The long term value of gold

13 September 2008

How do we make sense of the sudden strengthening of the US dollar and the drop in commodities and in particular gold prices? This article tries to give some logic as to how the long term price of gold is being derived. We will first look at the growth in money supply. How much money is being created out of thin air year after year? I am still amazed that some friends still think that Governments cannot create "fiat" money and that any money created have to be backed by gold. This was abandoned since the early 1970s and Central Banks have the power ot create money at will. So let us look at what some journalists say about this money suppy growth.

This was reported in the Economic Times on 12 Septembr 2008:
BEIJING: China's broad measure of money supply rose 16 per cent year-on-year at the end of August, level with the government's annual target, the central bank said on Friday. Here is an excerpt from the Press Release of the European Central Bank on 27 Feb 2008:The annual rate of growth of M3 stood at 11.5% in January 2008, compared with 11.6% in December 2007.

China has pegged its currency to the US dollar which means that as the US expands its money supply, China has to follow suit. The increase in China's money suppy gives us an indication of the US money supply as well as described in the article below:

Financial Senses University wrote on 28 Feb 2008:
In a story published in July, 2006 by the China Daily newspaper titled “Money supply growth unlikely to slow” we were told that, "the ballooning forex reserve is a major factor behind the dynamic growth of the money supply," by Li Yongsen, an economist at Renmin University of China. "The central bank has to release new money to mop up the excess US dollars in the marketplace and enforce a floating band for the renminbi, which is driving up money supply growth," he said. So we ask again. How can there be negligible money supply growth in the US and 2-3% inflation, when China, a country with a pegged currency to the $US, is experiencing money supply growth in the mid-teens and 6.5% inflation in December?The answer should be obvious.That is what the continued rise in the $US prices for precious metals and commodities is telling us."

FXStreet.com wrote on 31 July 2008:
SINGAPORE (Thomson Financial) - Singapore's broad money supply, or M3, rose 7.9 percent to S$325.08 billion ($239 billion) in June from a year ago, data from the Monetary Authority of Singapore showed on Thursday.
M2 edged up to S$315.70 billion from S$293.61 billion a year earlier.

Prices are dependent on two things. Supply and demand and the value of money. We have often think of prices only in terms of supply and demand. If demand exceeds supply, then the prices will go up. What we have often not looked at is the value of money. There is $X amount of money in the world available to buy $Y amount of assets whether it is gold, stocks, properties or bonds. Over time , on an average basis Y must equal to X. Of course there are different asset classes within Y which may move in the opposite directions but over the long run, when we look at prices over one or two decades, then Y generally follows X. Let us take gold as an example. There is the supply and demand issues. On the demand side gold is bought mainly as jewelry with some industrial uses but mainly it is kept by Central Banks and investors as a store of value. Due to its limited supply, gold tends to hold its value better.

As more and more money is being created, then the price of gold goes up , not because there is a great demand but because there is simply too much money chasing after too little gold. Now gold is not an interest bearing investment and so when stocks and properties are going up, few would want to hold gold. Still over ten to twenty years, gold will show its ability as a store of value. Let's look at how gold retain its value over the past ten and twenty years

In September 1998, gold was selling at US$300 per ounce. today it has dropped to US$763. That is an annual increase of 9.78%. However based on money supply growth ,here is what gold prices should be:
1.If it follows a 16% increase ( see quote on China),: US$1,323.
2. If it follows a 11.5% increase (EU) :US$890
3.If it follows a 20% increase ( my guess for USA): US$1,857

Based on money supply growth rates, gold should be valued from US$890 to US$1857.
Let us go back twenty years to 1988. Gold is priced at US$485. Based on today's price of US$763, that is an annual increase of a miserly 2.29%. Assume different average growth rates in the money supply will show that gold is indeed undervalued:
1. 5% growth in money supply, gold should be US$1,286
2. 7.5% growth in money supply, gold should be US$2,060
3. 10% growth in money supply, gold should be US$3,262.

The recent drop in the price of gold is due to a recent contraction in the money supply and other factors described below.
The Telegraph on 19 August 2008 wrote:
"The US money supply has experienced the sharpest contraction in modern history, heightening the risk of a Wall Street crunch and a severe economic slowdown in coming months.Data compiled by Lombard Street Research shows that the M3 ''broad money" aggregates fell by almost $50bn (£26.8bn) in July, the biggest one-month fall since modern records began in 1959. "

This $50billion is a drop in the bucket compared to the amount of funds available world wide for investments. The drop in commodities and equities is most probably caused by hedge funds liquidating their positions probably due to the credit crunch, the sudden contraction in money supply and a herd mindset. The hedge funds managers that want to bet on commodities going up may not be able to borrow to leverage their positions. The sudden contraction in money supply reduces the ability of fund managers to increase their leverage which means if a large investor shorts or sell, the other investors are less able to balance them out.

Wall Street Journal on 9 September 2008 wrote:
“Hedge funds have delivered their portfolios and become defensive, and are now sitting on a lot of cash,” says Mary Ann Bartels, chief U.S. market analyst at Merrill Lyncht Journal Macro-oriented hedge funds, those that invest across a number of sectors and asset classes, were hit particularly hard in August, a result of weakness in widely-held technology shares and resource stocks.

The $155 billion in cash is equivalent to about 8% of hedge fund assets, according to Ms. Bartels, a bullish signal, for hedge-fund managers do not tend to stay in cash for long. With seasonal factors soon turning in favor of stocks (the last three months of the year are generally among the strongest for equities), investors aren’t likely to remain on the sidelines for long. “They’re going to want to participate to boost their numbers,” Ms. Bartels says.

The Wall Street Journal Market Watch on 29 August 2008 wrote:
"Three unidentified U.S. banks held 86,398 short positions, or bets that gold prices will fall, in the COMEX gold market as of Aug. 5 -- 10 times more short positions than a month earlier, a government report showed.The report by the Commodity Futures Trading Commission, which regulates U.S. futures markets, also showed short positions held by three U.S. banks in silver futures had increased more than four times during the same period." The data in the bank participation report is so clear and compelling that it is hard to conclude anything but manipulation," said Theodore Butler, a precious metals analyst, in a note.

The sudden jump in short positions coincided with a slide in silver and gold prices, which fell $12.30 an ounce in July and another $89.20 in August, their biggest monthly loss since at least 1984, according to Factset. Silver has slumped more than $4 an ounce in August, also the biggest since 1984. As for the banks involved in the recent short selling of gold, they are only market makers, taking orders from large money players, such as hedge funds, said Jeffery Christian, founder of commodities research firm CPM Group. "What you have here is the footprints of hedge funds exiting the commodities markets en masse," said Kitco's Nadler.

Bullion Vault on 14 August 2008 wrote:
IN THE WEEK ENDING the 25th of July, a decrease of €578 million in "gold and gold receivables" – reported by the European Central Bank – reflected the sale by two Eurosystem central banks roughly equal to the sale of just over 30 tonnes of gold, notes Julian Phillips of the Gold Forecaster.

The above articles seem to indicate that the drop in gold prices are caused by hedge funds exiting their positions and Central Banks selling of part of their gold reserves coupled with a contraction in money supply. But these are short term events and eventually $X and $Y has to come to some form of equilibrium. THE PRICE OF GOLD WILL BE DETERMINED BY ITS ABILITY TO HOLD ITS VALUE AGAINST PAPER CURRENCIES.

If the US dollar reverts to his previous exchange rate at the beginning of the year, gold will rise to US$806 based on this devaluation of the US dollar alone. However if the money supply growth over the decade is factor in, gold could easily exceed the US$1,000 mark. With the current Federal Deficit in the US , the poor performance of its economy, the large household debts, the depreciation of the US dollar is inevitable.