$800 Gold Bear vs. Bull
Wednesday, 7/23/2014 15:45
Bearish Campbell R.Harvey agrees more than you might expect with this gold bull...
Is GOLD over or undervalued? Are prices headed higher or lower?
asks Sumit Roy, managing editor at Hard Assets Investor.
The outlook for gold prices has seldom been as uncertain as it is now, with investors sharply divided in their views on the yellow metal. Two gold market experts, Adrian Day and Campbell Harvey, likewise have significantly different takes on the market.
But while their views on the "fair value" for gold are strikingly different, surprisingly, they arrive at many of the same conclusions.
Adrian Day is chairman and chief executive officer of Adrian Day Asset Management and the author of
Investing in Resources: How to Profit from the Outsized Potential and Avoid the Risks. Day is a recognized authority in both global and resource investing and a graduate of the London School of Economics.
First though, our gold bear, Campbell R.Harvey – professor of finance at the Fuqua School of Business, Duke University, and a research associate of the National Bureau of Economic Research in Cambridge, Mass. Harvey served as editor of the
Journal of Finance from 2006-2012 and has done extensive academic research on the gold market. In 2013, Harvey co-published
an extensive paper on gold's merits as an investment.
HardAssetsInvestor: Would you tell us the methodology you used to come up with your $800 target for gold?
Campbell Harvey: That is one part of the discussion in a larger paper. And the paper looks at many things and many different ways to value gold. The idea is incredibly simple: Gold holds its value over the very, very long run. What that means is that the value of gold is not eaten away by inflation, like a paper currency would lose value.
Another way of saying that is that the real price of gold over the very long term is approximately constant. In our paper, we go to great lengths to try to make that case. I'll give you two historical examples.
One of them is from multiple thousands of years ago. There, we determined the price of a loaf of bread in gold at the time of Nebuchadnezzar. Interestingly enough, if you take the weight of that gold back then and you applied the price of today, you get about $4 a loaf. Which is not that far from what you would pay for a loaf of bread today.
The second example is maybe even more interesting. It goes back to Roman times, where it turns out that the Romans kept incredibly detailed records of how they paid their soldiers. Given the number of people that a Roman centurion commanded, it is approximately equivalent to a US captain today.
What we did is we looked at the pay of the Roman centurion in terms of gold. They were paid with coins, and those coins still exist today. You can weigh those coins and you can figure the purity of the gold. We compared the centurion's wage in today's value of gold to a US captain's wage today and found that they were in the same ballpark.
Both of those historical examples corroborate the idea that, over the very long term, the real price of gold is approximately constant.
Let me give you another reason why the real price of gold might be approximately constant; it's kind of like a counterexample. Suppose it was the case that the price of gold goes up through time. Let's say it goes up very modestly – 1% a year. Given that gold's been around so long, if you compound that 1% over, let's say, 2,000 years, you get into a situation that appears to be unreasonable.
For example, a single Dollar in real terms would grow to be $500 million after 2,014 years. That just doesn't make a lot of sense, so we're leaning toward this idea that the real price of gold doesn't change over the long term.
That delivers this idea that if you take the nominal price of gold and you divide by the inflation level or the inflation index, that should be approximately constant. And that's what we do in our paper. There's a lot of variation above and below the constant number, but when you're above, you tend to revert lower; and when you're below, you tend to increase. That is where this $800 number comes from.
But it's critical to understand that the model doesn't say when you get this mean reversion. The examples I quoted you earlier were examples that were from thousands of years ago. Long-term gold will likely decline to its real value, but short- or medium-term gold could appreciate in value.
HAI: You've said that gold holds its value over the long term; doesn't that make it a good inflation hedge?
Harvey: Gold over the very long term does provide that hedge. However, the very long term is longer than most investors' time horizons. If you look at shorter term, then gold is a very unreliable hedge for inflation. You can see for a period of 10 years – even 20 years – where gold did not provide that hedge.
The problem is that gold is volatile and inflation isn't; gold is hugely more volatile than inflation. As a result, gold is going to be an unreliable inflation hedge over horizons that most of us would consider our investment horizon.
I do not recommend gold for inflation hedging. However – and this is also important – if you combine gold with a diversified basket of commodities, that's a different story. That is way more reliable as an inflation hedge.
HAI: Is there anything else you'd like to add?
Harvey: I've talked a lot about gold's value over the very long term, but in my paper, I also discuss factors that could lead to gold appreciating in value in the near term. For example, one thing that's really striking is that 70% of US reserves are in
gold bullion, and 75% of Germany's reserves are in gold. In China, it's only 1.6%. They're sitting on Dollars and Euros and not gold, and that's an issue for them. If China were to even modestly increase its holdings of gold, that could have an explosive effect on the price of gold.
Another thing we discuss in my paper is that the actual production of gold hasn't really changed that much over the last 10 years. Even though the price of gold has gone up dramatically, the actual mining production has remained approximately constant. If someone came on to the market wanting to increase their reserves, it would be potentially something that could drive the price much higher.
HardAssetsInvestor: Adrian Day, do you think investors should own gold right now?
Adrian Day: Absolutely. There are two main reasons to hold gold. One is as a very long-term portfolio insurance – a hedge on other assets and markets, and a hedge on instability. We know that sometimes gold and the stock market and other asset classes go up together. But all things being equal, over time, gold will act as a hedge on other financial assets, and particularly, one's own currency. Thus, I think gold should be a permanent part of one's portfolio, just like insurance is.
The second reason for owning gold relates to this latest 10-year time frame, where we've had extraordinarily easy monetary policy. Interest rates around the world in most major countries are negative. We're seeing that interest rates at the shorter end are lower than the rate of inflation, so anyone depositing money in the bank is losing money on a purchasing power basis.
We've had just extraordinarily easy money around the world, not just in the US In that environment, gold is an asset that will protect you against any consequences of these monetary policies.
HAI: What do you say to the argument that gold is too volatile to be an inflation hedge?
Day: Most people are more worried about volatility than they are about risk. And even modern portfolio theory defines risk as volatility, but they are actually two complete different concepts.
You can put the money in the bank and earn half a% if you're lucky, lose 2% to inflation, and be in an extremely low-volatility investment. And yet you are guaranteed to lose purchasing power.
As Warren Buffett said, "I'll take lumpy 20% over a flat 10% any time." And I'll certainly take a volatile asset like gold that acts contrary to other financial assets than an asset that is guaranteed to lose me money.
HAI: How do you come up with the value for gold?
Day: It's a very tricky thing to come up with a value on gold, because most of the traditional metrics that we use for valuing assets depend on future cash flow, future dividend streams, and so on. Gold, of course, famously doesn't have any cash flow or dividends. And so it's difficult to value gold on traditional metrics.
But there are all sorts of things one can look at. One can look at gold relative to the monetary base of the United States, or gold relative to the monetary base of the world. All of these things one can look at and they are valid ways of analyzing the gold market. But so much depends on your starting date.
Bears will say, "Well, from 1980 to 2014, gold has not even doubled." And bulls will say, "Well, if you go from 1970 to 2014, look how tremendous gold has been." So an awful lot depends on your starting point.
Ultimately, I think looking at gold relative to the value of money is the way to go. And unless you pick a particularly unfavorable starting point, gold today is definitely below where it would be on a historic basis. And that could be anywhere from $2500 to $5,000. I'm not saying it's going to go there any time soon necessarily. I'm saying that would be the range of values for gold based on the analysis of gold versus money.
HAI: When gold gets closer to fair value, do you think it will stop going up?
Day: I'm not going to say that gold is going to continue to appreciate forever. Nothing does. Over the very long term – 50 years, 100 years, 1,000 years – gold holds its value. Theoretically, gold is intended to hold its value; it's not meant to generate tremendous returns.
Given that most currencies lose most of their value, that's a good thing. Look back over the last 1,000 years and there aren't any currencies other than the British pound that have survived. You go back 500 years, and the same thing holds.
Even looking at the United States over 200 years, the country had several different currencies. France and Germany, likewise, has had several currencies. Every major country around the world sees their currencies come and go. I think gold will continue to hold its value over the long term as most currencies lose their value.
Email us