2007 Gold Valuation Over PaperMONEYIZATION, PART 35
by Ned W. Schmidt, CFA, CEBS
Schmidt Management Company
January 9, 2007
Moneyization: The global financial phenomenon of individuals and businesses moving their funds to monies in which they have the highest confidence, or money which has a higher store of faith.
Gold again served investors well in the previous year. As the first chart show, $Gold has for the second year in a row provided a return superior to U.S. paper equities. Results for 2006 extend the excellent record of performance being built by $Gold, and the best is yet to come. For five of the past seven years and six of the last ten, $Gold has outperformed U.S. paper equities. Guess that is what they mean by a “real” return. One would think that the paper asset groupies would soon be embarrassed talking in public and in the media about paper assets, given their inferior returns.
First Chart
Since the year 2000 investors have generally preferred to move their money to Gold, an asset in which they have a higher faith. Denominating one’s wealth in Gold rather than national monies has provided a greater protection and a higher return for wealth. This phenomenon of money moving to Gold as a haven is the moneyization process, about which we write on a regular basis.
Another interesting piece of information in the first chart relates to the variability of returns. U.S. paper equities had both the greatest positive and greatest negative return in the ten-year period shown. The statistical measure for total risk is the standard deviation of returns. Over this last ten-year period, the standard deviation of returns for U.S. paper equities was almost 50% larger than the returns on $Gold. What this means is that over the past ten years U.S. paper equities have been riskier than $Gold. Did we miss the gurus on CNBC mentioning that little matter?
Second Chart
Another interesting fact from that first chart is that three of the exciting years for U.S. paper equity returns happened 8, 9, and 10 years ago. To track these disappearing returns, we have created the second chart. In that chart the returns on $Gold and U.S. paper equities have been indexed to a $1.00 value at the end of 1996. As those good years are being dropped from the ten-year history, the lines have been moving together. When these lines switch positions, with $Gold having the superior return, will CNBC, the WSJ, and other business media report such a picture? Doubt it.
We now know that $Gold has been providing the superior return for some time. That noted, the future is what is important to investors. Will $Gold provide a meaningful return in the years to come? That question is the all important one. The odds favor a positive answer to this question, with $Gold continuing to provide a return greater than U.S. paper equities.
Future returns are generally built on valuation and fundamental factors. Valuation is the starting point. However, a note of caution on valuation. An asset can be under valued on price for some time. Under valuation in terms of price means that price has the potential to rise. Over valuation in terms of price means that price has the potential to fall. Valuation does not make an asset rise or fall in price, but rather is a precondition for that rise or fall. In other words, an asset undervalued on the basis of price has the potential to rise in price more than an asset that is over priced.
The impact of fundamentals is magnified, in a positive or negative manner, by the valuation in terms of price of an asset. What this means is that we want to buy an under valued asset where the fundamentals are favorable for the undervaluation of price to be corrected. Conversely, we would want to sell an over priced asset where the fundamentals are unfavorable. Generally speaking, the fundamentals of under valued assets are being ignored, or they would not be under valued.
Third Chart
The third chart will help us sort out the valuation question as it applies to Gold. Gold is the contra asset to paper debt and equities. In that chart is graphed the ratio of the price of $Gold to the S&P 500. When the ratio is falling, paper equities are performing better than $Gold. When the ratio is rising, $Gold is performing better than paper equities. When the ratio is at an extreme high, $Gold is over valued relative to paper equities. When the ratio is at extreme low, $Gold is under valued relative to paper equities. Note that $Gold continues near the lows, and is therefore undervalued relative to U.S. paper equities.
Also plotted in that chart is solid line which is the average value of the ratio for the sixty-one years shown in the graph. That average can then be used to assess the relative valuations of $Gold and U.S. paper equities. That is done in the following table.
IF
THEN
FOR RETURN OF
Gold =
605
S&P 500 Should =
511
-64%
S&P 500 =
1410
Gold Should =
1670
176%
Let us make sure we understand the table. If Gold is equal to $605, then based on the average ratio of the past 61 years then the S&P 500 should be 511 for a return of negative 64 percent. If the S&P 500 is equal to 1410 then $Gold should be at $1,670 for a positive return of 176%. Reality will be somewhere between these values. What the relative valuation tells us is the $Gold has far more potential to rise than U.S. paper equities. U.S. paper equities have the potential to fall far more than $Gold.
Where investors should place their money is easy to conclude on the basis of valuation. Investors have in fact been moving to Gold, as witnessed by the near ten billion dollars invested in one Gold ETF alone. Valuation has been the precondition which has allowed $Gold to provide a higher return for the past few years. Thus, investors begin 2007 with the valuation of $Gold at an extremely attractive level, both in absolute terms and relative to U.S. paper equities.
As mentioned above, under valuation is only a necessary precondition. The fundamentals need to be moving favorably for Gold for that under valuation to be ultimately translated into over valuation. For the price of $Gold to reach its ultimate potential what is needed are positive fundamentals. As we look around again this year the fundamentals remain in place, and have gotten stronger.
Essentially, the favorable fundamentals continue to be the many discussed here and in other articles on Gold. They include the following:
- U.S. trade deficit continues at a high level
- U.S. government deficit
- U.S. economy being financed by foreign investors
- U.S. dollar over owned by global investors
- Gold under owned by global investors
- Federal Reserve has failed to acknowledge the potential problems of the dollar
- U.S. economy has been built on asset appreciation, stocks and homes
- Housing/Mortgage Bubble in U.S. unraveling
- U.S. economy likely to enter a recession early in 2007
- and the list goes on
Investors, therefore, face a really rather easy choice. $Gold continues undervalued by a considerable margin. U.S. paper equities, and likely most paper equities, are over valued. That under valuation of $Gold sets the stage for investor opportunity. The strategic framework, or the fundamental factors, continue to support the view that the under valuation in $Gold will be corrected. The remaining consideration is the tactical one. Is the current price of $Gold at a level that should spur investors to buy it?
In the past week the Gold market again witnessed selling by the funds. That selling began the correction of the over bought condition that had existed, as shown in the last chart of $Gold. This lower price will continue to move the Gold market toward an over sold condition. Pessimism has already started to build, with analysts now racing to have the lowest forecast for the bottom of the correction. Regardless of the lowest price in the week ahead investors should be starting to add to positions in Gold. The potential opportunity cost from not buying Gold at this week’s prices far exceeds any gain from a few dollars lower on the buy. The Gold Super Cycle to $1,400, or so, is the more important target, not whether $Gold trades below $600.
Fourth Chart
$Gold Source: Value View Gold Report
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