Calculating the "Fair Value" of Gold

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 myGold 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 Calculatoris 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 myGold 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.