Last August I wrote a short series for Forbes.com on valuation techniques for gold, (Some Thoughts For The Gold Bulls, The Case Against Buying Gold, and At $1,850/Ounce, Does Gold Still Glitter?). At the time I concluded that gold prices at $1,850 an ounce had been far too high; then in a follow-up piece after a large decline in gold prices, I suggested that gold even at $1,700 was still above a proper valuation range. I argued that although it is widely held to be impossible to put a valuation on gold (it has no inherent value, it is completely emotionally driven, etc.), gold in fact has a value and the value can be calculated.
The confusion about gold valuation is a symptom of a larger confusion about valuation in general. We don’t understand any longer what things are worth, because we don’t understand any longer what ‘worth’ means. Worth is merit: the medieval book “The Nine Worthies” was a series of portraits of men of merit. To assign worth to something is to properly rank its attributes in relation to the attributes of another object. The word ‘worship’ is derived from this. Worship is ‘worth-ship’ and in modern English has strong religious connotations; to worship God is to acknowledge His value above all others. But it’s not always religious. In the old Anglican marriage service, the man would say to the bride ‘with my body I thee worship’, meaning…well, you know.
Valuation theory has become so formalistic and abstract that it has become almost completely divorced from reality. Valuation becomes a matter of ratios of highly formalized GAAP earnings in relation to fluctuating prices adjusted by highly abstract notions of variance and value at risk.
So, let’s get real. Gold is real. It is obvious that it has value: it is beautiful, portable, enduring, malleable, divisible and scarce. For these reasons it can be exchanged easily for goods and services. It does not have a great deal of industrial productive value (although it has some), but why is that a problem? A few years ago I had a debate with a colleague about including gold in a portfolio which at the time was filled completely with paper assets. He said that gold, unlike stocks and bonds, had no intrinsic value. By that he meant that it has no internal rate of return like stocks and bonds do.
What he missed and what the paper-only financial establishment always misses is that the end towards which all investments are aimed is exchange value. We hold paper bonds, in the hopes that we will get future paper interest payments, which we desire in the hopes that we can exchange all that paper for something real. In the end, all investment is about exchange value. Gold’s worth is that it holds exchange value very well.
No, gold does not have a P/E ratio, because it doesn’t have an E. But it does have an S, scarcity. Gold is scarce relative to paper in the current environment. That is its value, its worth.
But dollar gold prices got far ahead of the levels that one would expect even given the rapid increase in U.S. money supply. Since 2008, the money supply has gone up by roughly one third while the gold price has roughly doubled. And over the past decade, since 2001, the money supply has roughly tripled, while the gold price has nearly sextupled.
This was a puzzle to me. Gold has settled into a spot which is at the high end of my expected range, which is to say that of several models I use which are based on the relative scarcity of gold, gold prices have been converging on the models which have given the highest valuations to gold, at $1,676. My lowest scarcity based models would put gold at around $1,200.
So, what was I missing? It is easy to see what Bernanke is missing: he thinks that low growth and high unemployment create some undefinable something called an output gap, which leads to other undefinables called resource slackness, and these undefinables protect us from inflation. He looks at the difference between conventional Treasury rates and inflation protected Treasury rates, forgets that he and his monetary authorities have used their powers to set those Treasury rates at artificially low levels, and then concludes that the market expects low inflation. Of course, in order to use this as an argument that inflation is not a problem, he has to assume that the market has enough wisdom in it to properly gauge future inflation, but then he immediately turns around and forgets the wisdom of the markets when he overrules its price setting mechanism with an unprecedented series of operations, from open market to twist.
So, gold investors knew something which Bernanke didn’t. But they also knew something which I didn’t which is why, although by the grace of God I got the gold direction right, I did not get the magnitude right. Gold is much higher than can be explained by money creation, and it’s been there for some time. And it’s done that a few times before. Why? I’ll address that puzzle in the next in this special series on gold valuation.
Mr. Bowyer is the author of "The Free Market Capitalists Survival Guide," published by HarperCollins, and a columnist for Forbes.com.
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