Is Gold a Good Investment?

Even though gold has already enjoyed an 11-year bull run we still think that it’s a good investment. Here we present a few charts that suggest that the current gold price is actually quite cheap!

There are three simple (but apparently elusive) charts that indicate the cheap valuation placed upon gold at present. [Note: We'll be updating these charts every week so that you can track their progression over time.]

Chart 1: What Percentage of Each Federal Reserve Note is Backed By Gold?

The degree to which Federal Reserve Notes are backed by gold. - 

Click to enlarge. Source: St Louis Fed, World Gold Council

The chart above plots the market value of the Federal Reserve’s gold as a percentage of the Fed’s total balance sheet. The result is the ‘degree to which the Federal Reserve Note is backed by gold’ or the ‘% of the dollar covered by gold’. With the current gold price and Fed balance sheet size only ~15% of the dollar is ‘backed by gold’. This is far from the extremes that one would expect during the latter stages of a gold bull market. [Note: In the late-1970s / early-1980s the dollar was 'over-backed'by gold.]

Chart 2: What is Gold’s ‘Fair Value’?

Gold's 'Fair Value' Vs. The Market Price - Click to enlarge. Source: St Louis Fed, World Gold Council

The second chart shows the ‘fair value’ of gold against the market price. This ‘fair value’ is the price at which the dollar is fully backed by gold. The current price reflects the market’s resilient faith in the integrity of the other assets on the Fed’s balance sheet, namely; Government bonds, Mortgage-backed securities, Federal-agency debt securities, the carcasses of AIG & Lehman Brothers and so on… Currently the ‘fair value’ of gold stands at more than $11’000.

Chart 3: What’s the Potential Upside in Buying Gold Here?

Upside in Investing in Gold - Click to enlarge. Source: St Louis Fed, World Gold Council

This chart demonstrates the ‘potential percentage upside’ in investing in gold. At present the gold price would have to increase more than five times to reach ‘fair value’. This reveals the surprisingly large optionality in an investment in gold. Moreover, according to this chart the greatest potential upside in a gold investment was actually available during the 2008/2009 crisis (as opposed to the eve of the nominal price bottom in 1999-2001)!

If you’d like to know more about this type of analysis then we suggest you pick up Constantino Bresciani Turroni’s fantastic book; The Economics of Inflation – A Study of Currency Depreciation in Post War Germany.

Click here to recommend Constantino Bresciani Turroni’s fantastic book to your friends. If you recommend it to 4 or more people we’d be delighted to add you the ‘Musings of a Macro Investor‘ subscription list for 1 month (please remember to keep us cc’ed in the email so that we know to add you). [For the super-friendly - we'll give you 1 extra month for each additional 20 friends that you email!]

[Full Disclosure: The link above is an affiliate link. If you do not wish to pass affiliate credit to us (but nevertheless do wish to purchase the book) then fear not there is a solution! — Click here instead.]

Here are a few of our favorite quotes from the book:

On the opinion of policy makers:

The opinion, on this subject, formed in administrative circles, is clearly expressed in the following words of Helfferich: “To follow the good counsel of stopping the printing of notes would mean as long as the causes which are upsetting the German exchange continue to operate—refusing to economic life the circulating medium necessary for transactions, payments of salaries and wages, etc., it would mean that in a very short time the entire public, and above all the Reich, could no longer pay merchants, employees, or workers. In a few weeks, besides the printing of notes, factories, mines, railways and post office, national and local government, in short, all national and economic life would be stopped.”

On the culture of speculation:

The number of people whose interests were favoured by a continuous depreciation of the mark, increased continually in Germany. Not only the great industries and the large merchant firms, but also very numerous classes of investors hoarded foreign bills or currency. The thoughts of all—from the great captain of industry to the modest typist—were concentrated on the dollar rate; and the face of the modest burgher was illuminated by a complacent smile when the daily bulletin, impatiently awaited, revealed to his greedy glance an increase in the dollar rate, while it was clouded if the official quotation showed an improvement in the mark. In a much-frequented cabaret the manager used to address the public in these words: “Many gentlemen are good-humoured this evening, that is to say, the dollar rises!”; or even: “Many people this evening have melancholy faces, that is to say, the mark rises!”

On the scarcely-known geniuses:

Another characteristic of the new wealth was the rapidity with which it was accumulated. Stinnes had already considerable wealth just before the war—about thirty millions; it increased rapidly during the war; but it was during the brief period 1919-23 that he added enterprise to enterprise. Minoux, one of the general directors of Stinnes, after breaking away from his chief in the summer of 1923, made in a few months quite a large fortune for himself, succeeding even in profiteering from the final phase of the depreciation of the mark. Another typical example was Jacob Michael. Like many other fortunate post-war speculators (Kahn, Mannheimer, and Steinberg in Germany and Bosel in Austria) he was in 1924 scarcely thirty years old. His case was interesting because, unlike the other new rich, Michael made the greater part of his money in the period immediately following stabili- zation. He threw over the principle which had ruled during the inflation, when the watchword had been “fly from the mark and buy material goods.” Michael shrewdly foresaw that the first effect of the stabilization would be the appearance of a scarcity of capital, which had been hidden until then by the continuous issues of paper money. Consequently, in the first period of stabilization, when everybody was jealously holding on to the real goods bought during the inflation, Michael sold the majority of his own shares, and, at a time when the ordinary sources of credit were almost dried up, had at his command enormous sums of money, which he lent out at extremely high rates of interest.

On the structure of fiat currencies:

Another characteristic of an advanced stage of the inflation, which I have illustrated in an earlier chapter, was that the depreciation of the paper money proceeded more rapidly than the rise in the quantity of money in circulation. From this there arose a phenomenon which was at first sight surprising, and which led to erroneous interpretations, i.e. the continual depreciation of the total “real” value of the notes in circulation, which in the end was reduced to a small fraction of the value of the circulation in normal times. Towards the end of October 1923 the total sum of paper marks issued in Germany equalled scarcely 150 million gold marks. As I have already explained, the phenomenon was a consequence of the very great increase in the velocity of circulation.

In the case of Germany it is necessary to consider also the following circumstances: (a) for a long time the existence abroad of a great quantity of marks and at home of important credits in paper marks in favour of foreigners in German banks (the total in paper marks towards the end of 1920 was said to be 30 milliards) was a circumstance which imperilled the success of attempts at the stabilization of the German mark. But thanks to the depreciation which occurred in 1923, the value of paper marks possessed by foreigners was practically reduced to zero; (b) the existence of a great mass of short-term floating debt is a very important circumstance which must be taken into account when the stabilization of a currency is attempted. Now, every difficulty of this kind had been eased in Germany by November 1923; the entire floating debt having been reduced to scarcely 200 million gold marks.

The facts expounded in the preceding paragraphs explain the “miraculous” event of the sudden stabilization of the German exchange. The most important factor was the continual fall in the real value of the quantity of paper marks in circulation. Already towards the end of 1922 this real value had become less than the value of the gold reserve of the Reichsbank. Similarly, in certain other countries, where the legal currency fell to very low levels, the gold cover of the notes (the gold being valued according to the foreign exchanges) was much greater than in countries where the currency depreciation had not gone to such lengths.

Source