calculator is the discount rate used. Because it's not simply the
headline rate of inflation, but the real return on currency which counts. Is
your money on deposit losing purchasing power? Negative real rates of return
on currency are what drove gold higher in the 1970s, and again in the last
decade. Because why would you choose to store value in something which isn't
retaining its purchasing power, and has no short-term prospect of doing so,
when you can choose tightly supplied, indestructible gold instead?
Without today's
large public deficits, risk-free returns to cash did not need to be
suppressed below inflation at the start of the 1980s. Looking ahead today, in
contrast, the Federal Reserve, Bank of Japan, ECB and Bank of England appear
to have little choice.
Using the inputs we
just looked at, I calculate gold's risk-adjusted value to be above $3,800
today. That's significantly higher than the market price, and well above 2011 price forecasts from bullion bank analysts . My
present valuation seems outlandish, therefore, which is why you can download
and judge my Gold Value Calculator for yourself.
You can see the
formulae and decide if the method, inputs and valuation are reasonable. And
as the model shows, gold could of course go down substantially, as well as
up, depending on the outcome path for inflation and the rate of return you
can earn on cash savings.
Paul Tustain
Director and Founder
Bullionvault.com
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