It’s not surprising that clients are inquiring about gold, as it has risen 25.3 percent so far this year.
When we started this business in August 2002, I thought gold was a terrible investment idea. However, in the 273 months since then, it has handily beaten foreign stocks and bonds, and even eked out a small win over the S&P 500.
That’s right, during this time frame, gold gained 10.9 percent, compared to 10.6 percent for the S&P 500. It’s fair to say that I was wrong about gold.
Does that mean we should add gold? I’m not as opposed to gold as I once was, and I wrote about my shifting thought process as far back as ten years ago (click here for the original article).
I still don’t have it in my portfolio, and just a few of my clients have it, but I’ve been paying attention to the rising price as well. One of the podcasts that I listen to regularly (I can’t remember which one) recently featured a well-known academic named Campbell Harvey.
Harvey is well-respected because he was the first person to demonstrate that an inverted yield curve is a strong signal that a recession is imminent. Interestingly, he thought ‘this time is different’ and said that the inverted curve coming out of the pandemic wasn’t likely to lead to recession, and he was right.
So, when I heard Harvey discuss gold on the podcast and how he’d developed a valuation for it, I was very interested. I found two papers that he wrote on the subject, and while I mostly skimmed them, they didn’t disappoint.
The thrust of his valuation method, as I understand it, is that gold is linked to inflation over the long run (the very long run, as an ounce of gold paid for a toga in Roman times, and a fine suit today).
In one paper, Harvey wrote about the “Golden Constant Value” of gold, which compares gold prices to the Consumer Price Index after the US removed itself from the gold standard under President Richard Nixon.
I came very close to replicating his data, which goes through 2016. He thought the constant value at that time was $839 per ounce, and my attempt to mimic his work resulted in $841 per ounce, which I like to call ‘k for close.’
He then compares the constant value to the actual price to judge whether gold is under- or overvalued. You can see from the chart below that it was overvalued in the late 1970s when people bought after the inflation runup, was undervalued for about 30 years, and has become pretty overvalued in recent years.
In another paper, he ties the overvaluation, in part, to the introduction of gold ETFs in 2005. That innovation enabled more investors to buy gold efficiently, without having to deal with the headaches associated with physical gold (shipping, storage, security, etc.) or trading futures.
That chart makes gold look a little scary right now, but if I made it through 2020, it wouldn’t have looked good either, and the returns have been fantastic since then.
I think there is good reason to be skeptical of this analysis, although in fairness, Harvey is a true academic, and I only skimmed his work. Still, the analysis overlooks the value of the dollar and focuses solely on US inflation. The primary value of gold is that it serves as a global currency (and stateless, which is another benefit). Shouldn’t other inflation rates matter, or does the exchange rate capture that?
I think there is still much mystery around gold. I also find Bitcoin and other cryptocurrencies mysterious, and wonder how their introduction as stateless, global currencies fits into the analysis.
I once heard former Fed Chair Ben Bernanke say that ‘nobody really understands gold,’ which makes me feel better that I don’t understand it. For his part, Harvey seems to be warning investors about buying gold today.
I’m still not ready to buy gold, but when clients want it, I don’t try to talk them out of it. Ten years ago, I wrote that I didn’t think we would likely add it as an asset class anytime soon, and I still believe that to be true today. I’ll let you know how that went in ten years.
