Is gold price low or high?

In natural science, behaviour in nature can be measured and analysed with precision. In this way, physical laws can be determined and precise assessments and predictions can be based on them. There can be no such constancy in the field of economics, however, since circumstances are constantly changing. A given economy is the result of a number of processes.

The value of a good or a service is not an objectively measurable quantity, but rather the result of a subjective evaluation. The value of a good is therefore always subjective.

A classic example: a glass of water is probably the most valuable commodity in the world to someone who has just spent a long, dry spell in the desert, but once their thirst is quenched, its so-called marginal utility quickly decreases and the hundredth glass of water is hardly worth anything. It is precisely this last glass that determines the value. It follows that the objective calculation of a “fair value” of each good, including gold, is impossible.

Gold compared with the real interest rate

Nevertheless, there are some interesting comparisons to determine whether gold is relatively expensive or cheap in a historical context compared with other investments. The initial consideration is that in the long term a return to the mean value of the relative performance of two investments can be expected and extreme relative valuations can be used as an indication of over- or undervaluation.

One of the most important factors influencing the gold price is the real interest rate level and its trend. The real interest rate is the interest rate that can be obtained on an investment after deducting the loss of purchasing power (= inflation). So, you should compare the (non-interest-bearing) gold investment with a fixed-interest investment. If the inflation rate is higher than the interest rate on the investment, it is referred to as a negative real interest rate. As a rule of thumb, low or falling real interest rates tend to have a positive effect on the gold price, whereas high or rising real interest rates mean a negative environment for gold. This is because real interest rates represent the opportunity cost of investing in gold. This thesis can also be proved empirically. During the 20-year gold bear market of the 1980s and 1990s, real interest rates averaged 4 per cent. Investing in fixed-interest investments resulted in yields well above the inflation rate. Real interest rates were only in negative territory in around 6 per cent of all months. This was in stark contrast to the situation in the 1970s, when the real interest rate was negative in 54 per cent of all months.

Real interest rates have been falling since 2000 and have been negative for quite some time, which means a favourable environment for gold. And right now, almost everything indicates that real interest rates will remain negative for the time being.

Gold versus stocks

A comparison with productive assets such as stocks and shares is sometimes also interesting for gold investors. The ratio between the Dow Jones Index and gold expresses how many ounces of gold it takes to buy one share of the Dow Jones Industrial Index. With a current (05/2021) Dow Jones index level of currently almost 35,000 and a gold price per ounce of USD 1,900, the ratio is 18.4. This means that 18.4 ounces of gold are needed to buy one unit of the Dow Jones Index, which includes 30 large publicly traded companies.

Historically, the Dow Jones Index was undervalued whenever the ratio fell below 5. This was last the case in the wake of the crash of October 1987, when the ratio dropped to around 3.5. Subsequently, the Dow Jones index and the gold price developed in a diametrically opposed manner: the gold market continued its long-term bear market in the years that followed, while the Dow Jones rose rapidly. The ratio reached an all-time high of over 40 in August 1999.

In the last century, the ratio dropped to as low as 1 twice as a result of extreme downturns in the financial markets. This was most recently the case at the end of the stagflationary 1970s, when the Dow Jones was trading at around 900 points and an ounce of gold cost USD 850. And after the great stock market crash of 1929, there was parity between gold and the Dow Jones Index.

Since the collapse of the Bretton Woods Agreement in 1971, the average has been 13.7, which is below the current level. This means that gold is currently undervalued compared with stocks and shares– and that stocks and shares are overvalued by historical standards.

The comparison of gold with fixed income investments and stocks can help provide a rough idea of how gold is valued relative to other types of asset. However, an investor who is interested in a gold investment should bear in mind that gold is particularly suitable as a long-term investment and should therefore not be valued and traded speculatively in the short term.

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Source: muenzeoesterreich.at