The Gold Valuation Puzzle

Last Updated Jan 10, 2011 10:50 AM EST

Gold is trading at a little under $1400 per ounce, having sold off a bit in the past few days. I don't really think about gold that much, as an investment or as jewelry, but because a lot of people do, I try to stay informed. This note is just a quick alert to an excellent, if not entirely conclusive, analysis of today's gold valuation, from the FTfm section of the Financial Times.

Click to enlarge Source: Financial Times

The source of this decoding is Edward Chancellor, who is an investment manager at a Boston firm called GMO, in my view one of the smartest organizations on the planet when it comes to making sense of the current markets, and divining medium to long-term trends.

If you're a goldie, you'll click through and read his piece, if not, here are the highlights.

You can't rigorously value gold as you can other investments, because it earns no income. Its price is more a reflection of the world's confidence, or lack of confidence, in what is going on in the global financial system. ("Inflation coming? Buy gold. Deflation coming? Buy gold." That sort of thing.)

Still, people make forecasts:

Wall Street is extrapolating recent price appreciation into the distant future. Goldman has a target $1,690 an ounce for 2011, some 20 per cent above the current price. HSBC forecasts gold will rise by 8 per cent annually for the rest of the decade and recommends a 15 per cent investment allocation to the precious metal.
Chancellor compares gold to other commodities and assets. According to traditional measures, gold is overvalued against bread, according to the ancient Babylonians, whose rules suggest $850 an ounce.

Gold is more in line with other commodities:

Since 1900, an ounce of gold has on average purchased 50 times its weight in silver. After last year's run-up of silver, this ratio has fallen to 47 times. The price of gold in terms of oil has also been pretty constant. Since 1900, an ounce of gold has purchased on average 13.4 barrels of oil. Today, the same ounce buys 15.5 barrels.
Gold is also far, far above its long-term average inflation-adjusted price of $440 -- 2.5 standard deviations, for the statistics enthusiasts. And here's Chancellor's punch line, which I endorse:
The bulls hope that in real terms gold can regain its 1980 bubble peak, which would provide an upside of more than 70 per cent. But the average of our crude valuation metrics suggests a fair value for gold of less than $1,000 an ounce, about a third below the current price.
This is not to say gold will not rise over the coming year or that there is no need to hedge inflation risks. Rather that prudent investors should look to other, less meretricious, assets to protect the purchasing power of their savings.