Gold-related investments comprise just one area of the markets that we invest in, but the topic of gold prompts a lot of questions (especially since our exposure to the gold mining sector has been a major contributor to our recent market-lagging investment performance). So we recently sent our clients an in-depth review of the fundamental case for gold and gold mining stocks.
Part I, below, reviews what drives the gold price (it's not what most people think) and advances the case for higher gold prices in the years to come. Part II examines valuations of gold mining equities, which we find to be extremely undervalued and poised for potentially dramatic gains ahead.
What Drives the Gold PriceThe investment case for gold is widely misunderstood. Gold is not simply an "inflation hedge" -- sometimes it serves that purpose, under certain conditions, but sometimes it does not. It's not just a commodity driven by industrial or jewelry demand -- the great majority of gold is held for investment purposes. And it's not "disaster insurance" -- there is little relationship to be found between the gold price and "disasters." These common explanations of gold's function are incomplete at best and outright wrong at worst.
The best way to truly understand what drives the gold price is to think of gold as an alternate form of money. We live in a pure paper money system in which dollars can be, and regularly are, created in huge quantities at the touch of a button. Gold is primarily an alternative store of value to the paper money that emanates from this system.
It follows that the fundamental driver of the gold price is confidence, or lack thereof, in the paper money system.
The more confidence people have in our monetary system, the central bankers that run it, and the currency at its center -- the US dollar -- the less they feel the need for an alternative. Conversely, the less confidence people have in our monetary system, the more we should expect demand for gold (the most recognized alternate form of money throughout history and across the world) to rise. And, because gold supply changes very slowly over time, the more we should expect the gold price to rise along with demand.
So the most important question when assessing the gold price is this: are people going to become more or less confident in the paper money system?
Monetary Confidence: Headed SouthWe believe quite firmly that a tremendous amount of confidence in our monetary system will be lost in the years ahead. We base this forecast primarily on the four following premises:
1. Too much money has been created
Ever since the economy started to weaken, the Federal Reserve has been engaged in extremely loose monetary policy, including dramatic amounts of "quantitative easing" (a technocratic euphemism for creating new money). As a result, the amount of money in the economy has grown explosively. Based on what we believe to be the most meaningful measure of money in circulation, the TMS money supply aggregate1, the US money supply has surged by over 60% just since the beginning of 2008.
All other things being equal, when new money is put into circulation, it renders all the money in existence slightly less valuable. This is just math. When there are more dollars chasing the same amount of "stuff" ("stuff" here referring to anything that can be bought with dollars), prices must rise.
It's true that all other things aren't precisely equal. The supply of "stuff" does grow over time -- but typically only by a few percent per year, a rate that pales in comparison to recent monetary growth. And at times (especially uncertain economic times), people are less inclined to spend their dollars and more inclined to hang onto them. That is certainly happening now, and helping to blunt the effects of the increased money supply for the time being.
But such inclinations come and go. As the crisis mentality fades, or as people tire of being punished for holding onto cash (see #4 below), the increased tendency to hang onto cash will likely fade. And as we will discuss in item #2, this change is likely to take place over a backdrop of even more money creation.
While there may be long and unpredictable lags between cause and effect, both history and monetary theory support the idea that the recent frenzy of money-printing will cause a significant decline in the purchasing power of -- and confidence in -- our currency at some point down the road.
2. There is a lot more money still to be created
Money supply growth shows little sign of letting up, having recently clocked in at a 15% annual growth rate. We suspect this elevated pace of money creation will continue for some time to come.
The leaders of the Federal Reserve have made it clear that they stand ready to engage in more quantitative easing/money printing should economic growth falter or the stock market take a turn for the worse. Both of these outcomes are possible, if not probable, given the fragile state of the economy and the level of stock market valuations. We can't know when it will happen, but at some point in the future, we are sure to hit a rough patch. The Fed stands ready to fire up the printing presses again when that happens.
In the meantime, as economic growth and optimism improve, there's always the chance that a portion of excess bank reserves (which have grown massively as a result of the Fed's quantitative easing operations) will get lent into the economy and drive up the amount of money in circulation.
So whatever money is out there now, odds are that there is plenty more to come. And that's if we don't run into serious debt trouble.
We have previously explained why we believe that the US is very likely to experience its own debt crisis. Should this happen, our public debt and deficit will need to be brought under control quickly. Out of the potential actions that politicians can take to achieve this -- cut spending, raise taxes, refuse to pay the debt, or print money -- it's very clear to us that the latter, printing money, is by far the most politically expedient. It is already happening, after all, and the debt crisis has not even begun yet! We don't pretend to know exactly what combination of approaches will be taken to get our debt load under control, but we are highly confident that the creation of new money will play a very big part.
Far from being near any "exit strategy" in which the Fed either tightens policy or removes the excess money it has created, we believe that there is a lot -- potentially, an enormous amount -- of new money printing to come. This excessive monetary creation should result in a decrease in the value of and confidence in the dollar. This is especially so if, as we believe will happen, the printing takes place in an environment of higher inflation and a dollar-denominated debt crisis rather than a deflation scare, as was the case in quantitative easings thus far.
3. A debt crisis would not be good for confidence
There will be more problems than just money printing should a debt reckoning take place in the US. A flight out of US Treasuries would be a flight out of US dollar-denominated assets, and just as the global appetite for Treasuries has propped up the dollar over the years, a dishoarding of Treasuries would cause the dollar to weaken and inflation to rise. More generally, an outright sovereign debt crisis in the US would severely damage the "safe haven" reputation of Treasuries and the dollar. Both these factors would undermine confidence in the future purchasing power of the dollar and in the monetary system that allowed our debt to get so out of control in the first place.
4. Interest rates are, and will remain, well below the rate of inflation
The "real" (inflation-adjusted) Federal funds rate is negative, i.e., it is below the rate of inflation:
This means that your purchasing power is eroded simply by putting money in the bank. It costs money just to hold the currency. That is most certainly negative for confidence in the dollar over the long haul. Based on the Fed's promise to keep rates low at least through late 2014, we can anticipate that negative real rates will continue to chip away at this confidence for years to come.
Valuing GoldPutting all four of these factors together, we anticipate a potentially severe loss of confidence in our currency and our overall monetary system in the years ahead. So, the fundamentals for gold are exceedingly positive.
However, this still leaves an important question: could those fundamentals already be "priced in" to gold?
There are several reasons to believe that they are not.
1. Gold is undervalued based on current money supply, and dramatically undervalued based on near-future money supply
We evaluated the historical relationship between gold prices and the supply of money in circulation (again using the TMS aggregate1) to estimate a fair value for gold -- an expected "exchange rate" of sorts between gold and the US dollar. Of course, the reality is that the gold price fluctuates dramatically around this fair value estimate based on changing confidence in the monetary system and the dollar. But we think it's very useful to arrive at that fair value in order to determine whether a future change in confidence is already being priced in.
Our finding was that despite its price increase to date, gold is actually slightly below the fair value we would expect based on the amount of money in circulation. Given that this fair value estimate assumes a "typical" level of confidence in the monetary system, we can infer that virtually no future deterioration of monetary confidence is currently priced in to gold.
Importantly, that analysis is based on the present money supply. If we factor in the likely scale of future money creation that we detailed in the previous section, gold becomes dramatically undervalued at current prices.
2. Real interest rates are supportive of further gold price increases
Below we've combined the above chart of the real Fed funds rate with a chart of the gold price since 1971, when the US left the gold standard:
We've broken this history into three periods -- the two shaded regions on the ends in which rates were typically negative, and the unshaded region in the middle in which rates were typically positive. There is a very clear pattern: the gold price tended to fall (or, at best, languish) during the positive real rate period, but to rise during the negative real rate periods.
This makes sense: as people grew tired of losing purchasing power just for the privilege of holding dollars, they tended to seek out an alternate store of value. Thus, negative real interest rates have historically been supportive of the gold price.
Note that real rates are very near the lowest they've been for this whole period, and, as mentioned above, the Fed has promised to keep rates extraordinarily low until at least late 2014. Assuming the historical relationship between real rates and gold prices remains intact, the interest rate backdrop will be very supportive of the gold price in the years ahead.
Since we are primarily concerned with the dollar-denominated gold price, we have focused on US-based data in this article. It is worth noting, however, that steeply negative real interest rates, rapid money creation, and excessive government debt can be found throughout the world these days. Thus, the same underpinnings we expect to support US-based demand for gold will likely strengthen demand from many other countries as well.
(As an aside, these charts do a good job of debunking the common explanations of what drives the gold price. There was plenty of inflation between 1980 and 2002, as well as many crises and disasters, but gold went nowhere. Conversely, gold has risen steadily over the past decade even at times when the economy was doing fine or inflation was subdued. Gold's price changes over this history only make sense when viewed through the lens of waxing and waning confidence in the monetary system.)
3. No sign of collapsing monetary confidence can be found in other markets
Another indicator that the likely decline in monetary confidence is not yet priced into gold comes from other markets. The 5-year Treasury yields .8% and the 10-year Treasury just 1.9%. This means that the government can borrow for 10 years at less than 2% per year (CPI inflation most recently rose at 2.7% annually). Admittedly, the Fed and other central banks have provided a lot of the demand for Treasuries recently. But they aren't the only ones buying Treasuries, and US investors have been pouring money into bonds in general over the past several years.
Other markets appear equally unperturbed. The dollar index is up more than 7% over the past year, and the US stock market is on a tear despite being significantly overvalued based on normalized earnings. These are hardly signs of collapsing confidence in our monetary system. These markets indicate a distinct lack of concern about either the future purchasing power of the US dollar or the prospect that the US debt situation will pose a problem in the future.
4. Investor behavior indicates complacency about the dollar
Finally, we can observe investor behavior -- more subjective, to be sure, but important nonetheless. Skepticism about gold is absolutely rampant. Everywhere we turn, there is someone pounding the table about an alleged bubble in gold, despite its distinctly un-bubble-like price behavior:
Not surprisingly, we have yet to encounter a gold bubble-caller who is able to correctly articulate the fundamental underpinnings that actually determine the gold price. (We also can't help but notice that most of these same people were completely oblivious to the dot-com and housing bubbles, but never mind that).
Many investors give lip service to the potential for rising prices, but it seems to us that few have taken serious steps to protect themselves. People are generally quite complacent about their dollar-denominated assets (or their plain old dollars), and for all the talk about gold, it still seems to be "underowned."
A brief story illustrates this last point: a while back, John attended a conference of investment advisors. At one point, he asked the 150 or so attendees how many owned gold-related investments for their clients. Sixteen hands went up. That's fewer than 11% of advisors who owned any gold-related investments for their clients. John then asked how many advisors allocated 10% or more of their clients' assets to gold. In a room full of 150 people, 3 hands went up. One of them was John's.
All in all, we find the evidence quite compelling that gold's fundamentals are very good, that they are set to get dramatically better, and that this scenario is far from being "baked in" to the gold price. We believe that gold is an excellent value, as well as a crucial investment to protect against the risks to our monetary system that very likely lie ahead.
See Gold Revisited, Part II: Tremendous Potential in Gold Mining Stocks
1 We favor the "TMS" monetary aggregate, first developed by Rothbard and Salerno, as a measure of money in circulation because it includes all "money" and "money substitutes" available to be spent immediately, but excludes "credit claims." This distinction is very important and is explained quite well in this excellent article by Michael Pollaro at Forbes. Please note that we are not referring to the monetary base, much of which is sitting idle in bank reserves, but to money actually available to be spent in the economy. For what it's worth, the monetary base (which can be thought of as money that can potentially make its way into the economy) has grown far faster than money in circulation, more than tripling since the beginning of 2008.