I am basically coming to the conclusion that the price of gold has been outstripping the fall in the purchasing power of the USD for a while now. The main explanation for this is simply that gold traders are building in a premium into gold prices based on future erosion of the USD as a possible outcome of QE and global major central bank monetary easing i.e. expected inflation. Currently inflation is expected to rise. This has not happened, and interest rates will remain low for at least two years if not longer. Consequently there is no real reason for gold to trade relatively high – until inflation is confirmed which may take several years. In the meantime, gold will either stay range-bound at best, or could drop much further. My question is how far could you see gold falling in this "overvalued" context, and how long could it then take before gold prices break out decisively?
The best way to answer this may be with the chart we published in our essay on gold and the U.S. dollar, which was the second part of our two-part story on gold and the dollar collapse. Please look at the chart from this essay and what we wrote then.
The yellow line represents the price of a troy ounce of gold between 1980 and 2012. The solid red line is the price of gold during the 1980 top ($850) corrected for the official U.S. inflation numbers and the dashed red line is the same price corrected for inflation numbers as they would have been calculated prior to a change in the methodology of inflation calculation (this change actually coincides with the 1980 top). In other words, the solid red line shows you how expensive gold would have to be to buy you the same things it bought in 1980 if you followed official data. The dashed line shows you how expensive gold would have to be if you took into account unofficial data.
As of the end of November 2012, according to official U.S. Bureau of Labor Statistics, gold would have had to trade at $2,527.24 to match the 1980 top. It traded at $1,719.00, which could imply that if the top were to be seen in the nearest future (very unlikely), gold could shoot up by 47.0%.
Taking a look at the unofficial data, gold would have to appreciate to $9,548.34 to be able to buy you the same amount of goods it did in 1980. Compared to the price of $1,719.00 (end of November 2012), this would mean an appreciation of 455.5% (!). The target of $10,000 without the collapse of the dollar seems far-fetched, but even if the unofficial numbers exaggerate the inflation, and the latter has been so far somewhere between the official and unofficial numbers, this would mean a possible price for gold beyond $2,500.
Long story short: if gold were to match the price from the 1980 top in real terms today (using the official inflation numbers), it would have to trade at more than $2,500. So, based on inflation, we don’t see a strong case for gold to go lower. In fact, if there is any case, it is for gold to go up. Please note that the long-term trend for gold is up.
As for measuring the price of gold in terms of monetary aggregates: please note that the mere fact that there is more and more of the US dollar circulating in the economy does not mean that that money will ever be redeemed in gold. That could be the case, but it doesn't have to. To refer to your $1,530-$1,800 target price for gold we would have to know your methodology and assumptions. However, we have done research on the possible price of gold in terms of U.S. debt under the assumption that some kind of gold standard similar to the Bretton Woods agreement would be reinstated. You can find these results in the first part of our article on gold and the dollar collapse. In short, if our assumptions were met, gold could go up to the level of $6,200.
Obviously, the $2,500-$6,200 (or even $10,000) range is just an indication that, looking at gold from two different angles (the dollar collapsing and not) yields the same result: that the fundamentals for the yellow metal are still in place.
The collapse of the dollar is no sure bet. For instance, currencies could be inflated at the same time so they would decline in value and inflation would soar, but the currency exchange rates wouldn't be severely impacted. Consequently, we don't think that this is really discounted in the price of gold. Another point here is that, in practice, inflation expectations are very much adaptive. The factor that determines future inflation expectations the most is the current inflation level. In times of low inflation most of the market players don’t expect inflation to rise. In times of high inflation, average expectations are high as well. Taking that into account suggests that, in fact, possible future inflation has not yet been discounted in the price of gold. So, our idea is instead that if inflation rises in the future, it could only be discounted in the price of gold around the time inflation takes off (and – let's face it – the vast majority of investors use the official inflation numbers). Consequently, gold could go higher.
As always, there might be some indications as to what might happen if the U.S. economy finds itself in much more trouble than what we've seen so far. We would focus on two broad scenarios:
- Stock indices plummet but investors are still confident that the U.S. will manage to deal with its problems.
- The same as above but the investors ditch bonds and “run for it.”
The first case could be in fact similar to what we saw in 2008 but on a larger scale. Investors could be selling off “everything” just to switch to U.S. bonds. Gold could correct significantly in the short-term but rebound and shoot up in the long-term.
The second case would see investors storming to buy Swiss francs and gold. In this scenario, there needn't be any significant decline in the price of gold. Conversely, gold could strongly appreciate even in the short-term.
In either case, gold could be a great long-term investment. If it declined initially, this could be an extraordinary buying opportunity. If it didn't, there could be significant short-term gains.
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