Julian Van Erlach
What is the likely course for the price of gold after its massive recent decline? To answer that meaningfully, a testable theory of gold valuation is needed together with an assessment of the causes of its recent fall and probable outcomes. According to Required Yield Theory™ (RYT™) gold is undervalued by 20% — a nearly three standard deviation event in relation to fair value. If correct, the indicated investment actions include going long gold and its derivatives such as NUGT based on one’s risk tolerance and portfolio allocation preferences.
Figure 1: Gold vs. RYT Quarterly Through 2011, Weekly Since 1978
The model in Figure 1 has a 13.4% average absolute variance from actual gold price since 1978; 6.5% absolute variance since 2008 and 5.4% since 2011 (inception of weekly tracking).
RYT asserts that gold (referenced Jrl. Of Investing paper), like stocks and bonds (referenced paper published by NYU), is priced according to a single, general, immutable valuation principle: akin to a Fisher Effect wherein these assets are priced in relation to a global real constant — long-term real per capita productivity growth. The main factors used by the model are:
- Growth of gold stock in relation to world real GDP growth
- Expected world inflation rate
- Cumulative inflation
- The long term after tax real rate of interest (proxy for expected per capita productivity growth)
- The exchange rate for the local or national price of gold
- Fiat asset effective tax rates
Contrary to current beliefs in Finance, gold has a real yield due to the relationship of world gold stock growth to world real GDP: the above ground stock of gold grows at the rate of population growth (due to mine economics), which means that per unit, gold yields the same as labor: real global per capita productivity growth of about 2% long term. Note that real GDP growth is the sum of population and productivity growth. Fiat money yields (minus) the inflation rate. To see this, consider the U.S. M3/real GDP vs. the CPI (Figure 2) wherein excess money vs. production of goods and services determines the CPI:
Figure 2: U.S. M3/Real GDP vs. CPI 1981-2006 (latest date for M3 available data from Fed)
Now look at gold stock/world real GDP vs. World CPI during the pure Gold Standard:
Figure 3: World Gold Stock/World Real GDP vs. World CPI 1820 – 1913 Pure Gold Standard
© Julian Van Erlach 2/2013
When gold was money, and CPI was measured in relation to gold, the same determinant of the CPI held. However, absent large, easy-to-mine gold ore discoveries, the gold stock can only increase at the rate of world population growth, which provides gold a real yield. Despite the numerous such discoveries during the above period, note the general fall in CPI (rise in gold purchasing power/deflation in terms of gold).
Since gold has a real yield, and fiat money has a negative real yield, there is an exchange rate between the two. Moreover, like a long bond paying a stream of interest payments, gold’s real yield makes its price inversely sensitive to the real long-term interest rate (which is different from current beliefs that low interest rates make holding gold less costly and the reverse assumption).
The model shown in Figure 1 is proprietary and enhanced from the patented but incomplete model disclosed in the referenced Jrl. Of Investing paper (this is the only patent ever granted for a new asset valuation mechanism).
The enhanced RYT model also predicts and solves the Gold Standard Gibson’s Paradox by demonstrating that the real rate of interest was always constant, not variable, as assumed by Barsky-Summers and others. This is a critical finding and evidenced by computing the real purchasing power of the consol fixed interest divided by the nominal consol price, which result was always constant real yield.
Causes of the April 2013 Gold Price Decline
The recent large drop in the price of gold is unrelated to either a spike in the real long-term interest rate or a sharp decline in inflation expectation as evidenced by TIPS yields and the difference between like term TIPS and nominal Treasury yields (inflation expectations proxy) (Figure 4). Nor does the dollar exchange rate e.g. DXY explain the price move.
Figure 4: 5-Year TIPS Yield vs. Gold Price (Bloomberg)
The 2008 TIPS yield spike was caused by a huge fall in expected inflation from 2.16% in July to -2.2% in November. Real TIPS yields are currently slightly higher and inflation expectations slightly lower (both marginally negative for gold) but enough to cause only small declines in the price of gold. Global interest rates and inflation expectations appear to be similar and not supportive of a sharp gold price decline. Moreover, mine production appears to be declining which is positive for gold’s real yield. There does not appear to be a fundamental case for the sharp decline in the price of gold. Historically, the price of gold and its RYT valuation have converged within a few quarters’ time frame. There can be no assurance that this pattern holds for any given divergence such as is occurring now.
It is possible, thought not likely, that the enhanced RYT is missing a key heretofore undiscovered gold valuation factor currently operating to push gold valuation lower. This is not likely because RYT solves the price of gold fully under both fiat and gold standard economies spanning 200 years. It is also possible that emergent beleaguered country central bank selling of gold and pressured hedge fund selling may hurt gold prices further or prolong the price depression. Finally, if world growth expectations spike and/or significant deflation expectations arise, the price of gold will be hurt. The author believes the latter are unlikely.
This article posits that gold is severely undervalued according to RYT. An overview of the RYT valuation model is presented, which asserts that gold is valued according to an absolute principle and presented evidence for this principle from published academic papers and other public domain data analysis. Moreover, evidence is presented that this principle is general and applies to the valuation of stocks and bonds as published in NYU’s Jrl. Of Financial Markets, Institutions and Instruments.
Gold has in inherent real yield, whereas fiat assets produce a real yield through fiat payments of interest, dividends and earnings per share growth (capital gains). Zero Hedge offers this review of the original RYT theory for interested readers.
Investors should form their own reasoned opinions and act according to personal risk tolerances and portfolio strategies in relation to opening long positions in gold and its derivatives. The author is long NUGT.