Gold is burning bright. And everyone wants a piece of the yellow metal. Bolstered by rating agency Standard & Poor's (S&P's) downgrade on outlook of US debt from stable to negative, experts predict a brighter future for the yellow metal. Globally, gold has marched past the $1,500-per ounce mark whereas in India, the yellow metal has crossed . 22,000 per 10 gram level. Macroeconomic factors and demand-supply dynamics are in favour of gold. However, most investors find themselves in a fix. With prices touching new highs at regular intervals, they are finding it difficult to take a call on the precious metal. The question which everyone would like to ask — is it wise to buy gold at such a 'high' level? Is gold ruling high? For all its glitter, gold doesn't lend itself easily to valuation. Since gold does not generate cash flow like interest or dividend like bonds or equities, respectively, ascertaining the value of gold is a bit difficult. A better way would be to compare gold with other variables to decide its real value.
GOLD VERSUS SILVER
Let's take a look at its ratio with silver, another precious metal that is attracting a lot of investor interest lately. Both these metals have a very long trading history and their long-term ratio stands at 55. At the current price of $46 for an ounce of silver and $1,505 per ounce of gold, the ratio works out to 33. What if the ratio were to revert to mean? If the silver prices were to stay where they are, an ounce of gold will be priced at $2,530. Many would not be comfortable with this number and will attribute it to the rally in silver prices. So let's look at some other comparisons.
GOLD VERSUS CRUDE
Crude oil prices are the next stop. Crude oil being the chief source of energy, rising prices are inflationary in nature. Gold is the ultimate tender and tries its best to protect the purchasing power. Naturally, their prices share a long-term relationship. The long term gold-crude oil ratio – how much gold can be sold to buy a barrel of crude oil – stands at 15. At the current prices, the ratio stands at 13. Gold has to rise to $1,845 per ounce, if the ratio were to revert to mean and crude oil were to remain at the current level. As the crude-producing nations in Middle East and North Africa (MENA) are experiencing volatile political upheavals, crude may not correct in the short term. That makes a case for gold moving up.
GOLD VERSUS INFLATION
Another way is to look at inflation adjusted (based on the US consumer price index), the price of gold since 1980. The price of gold should be $2,303 per ounce in that case. Across the globe, governments find it easier to print currency notes to fund their deficit. Since 1980, the money supply growth the world over has exploded due to various policy (monetary) and non-policy reasons. Global money supply (M3) growth since 1980 is around 9-10 times as per various estimates. Whereas gold prices since 1980's peak are up just by 1.7 times. If all the money supply growth since 1980 has to be hypothetically backed by gold by global central banks, the price of gold would be anywhere around $6,500-7,000 per ounce.
THE DRIVERS
Ø The reckless printing of currency notes and the commodity price-driven inflation are robbing most currencies of their purchasing power.
Ø World over investors are trying to find a better currency.
Ø Gold is the only currency that has existed for the past 5,000 years and has emerged as the only supply-constrained currency today.
Ø Central banks have been buying gold since the last decade to maintain their reserves in a global tender in their efforts to diversify away from the US dollar.
Ø Inflation and low interest rates have resulted in low or negative real interest rates — real interest rate is nothing but the rate of interest payable minus the rate of inflation.
Ø A low real-interest rate environment is conducive for rising gold prices.
Ø As the fixed-income instruments fail to protect the purchasing power of investors, they prefer to stay invested in gold to protect their purchasing power.
Ø The demand for gold as a safe haven is undoubtedly very high.
Ø As crude inches higher on the back of the unrest in Mena, the risk aversion among investors across the globe is expected to grow.
Ø A possibility of a sovereign default in Europe can further add to the worries. That would make a strong case for investing in gold.
Ø As the volatility in global financial markets is expected to be in the higher band, gold will remain as a preferred bet for investors.
Sure, all these factors point towards a brighter future for the yellow metal. But don't think there are no deterrents. Consider Dow Jones Industrial Average gold ratio which stands at 10 in the long term. At the moment, the ratio stands at 8. If the ratio were to revert to the mean value of 10, DJIA remaining at the current level, gold will have to to $1,251 per ounce. One must note the fact that DJIA is quoting near its three-year high and enjoying valuations ahead of fundamentals. It is highly unlikely that it will sustain at these levels for long. Also, relative valuations will never offer the precise upside and downside in the prices of commodities. Investors and traders should note that the relative valuations can be helpful as a reference point to understand the direction in which the prices may move. In the meantime, it is better to pay heed to the macroeconomic factors that influence gold prices.
Before you rush to buy the gold exchange-traded fund or call your investment advisor to invest in a gold fund of funds, include these negative factors also in the picture. A calmer MENA, cooler crude oil prices, and financially stable European nations and appreciation in the US dollar on the back of a strong US economy are some of the key risks to strong gold prices.
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