Is Gold Overpriced?

Is Gold overpriced?  This article answers the question two ways.  First how is gold priced compared to similar composites?  Second, what would happen if Gold was indeed overpriced?   From the early 2000’s the price of gold has seen a dramatic rise from $250/ounce to $1,200/ounce.  This paper will address whether gold may be headed for a bubble.

 

Source:  www.goldprice.org

The recent price increase seems reasonable when taken in the context of the current macro economical and geopolitical situation.  The following reasons are commonly cited for owning gold:

1. The Federal Government is taking on significant debt.  (Dickson, 2010)  Monetizing this debt may ultimately lead to inflation.  Gold is a hard asset rather than a fiat currency, and should act as an inflation hedge.
2. Outsourcing has increased the wealth of China and India and both countries place high cultural value on gold.  Increased wealth in these countries will increase the worldwide demand for gold.
3. There is fear that the United States may face social unrest as a result of extreme opposing ideologies.  During a collapse in society, gold is a stable monetary instrument.  Gold’s historical role, durability and finite quantity make it an ideal monetary instrument during times of uncertainty.

While the above reasons seem rational, behavioral finance may provide reasons why the increased price of gold is irrational.  Increased TV, Internet, and radio advertising may be increasing the general awareness of gold leading to availability bias.

Gold is a precious metal and does not have an underlying value like equities.  However, one measure of gold’s value is the ratio of the price of gold to the price of silver.  If people are using precious metals to hedge uncertainty, then the price of silver should rise along with the price of gold.  Historically, the ratio between gold and silver has been 16:1 (Seeking Alpha, 2010) mostly due to the fact that gold and silver exist in the earth with similar ratios.  Since 2006 the ratio has been around 55:1.  As the ratio increases gold has greater relative value compared to silver.

 

Source Yahoo! Finance using ETF for GLD and SLV

The current ratio being 66:1 leads to the concept of Ellsberg’s Paradox being a factor in such irrational thinking.  If precious metals are seen as a hedge against uncertainty, then the same assumptions should be used for silver as for gold.  However, silver is currently undervalued in relation to gold.  A continued increase in this ratio would signal irrational behavior.

One other aspect that may point to irrational behavior is the role of Exchange Traded Funds (ETF) like GLD.  Previous to 2003, if you wanted to buy gold as an individual investor you either had to buy it from a company and have it delivered by money or you went to a local coin dealer and both sources charged a relatively high transaction fee.  To sell gold you also had to work with similar institutions and incur a transaction fee.  In addition the gold needed to be either hidden in your house or locked in a safety deposit box at a local bank.  This slowed down the number of transactions and limited the market to serious investors.  With the advent of ETFs, people could buy shares of gold from their desk at work with the click of a button.  Additionally the shares were subdivided into units of 1/10th of an ounce.  This lower price point and increased convenience has brought in new in-experienced investors.

 

Gold Held in ETFs (Money Markets)

Investing in ETFs may be the result of several biases that would point to irrational behavior.  Bounded rationality where people do not understand the fundamentals of gold may cause new investors to make poor decisions.  The endowment effect may provide personal satisfaction for some people by owning gold.   With ETFs, the gold is stored in a vault and the owner will never even see the gold.  Additionally, the claim that gold can be traded for food during a collapse in society does not hold true if the gold is held in an ETF.

The biggest impact of the ETFs in relation to asset bubbles is the increased liquidity.  The same convenience that brought new investors into the market will work against the market during a sell off.  In 2008 the worldwide production of gold was 75 million ounces (Gold Sheet Mining, 2010).  In 2009 the combined holding of the ETFs was close to 50 million ounces and the number is still growing.  This means that during a panic selloff, the world’s supply of gold could almost double with a click of a button.