How Do You Value Gold | What Price Could it Reach

How Do You Value Gold | What Price Could it Reach

Apr 24, 2012

We received a question recently from a reader “What will the future resale value of gold be?” Or rather what they were really getting at, what price will gold likely reach in the future?

They accepted we did not have a crystal ball, (that would be handy!) but were after some kind of methodology to give them a possible indication.

We pointed them in the direction of an old article we wrote a year or 2 back “When will you know it’s time to sell gold?

This gives a number of indicators to follow to determine when it might be time to sell.

However this article didn’t give an actual method for trying to place a value on gold.

Just like Warren Buffett many people run into the problematic thinking that there is no way to value gold as it has no earnings and is of no productive use etc etc. And so therefore how can you place a value on it? The argument expounded by Buffett and others then goes that buying gold merely relies upon you finding a bigger fool to buy it off you.

To put it not so politely, this is all arse about face. You can’t measure gold using the elastic tape measure that is fiat currency. New currency is constantly being created distorting any measure. Rather it is gold that is actually the barometer of the fiat currency being produced. So to try and put a price on it is nigh on impossible because it is dependent upon how many more fiat Dollars/Yen/Pounds/Euros/Renminbi the Central Banks of the world create.

That’s why we like to use measures like the housing to gold ratio to look at house prices. As using gold can give a more accurate picture of value rather than using inflated dollars.

But we digress, back to the topic at hand – how do you value gold?

The best methodolgy we’ve seen has now been wonderfully laid out over on Greshams-Law.com (where it is regularly updated so we’d recommend you bookmark that page to visit it from time to time).

This methodology starts with simply looking at the percentage backing of the dollar at the current gold price.

How do you do that?

Simply take the dollar amount of the Federal Reserve’s total balance sheet and divide into this the current value of the Federal Reserve’s gold (supposing they still have it all!).  See the chart below from Greshams Law.

Doing this shows the dollar is currently (as of 4 April 2012) only 15% backed by gold. Compare this to the 1980 high where the dollar was in fact over 130% backed by gold!

Gold backing of the dollar 1915 to 2012

Click image to enlarge

Or said another way in 1980 gold was overvalued by 30%. And perhaps not so surprisingly this is when it also started to fall.

(Interestingly at this point in time the US could have again returned to a gold standard had it chosen too but the Reagan Gold Commission of 1981 didn’t quite conclude that. As an aside here’s an interesting article on the Gold Commission with some mind bending conclusions about it. http://www.roadtoroota.com/public/117.cfm)

So that’s useful as an indicator as to when to sell or swap your gold for something else i.e. when the dollar is close to 100% gold backed.

But what about a likely future gold price?

As we said above, determining a future price of gold is dependent upon how much more currency is created in the future so it is a constantly moving value.  Nonetheless, it can give us a good indication of where the price could go based upon present numbers.

So using the methodology above you can plot over time golds potential fair value. That is if the dollar was to be 100% backed by gold today what price would it need to be at?

With the size of the Fed balance sheet today – almost $11,000 would be the answer!

Fair value of gold 1915 to 2012

Click image to enlarge

At 15% gold backed today and a current US dollar gold price of about $1650, it seems there is plenty of upside in gold yet and a long way from the bubble territory of 1980.  Again you can see in this chart how in 1980 gold reach its “fair value” – that is it was 100% gold backed.

So the next time someone tells you Gold is in a bubble ask them – Why? And unless they say “Because Gold is at fair value as the dollar is now 100% backed by gold” then you’ll know not to pay them too much heed.

Note:  This $11,000 value is a fair bit lower than that arrived by Mike Maloney.  But it’s similar to that reached by James Turks GoldMoneyIndex.  These all use slightly different methodologies to compare gold to fiat currency but they arrive at the same conclusion as GreshamsLaw.com – gold remains cheap today.  In fact due to the amount of currency created in the past few years, almost as cheap as it was in 1999.

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