Gold Is Still Looking Strong

Source: Thinkstock

Source: Thinkstock

Gold has traded down over the past month by about $100/ounce to just under $1,300/ounce today. Longer term, the price has corrected by $600/ounce from its $1,900/ounce 2011 peak to today’s $1,300/ounce price. Despite this weakness, however, the fundamental drivers that have been pushing the gold price higher over the past decade are still intact. Gold has outperformed just about every asset class since bottoming in 1999. Even longer term, the price of gold has outperformed stocks. Since the U.S. government stopped pegging the gold price to $35/ounce back in 1971, gold has markedly outperformed stocks. While there have been periods of weakness such as the bear market from 2011 to 2013, prudent investors have made money by buying gold on the dips. This is so for the following reasons.

First, the money supply is rising. With very few exceptions, the supply of U.S. dollars outstanding has been perpetually increasing. This has been the case since the Federal Reserve started keeping records of this data going back several decades. Despite all of the media hype surrounding the “taper” and rising interest rates, the fact remains that the money supply has been rising, and so naturally it takes more money to buy gold.

Even with the Federal Reserve buying $55 billion in assets monthly, the monetary base is increasing in size at a rapid pace — by about 1.25 percent per month! While a lot of this money hasn’t been lent out, which would send prices soaring, that potentiality is real, and once money starts getting lent out and changing hands at a faster rate (i.e. once the velocity of money picks up) the gold price will start soaring.

Second, investors throughout the world have been buying gold. This is a relatively new phenomenon, especially in many of the emerging markets where people were too poor and too economically repressed to buy gold. Central banks have begun to buy gold as well. We see this from Brazil, China, South Korea, Turkey, Russia, and Kazakhstan. Despite this, gold mine supply hasn’t really risen so much. In fact, lower prices in 2013 led to a slight decline in production despite record demand coming out of China. While these changes couldn’t compete with the speculative short selling that drove the market lower last year, supply and demand fundamentals are very real, and they will eventually drive prices higher.

Third, assets that investors are more familiar with — stocks and bonds — are overvalued if you look at these values historically. The S&P 500 has an historical average dividend yield of about 4 percent. It also has an historical P/E ratio closer to 13 or 14. Nevertheless, according to the iShares data for its iShares S&P 500 ETF “IVV,” the dividend yield on the S&P 500 is a mere 1.8 percent, and the P/E ratio is 22.5. Bonds are historically expensive as well, with 10 year Treasury yields below 3 percent when they are typically closer to 6 percent. These over-valuations can be sustained for a while, but not indefinitely.

Consequently, investors will pull their money out of these assets. This money will need to find a home, and some of it will go into gold, especially as the first two factors I mention start to drive prices higher. People will realize gold’s intrinsic value and start to bid up the price, and this can continue until stocks and bonds reach an historically appropriate valuation. Historically, stocks are at generational lows when they trade at less than 10 times earnings and when they yield 6 percent to 8 percent. Given current valuations, we have a long way to go.

Gold is a scary asset to own now. It has been trending lower for the past couple of years. It is also esoteric. Therefore, people simply want nothing to do with it. Eventually, this sentiment will change in the United States. As previously mentioned, citizens in many other countries have no trouble storing their wealth in gold. They understand that it will preserve their purchasing power over long periods of time, and that speculators in the futures pits have been giving them a long term buying opportunity.

Disclosure: Ben Kramer-Miller owns gold coins and select gold mining companies.

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