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In the absence of cashflow,
judging gold's present "fair value" means analysing it like an
insurance actuary would...
WITH ITS incredibly constant supply
and unsurpassed history as a store of value, physical gold is the wise choice
for retained wealth during currency crises. But for new buyers, is today's
price too high?
From post-war Austria to
Argentina a decade ago, it is clear that holding gold offers insurance
against many levels of currency crisis – something which a growing
number of economic historians, such as Reinhard and Rogoff and Niall
Ferguson,
thinks increasingly possible in the developed West today.
Across long periods of
history, from imperial Rome through to Elizabethan London and late 20th
century America, the value of gold in terms of the goods and services that it
can buy has remained remarkably stable. It is commonly noted that one ounce
of gold could buy a good suit of
clothes in
each of those periods, a base value to which, over the ultra long-term, it's
likely to revert at some point in the future. Gold's ability to defend wealth
in periods of monetary crisis, whether strong inflation or deflation, can
give it a valuable premium above its long-term base value. But today, this
metric would mean gold is around 75% over-valued.
Is today's premium –
over and above gold's long-term base value – excessive? In the absence
of cash flow, we need to judge gold's present value in the way that an
insurance actuary would, pricing it in terms of risk-adjusted outcomes. That,
in turn, means estimating the likelihood of different degrees of currency
meltdown. Doing this, I find that it is hard to push gold's fair value down
to today's market-price of $1,400 per ounce without setting the probability
of a serious inflation or even hyperinflation to zero.
I'm much more fearful of
currency devaluation that the market is, in other words. But discounting to
zero the probability of an event not experienced in our lifetimes is a
classic mistake. Most recently, it caused the credit ratings agencies to
incorrectly estimate the risk of a mass sub-prime mortgage default. In 1980,
this same mistake caused the gold market to anticipate strong annual
inflation rates, just as we'd experienced throughout the 1970s. Gold's then
premium, over its base value, hit 240%. But the market hadn't reckoned with
the shock of strongly positive real interest rates which the Volcker Fed
– in the absence of large, structural government deficits – could
and was about to deliver.
Today, historical inflation
data shows that the risk of a serious currency devaluation in the next 15
years is most certainly not zero. (Since WWII, for instance, the Pound
Sterling has lost between 80-90% of its purchasing power in nearly 11% of
those time frames.) The historical record I've included in my Gold Value Calculator also includes the currency
collapses of Weimar Germany, post-war Austria, Peso-crisis Mexico and
Argentina's bond default at the start of this century. Because Western
Europe, Japan and the United States have now accrued a significant level of
government debt, and I fear we are entering the same state of political
denial which led those countries to lurch from crisis to crisis over the last
100 years. I think our future is likely to look a bit like their past.
Though small, the risk of
severe inflation and currency devaluation is material at perhaps 0.5% in the
next 15 years. Also critical to the Gold
Value Calculator
is the discount rate used. Because it's not simply the headline rate of
inflation, but the real return on currency which counts. Is your money on
deposit losing purchasing power? Negative real rates of return on currency
are what drove gold higher in the 1970s, and again in the last decade.
Because why would you choose to store value in something which isn't
retaining its purchasing power, and has no short-term prospect of doing so,
when you can choose tightly supplied, indestructible gold instead?
Without today's large public
deficits, risk-free returns to cash did not need to be suppressed below
inflation at the start of the 1980s. Looking ahead today, in contrast, the
Federal Reserve, Bank of Japan, ECB and Bank of England appear to have little
choice.
Using the inputs we just
looked at, I calculate gold's risk-adjusted value to be above $3,800 today.
That's significantly higher than the market price, and well above 2011 price forecasts from bullion bank analysts
. My present valuation seems outlandish, therefore, which is why you can
download and judge my Gold Value Calculator for yourself.
You can see the formulae and
decide if the method, inputs and valuation are reasonable. And as the model
shows, gold could of course go down substantially, as well as up, depending
on the outcome path for inflation and the rate of return you can earn on cash
savings.
Paul Tustain
Director
and Founder
Bullionvault
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