The True Value of Gold

The Daily Reckoning: Let’s dive right into the price of gold. Gold had a rough year in 2013 — hitting a low of $1,178. Are you surprised by gold’s recent performance?

Paul van Eeden: No, I’m not surprised at all. I think even at $1,230 gold is still expensive. And it wouldn’t surprise me in the least to see gold go down another few hundred dollars. But I have to be very careful because I don’t try to predict what the price of gold is going to do in the next six months or a year. I pay attention to what I think gold is worth, because if the price is higher than what I think it’s worth, then I have very little interest in buying gold specifically. If it trades for less than what I think it’s worth, then I’m more inclined to buy it — without paying attention to the timing. I don’t mind buying assets if they’re trading below intrinsic value and holding onto them; I don’t mind buying more if they continue to decline. But I try not to buy assets when they’re trading for more than what I think they’re worth, regardless of what I think is going to happen in the next three-six months.

The Daily Reckoning: Building on that, how, exactly, do you figure out what gold’s intrinsic value is?

Paul van Eeden: The basic premise is the fact I think gold is money. And I analyze it as if it’s money. Whenever you talk about the price of something, whether it’s gold, or a Mercedes-Benz, or a widget — it doesn’t matter what you’re talking about — the minute that you denote something as a price, then you’re making a comparison between two different things. You’re comparing a Mercedes against a bunch of U.S. dollars. The minute that you express something as a price, you’re analyzing two things.

To make it very clear, if I tell you I think the value of a Mercedes-Benz is going to go up in the next four years, I might mean that I think Mercedes are becoming scarce, and therefore its value is going to go up. Or I might mean I think the value of the U.S. dollar’s going to go down, and therefore the Mercedes-Benz is going to retain value better than the dollar. Both have the same effect, but they mean very different things.

The minute you start talking about the gold price, it means you also have to understand what you’re pricing it in. In this case, most people price it in U.S. dollars. So you cannot start an analysis of gold without first analyzing the U.S. dollar. So I’ve spent a lot of time and effort trying to figure out how the dollar’s intrinsic value changes over time.

My own view is that a currency’s intrinsic value declines proportional to its inflation rate. We have to be very careful here because a lot of people, when you talk about inflation, think about price changes — or price inflation. When I talk about inflation, I’m talking about monetary inflation, changes in the money supply. So my belief is that a currency’s intrinsic value declines in proportion to an increase in the money supply.

If that’s the case, then whenever I want to think about the changes in value of gold relative to the U.S. dollar, I have to take into account the change in the intrinsic value of the U.S. dollar as a result of U.S. monetary inflation, the increase in U.S. money supply. But I also have to take into account the change in the intrinsic value of gold as a result of the change in the gold supply.

If gold is money, then its intrinsic value will decline as the supply of gold increases. So you have to know what the U.S. money supply is and how does it change from year to year. You also need to know what is the gold supply, and how does that change from year to year. So by looking at the change in the U.S. money supply and the change in the gold supply over the last 100 years, I’ve come up with a chart that gives me the change in the intrinsic value of gold vis-a-vis the U.S. dollar over the last 100 years, purely and simply as a result of the relative inflation rates of the two currencies.

And based on that, I think gold’s probably worth about $1,000 an ounce right now in U.S. dollars.

It was worth about $913 last year, and it should be about 5% higher this year. Call it $960 — could be a little bit higher — but it’s close to $1,000 an ounce. That’s accurate enough for most purposes.

The Daily Reckoning: Do you think that gold will, in fact, decline to that level?

Paul van Eeden: This is where I always find people misinterpret what I’m trying to say. I’m saying that in my opinion, I think gold is worth $1,000 an ounce. I’m not saying that gold is going to decline in price to $1,000 an ounce. I have no idea what the gold price is going to do. The gold price might decline to $700 an ounce. It might turn around and go back up to $1,800 an ounce. I have absolutely no idea.

What I do know is if I think it’s worth $1,000, I’m not going to buy it when it’s $1,200 an ounce. If the gold price declines below $1,000 an ounce, I’ll be inclined to buy some — not because I think it’s going to go up, but because I think it is underpriced. If gold continues to decline, I’ll buy more, again without any consideration for when the price of gold is going to go up, merely as a function of the fact I think the value of gold vis-a-vis the dollar goes up steadily from year to year.

And let’s say in theory, hypothetically, it goes up by, say, 4-6% a year. Let’s average that out and say every year it goes up about 5%. Well, if I can buy gold at a 10% discount to its value and it increases at 5% a year, and I keep holding it, eventually I’m going to be doing OK. But if I buy it at a premium to what I think it’s worth, even if it continues to appreciate in value against the dollar, I might actually lose money, depending on how large that premium is.

The Daily Reckoning: That’s an important distinction. Finally, to wrap up… would you explain what measure of the money supply you use for our readers? You call it the “Actual Money Supply,” correct?

Paul van Eeden: Yes, my measure of money supply is very simple. It’s the actual amount of money that’s in the economy and available to the economy. So in other words, it’s notes and coins. We all use notes and coins, all the money supply measures use notes and coins. It includes all of your bank account deposits — your checking account, your savings account, your term deposit account. I’ve never met anybody who believes the money they have in their savings account isn’t money or isn’t theirs or they cannot spend it. Similarly with term deposits. So I count all those things. But I don’t count anything else. I don’t count money market mutual funds, I don’t count other financial instruments, because they’re not money, they’re assets. And most other measures of money supply include items that are not money, but are assets.

The Daily Reckoning: Thanks very much, Paul. That’s a good place to stop today.

Regards,

Paul van Eeden
for The Daily Reckoning

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