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A ROUGH PROJECTION OF GOLD AND SILVER PRICES
Reinhard Seiser - August 24th, 2008
Gold and silver prices have collapsed in the last few weeks, and lower prices cause many investors to question if the bull market in commodities is over. Anybody who looks purely at prices might suddenly ask if the appropriate levels of precious-metal prices should be lower, and not what they thought to be just a few weeks ago. Successful value investing tries to ignore market prices and focuses rather on a set of fundamental reasons.
One fundamental factor for the prices of gold and silver is the assumption that these metals have somewhat served as monetary assets throughout history. They might not immediately be accepted at the next-door grocer, but they might be convertible into a local currency in almost any country around the world. As monetary asset, gold’s value expressed in a currency such as the US dollar should be proportional to the quantity of dollars, since quantity of above ground gold is almost constant. Beyond this, there are times when the currency is more or less trusted as a store of value, and therefore the real price of gold has fluctuated by about an order of magnitude in the past.
Expectations of higher inflation, i.e. the government’s creation of new currency, can cause gold to outrun the rate of money supply. This often coincides with cyclical shortages in commodities whose prices then universally rise. Higher commodity prices depress companies’ earnings, their growth rates, and therefore their market multiples [1]. Some of the money leaving the stock market in this P/E-contraction might then move into precious metals and also help underscore their price increase.
The second main factor then for estimating the future price of gold is a reliance on historical fluctuations. All of this is not an exact science, and who says that history repeats itself.
But I am trying to be as conservative as possible in my assumptions, and I also take in account the comparison of current and future events with those of the past.
Optimistic projection of future gold prices
To convert the nominal gold prices into real prices, a rate of inflation needs to be estimated. The consumer-price index (CPI) is widely available [2], but this index measures the prices of consumer goods which absent of inflation would get cheaper over time through improved production methods. It is also typically understated through the desire of government to present small rates of inflation. (This is especially so since the Boskin Commission in the 1990s when new adjustment methods were introduced.) An annual loss of the purchasing power of the dollar compared to hard assets is therefore at least 2% higher than the reported CPI. (The von Mises Institute uses a true-money-supply measure, which also turns out to be 2% higher than the CPI for the 1970-2008 period [3]).
Considering that gold production could add about 1%/year to current stocks of gold, I am using CPI+1% (instead of CPI+2%) as my deflator for the price of gold. This is very conservative, since it is very unlikely that consumer goods wouldn’t be produced by at least 1% cheaper every year compared to the price of gold. Any higher difference would make the fair estimate of the value of gold even higher. With the here assumed value, the real price of gold at the bottom in 2001 is close to the real price of gold in 1970.
The 1970s were a time of rising commodities prices, and gold rose until 1980 when inflation peaked and people were buying gold in droves [4]. From trough to peak, gold went up about 25 times in nominal terms, but most of the increase came during the last year. To be slightly more conservative, I am using an average growth rate of the real price of gold of 19%/year. This projection fits well with the price of gold which has been at times below or above this average, and it gives about a 1-year window for gold to remain at or above the projected top (Fig. 1). From 1981 until 2001, we had a time of disinflation, and with the public becoming more comfortable with paper assets, the real price of gold dropped significantly.
A rate of minus 8%/year brings us to the same level as in 1970. From then on, another commodities bull-market started, and a real gold increase of 17%/year would bring us in 2013 to the same projected level as in 1980. (Until 2013 is just a touch longer than the bull-market in the 1970s.)
Figure 1
Where will the price of gold be by 2013?
If history repeats itself with a similar period as in the 1970s, the real price of gold would reach $1750 (in 2008 dollars). And so far, the price is perfectly on track with the projection. Also, the economic problems are at least of the same magnitude as in the 1970s, with supply shortages in commodities, rising CPI, and government directly (bail-outs) or inadvertently (entitlement programs) increasing the money supply. So it would be no surprise at all, if a similar situation occurs as in the 1970s, and possibly even a “wildly bullish” mania like in 1980 could ensue. This case might push the real gold price to its previous monthly average high of $2500 (in 2008 dollars).
If all these forecasts are too uncertain, and one does not want to risk holding gold once it breaches a “fair value”, the historical average of $750 (in 2008 dollars) seems like a good estimate. At current gold prices slightly above that value, this would still allow gold to roughly maintain its purchasing power for the next years, or at least make sense during times when short-term interest rates are below the rate of inflation.
Figure 1 was all about real (inflation adjusted) gold prices in order to gauge its relative value in the cycle. We do not know what inflation will be like in the next years, but with an estimate of inflation, one can construct a prediction of nominal future gold prices.
As inflation is currently accelerating, a simple scenario would be one in which the CPI is expected to rise by 0.5%/year up to 7% in 2013 (0.5% equals about the annual increase from 2006-2008). Figure 2 shows the projected path for the optimistic case based on past history (yellow line). The nominal price of gold in this scenario would reach $2400 in 2013. The wildly bullish case would be $3500, and the fair value case would be $1000, all in 2013 dollars. Of course, if inflation turns out to be much higher, then these nominal prices will be much higher as well, but any inflation is not really a benefit to an investor.
If anything, it is a benefit to the government, since taxes might have to be paid for the nominal gains, and part of those gains are from inflation. To repeat, there are many people who think that inflation is or will be much higher than in my projection, but then nominal prices will just be proportionately higher. There is of course no limit as to how high gold can go when the currency trends toward zero.
Figure 2
The price projection for silver
With silver, the same analysis can be conducted, and the real and nominal prices are shown in the next two figures [5]. The real average growth rates are estimated to be 25%/year for the 1970s, negative 11%/year for the 1981-2001 period, and 24% after 2001. This somewhat connects trough to trough, fits with the 1-year long top, and makes silver rise twice as much as gold during the full commodity bull-market. This is realistic since the gold/silver ratio could well fall by a factor of two, as it has in the past, e.g. from 60 to 30.
Figure 3
Figure 4
With the same inflation scenario as for gold, nominal silver prices in 2013 could be $22, $75, or $125, for the three cases (Fig. 4). Note, that with the current sell-off, silver is way behind the optimistic case, and even the fair value case would give a respectable gain for the next years. A small concern is that silver prices might not track inflation as well as gold, as the 1970-2008 price chart seems slightly more tilted downwards than gold. It might be possible that silver as industrial metal is not hoarded as much, produced as by-product more efficiently, and therefore follows slightly different price dynamics. But if investor demand becomes strong enough, silver could reassert itself as monetary metal, and a 1980-like ascent might put it back on track for some of the largest annual gains in the commodity sector. Even without the Hunt Brothers!
http://libertyvalley.com/rough_proje..._silver_prices
Reinhard Seiser - August 24th, 2008
Gold and silver prices have collapsed in the last few weeks, and lower prices cause many investors to question if the bull market in commodities is over. Anybody who looks purely at prices might suddenly ask if the appropriate levels of precious-metal prices should be lower, and not what they thought to be just a few weeks ago. Successful value investing tries to ignore market prices and focuses rather on a set of fundamental reasons.
One fundamental factor for the prices of gold and silver is the assumption that these metals have somewhat served as monetary assets throughout history. They might not immediately be accepted at the next-door grocer, but they might be convertible into a local currency in almost any country around the world. As monetary asset, gold’s value expressed in a currency such as the US dollar should be proportional to the quantity of dollars, since quantity of above ground gold is almost constant. Beyond this, there are times when the currency is more or less trusted as a store of value, and therefore the real price of gold has fluctuated by about an order of magnitude in the past.
Expectations of higher inflation, i.e. the government’s creation of new currency, can cause gold to outrun the rate of money supply. This often coincides with cyclical shortages in commodities whose prices then universally rise. Higher commodity prices depress companies’ earnings, their growth rates, and therefore their market multiples [1]. Some of the money leaving the stock market in this P/E-contraction might then move into precious metals and also help underscore their price increase.
The second main factor then for estimating the future price of gold is a reliance on historical fluctuations. All of this is not an exact science, and who says that history repeats itself.
But I am trying to be as conservative as possible in my assumptions, and I also take in account the comparison of current and future events with those of the past.
Optimistic projection of future gold prices
To convert the nominal gold prices into real prices, a rate of inflation needs to be estimated. The consumer-price index (CPI) is widely available [2], but this index measures the prices of consumer goods which absent of inflation would get cheaper over time through improved production methods. It is also typically understated through the desire of government to present small rates of inflation. (This is especially so since the Boskin Commission in the 1990s when new adjustment methods were introduced.) An annual loss of the purchasing power of the dollar compared to hard assets is therefore at least 2% higher than the reported CPI. (The von Mises Institute uses a true-money-supply measure, which also turns out to be 2% higher than the CPI for the 1970-2008 period [3]).
Considering that gold production could add about 1%/year to current stocks of gold, I am using CPI+1% (instead of CPI+2%) as my deflator for the price of gold. This is very conservative, since it is very unlikely that consumer goods wouldn’t be produced by at least 1% cheaper every year compared to the price of gold. Any higher difference would make the fair estimate of the value of gold even higher. With the here assumed value, the real price of gold at the bottom in 2001 is close to the real price of gold in 1970.
The 1970s were a time of rising commodities prices, and gold rose until 1980 when inflation peaked and people were buying gold in droves [4]. From trough to peak, gold went up about 25 times in nominal terms, but most of the increase came during the last year. To be slightly more conservative, I am using an average growth rate of the real price of gold of 19%/year. This projection fits well with the price of gold which has been at times below or above this average, and it gives about a 1-year window for gold to remain at or above the projected top (Fig. 1). From 1981 until 2001, we had a time of disinflation, and with the public becoming more comfortable with paper assets, the real price of gold dropped significantly.
A rate of minus 8%/year brings us to the same level as in 1970. From then on, another commodities bull-market started, and a real gold increase of 17%/year would bring us in 2013 to the same projected level as in 1980. (Until 2013 is just a touch longer than the bull-market in the 1970s.)
Figure 1
Where will the price of gold be by 2013?
If history repeats itself with a similar period as in the 1970s, the real price of gold would reach $1750 (in 2008 dollars). And so far, the price is perfectly on track with the projection. Also, the economic problems are at least of the same magnitude as in the 1970s, with supply shortages in commodities, rising CPI, and government directly (bail-outs) or inadvertently (entitlement programs) increasing the money supply. So it would be no surprise at all, if a similar situation occurs as in the 1970s, and possibly even a “wildly bullish” mania like in 1980 could ensue. This case might push the real gold price to its previous monthly average high of $2500 (in 2008 dollars).
If all these forecasts are too uncertain, and one does not want to risk holding gold once it breaches a “fair value”, the historical average of $750 (in 2008 dollars) seems like a good estimate. At current gold prices slightly above that value, this would still allow gold to roughly maintain its purchasing power for the next years, or at least make sense during times when short-term interest rates are below the rate of inflation.
Figure 1 was all about real (inflation adjusted) gold prices in order to gauge its relative value in the cycle. We do not know what inflation will be like in the next years, but with an estimate of inflation, one can construct a prediction of nominal future gold prices.
As inflation is currently accelerating, a simple scenario would be one in which the CPI is expected to rise by 0.5%/year up to 7% in 2013 (0.5% equals about the annual increase from 2006-2008). Figure 2 shows the projected path for the optimistic case based on past history (yellow line). The nominal price of gold in this scenario would reach $2400 in 2013. The wildly bullish case would be $3500, and the fair value case would be $1000, all in 2013 dollars. Of course, if inflation turns out to be much higher, then these nominal prices will be much higher as well, but any inflation is not really a benefit to an investor.
If anything, it is a benefit to the government, since taxes might have to be paid for the nominal gains, and part of those gains are from inflation. To repeat, there are many people who think that inflation is or will be much higher than in my projection, but then nominal prices will just be proportionately higher. There is of course no limit as to how high gold can go when the currency trends toward zero.
Figure 2
The price projection for silver
With silver, the same analysis can be conducted, and the real and nominal prices are shown in the next two figures [5]. The real average growth rates are estimated to be 25%/year for the 1970s, negative 11%/year for the 1981-2001 period, and 24% after 2001. This somewhat connects trough to trough, fits with the 1-year long top, and makes silver rise twice as much as gold during the full commodity bull-market. This is realistic since the gold/silver ratio could well fall by a factor of two, as it has in the past, e.g. from 60 to 30.
Figure 3
Figure 4
With the same inflation scenario as for gold, nominal silver prices in 2013 could be $22, $75, or $125, for the three cases (Fig. 4). Note, that with the current sell-off, silver is way behind the optimistic case, and even the fair value case would give a respectable gain for the next years. A small concern is that silver prices might not track inflation as well as gold, as the 1970-2008 price chart seems slightly more tilted downwards than gold. It might be possible that silver as industrial metal is not hoarded as much, produced as by-product more efficiently, and therefore follows slightly different price dynamics. But if investor demand becomes strong enough, silver could reassert itself as monetary metal, and a 1980-like ascent might put it back on track for some of the largest annual gains in the commodity sector. Even without the Hunt Brothers!
http://libertyvalley.com/rough_proje..._silver_prices
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