Gold Price and the Money Supply

by: Adam Katz December 02, 2008 | about stocks: GLD    

Adam Katz

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For the past few weeks, I have spent a lot of time thinking about the valuation of gold. I have been struggling to figure out a metric for calculating how much demand the price of gold is discounting. Before I get into the details of this fairly simplistic approach, let me first explain this method in relation to equities.

When valuing an equity, it is fairly easy to see the relative demand for the security based on how much someone is willing to pay today for the security, relative to known earnings. Of course I am talking about the P/E ratio. While I see strategies of targeting purchases based on P/E ratios as being of little value, the underlying idea remains true. That is that a low P/E stock relative to comparable companies is cheap, while a high P/E is expensive. There is one discrepancy to clear up and that is that by using historical earnings, new information may distort P/Es. For example, a company reports earnings of $1 per share and then a few weeks later lands a deal that will double earnings for the foreseeable future. The price and the P/E ratio would advance significantly even though the security may still be cheap relative to future earnings.

Applying the P/E Concept to Gold

Valuing gold is very difficult because there are no underlying cash flows. In fact, the only cash flows that you can identify are negative (storage and security costs). So I have been looking for the underlying determinants of gold price. The problem - there are so many factors that determine the price of gold. After considerable thought, I decided to look at the money supply, a popular gauge used by speculators as to determine the future price of gold.

I also had to decide on what version of the money supply to use. Based on the data available I had to use M1, M2, MZM, or True Money Supply (TMS). I chose to use TMS, also known as Austrian Money Supply, after giving the matter a lot of thought (see Rothbard, Schotek). I also ran a study using M3 as I expected the bugs to give a lot of criticism had I ignored it. What I found was an R2 of 0.146 for TMS and 0.173 for M3. This shows M3 to be a slightly better predictor of gold price than TMS, but still not very significant. Either there is another, more relevant factor, or there are many factors and I would expect money supply to be one of the larger inputs. One could argue that the value of the dollar is a huge factor but for the purposes of this study it is irrelevant. The factors that affect dollar price would then have to be broken down to find the main determinant - which I would expect to be money supply in the long term. Immediately I observed the complexities of determining gold's price and how money supply is only part of the story.

click to enlarge images

Taking the Study Further

After deciding on TMS, I moved on. I wanted to see the premium that gold had historically traded at relative to TMS. I started by creating a TMS Index and a gold price Index - I did this by fixing the January 1971 value of both series to 100 and then building a new series using those derived values to the present day. I then subtracted the TMS index from the gold price index and plotted the new series. In theory, this should represent how gold has historically been priced relative the true money supply. What I found was very interesting.

My Analysis

I learned several things by doing this study. Firstly, the peak hit in 1979 was a bubble and using that inflation adjusted high as a target for gold price today is simply incorrect. Secondly, moves in gold price appear to come before moves in the money supply. In other words, gold is the leading indicator for money supply - not the other way around.

The implications for these observations are as follows. Firstly, the premium of gold price over TMS today shows that gold is discounting a future increase in the money supply - a pretty drastic increase. This leads to the second implication which is that the money supply can expand now without gold necessarily increasing in value. This is precisely what happened in the 1980's. True Money Supply grew 108.23% over the decade while gold price lost 39.64% of its value.

It's also interesting to note just how good a buy gold was in 2002-2003. Even though the money supply had been expanding for some time, the index spread was back to par. That shows just how much opportunity cost the market was pricing in terms of holding gold - Everyone wanted into equities and there was little demand for the precious metal.

Does This Mean That Gold Is Going Down?

Not exactly. All this tells us is that based on price, gold is already pricing in a sharp increase in the money supply. Should the money supply increase more than gold is already pricing in, gold can rise. It could also rise based purely on irrational exuberance as investors run to gold and the spread could increase further - but that is a bubble waiting to burst unless money supply grows rapidly.

If the index spread was zero today (if gold price tracked TMS perfectly), we would see a gold price of $385 per ounce. This is based on a 1018.0% increase in the TMS since 1971.

My advice is to find alternative ways to play the rising money supply. Identify assets/companies that will be affected and try to deduce if its current price is discounting a rapid increase in the money supply. Although both risky plays, treasuries and real estate are both on the opposite end of the spectrum. That being said, both have external risks outside of the money supply (i.e. quantitative easing and over supply in a slowing economy respectively).

Then there's the Nouriel Roubini opinion - that the Fed will be able to mop up a lot of the excess liquidity. After all, most of it is just sitting in excess reserves in the banking system. If that is the case then gold can move significantly lower as expectations of money supply increases diminish. What about the fiscal deficit? Ask Japan who is sitting with a debt-to-gdp ratio of 175% and isn't being forced to monetize their debt.

The 12 Trillion Pound Gorilla

The reason that things may be different in this scenario is that people may really start questioning the dollar as a reserve currency. I don't personally see the dollar losing its reserve status but I respect the argument. What I see as more likely is the dollar being one of several reserve currencies (likely with the Euro, and either the Yen, Yuan or an Asian currency basket). Such a move would really hit the dollar and send gold up in dollar terms. However that would alleviate a lot of the market's worries and gold globally could actually come down off such a development. That being said, we could also be moving to a new era where historical ratios are meaningless and the amount of inflation priced into gold is dwarfed by what actually comes. For this reason I am currently neutral on gold out of fear that the world as I know it is changing.

Disclosure: no positions

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This article has 36 comments:

  •  
    Dec 02 06:41 AM
    Your second to last sentence is most telling: "That being said, we could also be moving to a new era where historical ratios are meaningless and the amount of inflation priced into gold is dwarfed by what actually comes."

    All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident.
    Reply | Link to Comment
  •  
    Dec 02 07:20 AM
    That last paragraph, and those last sentences, were surprising in the context of the rationalism that had preceded them, and indicate a wholesome respect for a possible black swan on the horizon.
    Reply | Link to Comment
  •  
    Dec 02 08:09 AM
    Isn't that what the Nov. 15 meeting was all about? A new financial order where the us dollar is not the sole reserve currency? As you say, in that situation the pog should rise!
    Reply | Link to Comment
  •  
    Dec 02 08:21 AM
    Your thesis makes sense and IMO correctly explains the runup in gold into March '08; everyone was expecting a massive inflationary response to the credit crisis. "Inflationary expectations" were high. This was clearly visible in gold and later in oil. Always remember, the Fed officials regularly refer to that phrase. Markets run on business fundamentals, corruption, and psychology. Right now, it's mostly about corruption and psychology.

    "Inflationary expectations" have been allowed to recede by allowing deflationary pressures to build and begin to express themselves. IMO this is no accident. People now see the monster that wants to eat them, and there is readiness among the general public to accept a massive inflationary response. Remember Trichet's inability to overcome German resistance and lower rates earlier in this crisis? Where is that German resistance now?

    One weakness of your analysis though is that your time period is way too short to be of predictive value. It doesn't include any periods of actual deflation nor any periods of central bank pursuit of extreme measures such as the quantitative easing that has recently begun. When the Fed cracks open an ink jug and pours it into the printing press, that to gold smells like blood in the water. We are just now starting that process in earnest.
    Reply | Link to Comment
  •  
    Dec 02 09:00 AM
    Take a look at the Most Popular list at the top right column of the page, as it is always so interesting. The 2nd most popular item is "Last Thursday Was The Bottom- It's Time To Get Back In. Well, if you read it and got in on Friday.....sorry. Maybe today is the bottom???
    Truth is that everyday, and intraday headlines shout out various things. In fact, this morning today's headline in my daily paper said that we are in a recession! Who knew?
    Of course anyone breathing air already guessed that month's ago...just had to use some common sense. So it goes with inflation and the eventual rise of gold. Common sense. When will we see the definitive headline? Long after you have any chance of making any money from it! Remember Paulson's, and President Bush, and your brokers comments on the economy? "The fundamentals are strong", they declared, until your nest egg was wiped out.
    The "experts" on tv told you to keep your money in the market remember? They told you that over the long term the Dow outperforms everything. Now they are telling us we lost 11 years of growth...
    I am just saying that there are times in your life that you need to use your own judgement.
    Disclosure: Long Gold, unfortunately short the dollar....
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  •  
    Dec 02 09:18 AM
    SWRichmond,

    I rarely say this, but I think you are completely wrong. Firstly, as incompetent as the central authorities are, I do not in any way believe that there is a conspiracy to have inflation which is what you are implying. In fact, I believe the situation to be quite the opposite.

    In a credit based system such as ours, the Fed actually WANTS us to expect inflation - it's the only way that we will consume today instead of saving. If the public expects inflation then there is no need for ACTUAL inflation. They'll only choose to bring about inflation when there is an actual need to stimulate short term demand.

    Earlier this year there were inflation expectations. With the exception of shadowstats implied M3 (which I believe myself to be a useless measure due to it's inherent nature to double count), the money supply actually contracted violently over the summer. Had they tightened earlier this year we would be in big trouble right now. The only thing that worried me then, and now, is will foreign countries keep buying U.S debt to feed the deficit or will it have to be monetized.

    Lastly, time period. Before 71 gold was fixed for 25 years and before that was a very different era. I don't doubt that in the past gold held far more monetary significance, but using that data in a time series analysis would give skewed results for current times.

    We don't have a time in our recent history where we had such a serious financial and banking crisis leading to deflation and deleveraging where the Fed started printing - so I apologize if I didn't include such an event in my analysis. The closest we have is the great depression where the money supply was not expanded which lengthened the depression and Japan (Asian financial crisis) where they pumped in a fortune of liquidity and today sit with a debt-to-gdp of 180%. At the time, Japan's actions certainly seemed inflationary yet today, 17 years later, they've averaged -0.5% y/y CPI after substantial quantitative easing AND rates at 0% for years.

    There are two differences with the Fed. Firstly, they are admittedly doing more than Japan because all of the liquidity Japan pumped in was still not enough to get out of deflation. Secondly, Japan bailed out ALL companies while the Fed is being slightly more selective and trying to let companies fail that pose no systematic risk.
    Reply | Link to Comment
  •  
    Dec 02 09:25 AM
    The flaw in this analysis is it does not account for the massive deleveraging taking place. Gold is correcting. If a new basket of currencies does become the world standard, who do you think will want dollars? The strongest currencies will prevail and gold may become a part of that standard not as a currency but as a holder of value. I do not believe we will go back to the gold standard but i do believe some modification of it will occurr.
    Once the deleveraging process ends, massive inflation will take place, only to be held in check by massive deflation....one neutralizes the other....unless the minimum wage goes to 20us/hr. :)
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  •  
    Dec 02 09:29 AM
    Kelly,

    I'm not saying that what Bernanke is doing will work, he doesn't even know. But given current information it is a better approach than simply allowing everything to crash. Allowing everything to crash works in a system that is backed by gold in the first place. When everything was leveraged so high, allowing things to crash would set us back 50 years in terms of real wealth.

    Also, the thesis of my article is that gold is already overvalued and is pricing in a lot of credit expansion because EVERYONE is buying it. I'm sorry to tell you that you are not using your own head but rather following the crowd. If it wasn't for retail investment demand last quarter, gold's price would be significantly lower.

    For the record I haven't been short the dollar for a few months now but I am a long term bear.
    Reply | Link to Comment
  •  
    Dec 02 09:36 AM
    cruiser,

    Deleveraging has only just begun. I definitely agree that this deflation is caused by deleveraging - I just think that it has a long time to go. As equity values have come crashing down - D/E ratios have skyrocketted. On paper, companies are more leveraged today than they were before the crisis began. Cash is king during deleveraging. This gives some attraction to gold as well as it has value as a currency. However, cash, the asset being demanded in exchange for deleveraging, should outperform all other assets. Will this end with it being the peak value of cash? I don't doubt it...
    Reply | Link to Comment
  •  
    Dec 02 10:04 AM
    One way to value gold is not based on its increase, but rather its lack of decrease.

    Gold is simply a way to store wealth that isnt diminishing in buying power over time.

    Compare it to dollars, that are inflating at a rate of almost 18% a year, thus losing value at a rate of 18% a year.

    Gold isnt being inflated.

    2000 years ago an ounce of gold would fully clothe a man in the finest robe, sandals, hand crafted belt etc.

    Today that same ounce of gold will clothe a man in similarly fine attire.

    It holds buying power (and no I am not talking about shot 20 year cycles...thats what people focus on because in an inflationary economy ROI sucks up all of the common mans attention).

    Thats its value.
    Reply | Link to Comment
  •  
    Dec 02 10:15 AM
    Good article Adam. Nice analysis on the monetary aspect of gold pricing. There are other factors at play as well, which your correllations indicate to be the case. What impact the other factors will play in gold's price have yet to be seen. Chief among these factors would be:

    1) Flight to safety. This played some role in the March '08 run-up in gold with the Bear Stearns' crisis following Countrywide funding issues. More recently US debt has played a larger role for flight to safety, to the point where it is barely a breakeven proposition to own very short term treasuries.

    2) Dollar reserve status. This interplays with 1) and could be significant in the future. My guess is that both will be driven by the world's creditor nations. If they lose faith in the dollar (and US debt by association) then gold's history as a store of value will see significant moves into gold and out of dollars/US debt.

    While some 'basket of currencies' may replace the dollar for reserve status, there is a cultural bias toward gold in the creditor nations. They have a LOT of money sitting in dollars/US debt and even a partial move into gold in a short period could produce very much higher gold prices. We are starting to see the beginnings of such a move now. Iran has moved its reserves into gold, China has hinted that the dollar is unsuitable as a reserve, some of the middle eastern states have floated the idea of a gold backed currency and rumors of the same are seen from Russia.

    Will those very high gold prices last? Possibly not, but future events will drive the height and duration of any bubble. While it's very likely a bust in a gold bubble may happen, the final gold price in dollars will likely settle to something much higher than it is today if our creditors disgorge a significant portion of the dollar reserves they are sitting on now.

    The dollar will lose value, eventually. The FED/USTreasury's current actions make that highly likely. It has already lost 95% of it's purchasing power in the past 95 years and the FED has started printing much faster these last two months than they ever have before.

    Once monetary inflation of this magnitude is begun it is nearly impossible to reverse. The Trillions applied in bailout schemes are needed just to keep a small number of businesses afloat. Trying to sop up these amounts will pull the rug out from under the big money banks. They need this money until they can generate enough profit to put their balance sheets back in the black. That will be some time and until that happens those same big money banks will be leveraging those amounts to loan out and generate those profits.
    Reply | Link to Comment
  •  
    Dec 02 10:22 AM
    Adam,

    Then we will simply disagree. Central banks want to inflate, must inflate, and want to do so stealthily. A long-term solution to the US federal debt problem, a steady, stealthy debasement, was well underway until the credit crisis shined a bright light on USDX. Currency debasement benefits the government more than it hurts them. It works better when the public has no "inflation expectations".

    The concept revolves around the need to pay off debt: either we can produce enough excess to pay off debt, or we can render the present value of the debt meaningless by inflation.

    Debt levels appear to be unserviceable, witness bank failures and mortgage foreclosures. How do you suggest the debt will be paid? Productivity gains?
    Reply | Link to Comment
  •  
    Dec 02 10:36 AM
    "Central banks want to inflate, must inflate" - SWRichmond


    Here, here!! It's what they do.
    Reply | Link to Comment
  •  
    Dec 02 10:59 AM
    SWRichmond,

    Firstly, let me say that under normal business I believe the government's intention is to pay off debt through productivity gains. However, I agree that these aren't normal times and that the government debt has ballooned to very high levels. Let me point out two things. Firstly, timing of this implosion is impossible. You could still be sitting on seekingalpha making these claims in 10 years time when debt-to-gdp is sitting around 200%.

    Secondly, my focus is on using gold to hedge this event, which I think is very much priced into the gold price already. I see the the size of the U.S debt, so does the rest of the market. We all know the problems this will represent in the future and the size of the unfunded future liabilities. The dollar bear fundamentalists have all found their way into gold, pushing up gold's value and pricing in an increased probability of the event occuring. My whole argument is to look for other ways to play the flooding of the money supply because the gold space is already quite crowded - mostly by retail specs
    Reply | Link to Comment
  •  
    Dec 02 11:07 AM
    "My whole argument is to look for other ways to play the flooding of the money supply" - Adam

    Short US debt. There are inverse ETFs for this purpose. I believe TBT is one.

    This would also be a good position for profiting from the demise of the dollar or implosion of USDebt. I would expect a bit of a stampede out of USDebt when it becomes too obvious for even foreign central banks to ignore the FED is printing with abandon.
    Reply | Link to Comment
  •  
    Dec 02 11:23 AM
    Adam,

    Your point is well taken; I am one of those dollar-bear fundamentalists and also have a built-in distrust of central banks and the idea that something as big as an economy consisting of billions of minds can be successfully "managed". I don't think it can, so this entire credit crisis, for me, is one giant confirmation.

    I am, however, constantly looking for well-thought-out alternative views; I am very well aware of confirmation bias. I also agree that timing the implosion is impossible; however, the pace does seem to be picking up a lot, doesn't it? This is very visible in the Fed's actions, in Paulson's Panics, and in the sudden and obvious willingness of central banks and governments worldwide to shovel cash out the door. I am still trapped in confirmation; everything I see makes perfect sense. I am still able to discern no deviation from the path. Believe me, I am looking.
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  •  
    Dec 02 11:25 AM
    P.S. The opportunity to have a dialog of sorts with intelligent people here at SA is one way I "look". Thanks for sharing.
    Reply | Link to Comment
  •  
    Dec 02 11:41 AM
    "I also agree that timing the implosion is impossible; however, the pace does seem to be picking up a lot, doesn't it? This is very visible in the Fed's actions, in Paulson's Panics, and in the sudden and obvious willingness of central banks and governments worldwide to shovel cash out the door." - SWRichmond

    The central bankers of the world are either all incredibly foolish or incredibly shrewd. Time will tell which is closer to the truth.
    Reply | Link to Comment
  •  
    Dec 02 11:45 AM
    For those who like to see different analytical viewpoints on pricing gold give this a look:

    www.321gold.com/editor...

    It makes some interesting observations about the impact of central banking on the economy over the course of American history.
    Reply | Link to Comment
  •  
    Dec 02 11:49 AM
    Third possibility: They believe they have no choice, and are hoping to tether it on the other end once inflation has taken hold.


    On Dec 02 11:41 AM Smarty_Pants wrote:

    > "I also agree that timing the implosion is impossible; however, the
    > pace does seem to be picking up a lot, doesn't it? This is very visible
    > in the Fed's actions, in Paulson's Panics, and in the sudden and
    > obvious willingness of central banks and governments worldwide to
    > shovel cash out the door." - SWRichmond
    >
    > The central bankers of the world are either all incredibly foolish
    > or incredibly shrewd. Time will tell which is closer to the truth.
    Reply | Link to Comment
  •  
    Dec 02 11:54 AM
    Smarty Pants,

    I own TBT but I am skeptical of that play for now. How is the government debt going to be monetized? By buying long term government bonds to keep the yield low. That will eventualyl blow up in their face, but unfortunately timing is very uncertain.

    SWRichmond,

    Recognizing our own biases is the only way to be objective. I was personally long both gold and silver last year. Gold I was out before year end and silver I exited at $21.50 (to the sound of the bugs ridiculing me). What's funny is that I bought for the exact reasons that we are talking about now and now I'm not buying even though things have only gotten worse. For me it's a value issue, not an issue of arguing the fundamentals (which are quite obvious at this point).

    Alternatives are hard to come by and are different for different people. If you have a lot of money and can borrow at reasonable rates, then selectively borrowing to buy real estate could prove to be very profitable in the long term. It's one of the best ways to store long term capital and to actually get a loan only due in 30 years. I specifically would borrow to do so (although you should have the wealth to back your loans - no leverage) because you are expecting that 30 years from now the dollars that you have to repay will be worth nothing. I'm not only talking attractively priced residential real estate, but raw land and agricultural land as well. If you can get a USD loan to buy land in a foreign country, even better. That being said, be cautious on valuation and realize that in the short term these assets will likely decrease in value.
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  •  
    Dec 02 12:12 PM
    Agreed. It may be too early for a fearless jump into TBT. I keep the idea in the back of my mind for now, simply because it is an easy way to play rising interest rates of foreigners start balking at Treasury auctions.

    As for diversification, any tangible asset that is reasonably priced is a good idea, even better if it is productive. Timberland is another possibility. Trees keep growing regardless of the money supply. I'm not familiar with what financing terms might be for raw timberland though.

    Here is something I have found that you may find attractive as a diversified tangible asset that will provide a return as well: teak trees

    tropicaltreefarms.com/

    I have begun buying a 'crop' every year as a self financing stream of retirement income. If things work out, I will have a permanent annual income starting in about 14 years. I don't borrow to fund it though, I use savings.

    Gold isn't the only game in town. :-)
    Reply | Link to Comment
  •  
    Dec 02 01:09 PM
    How about the white elephant in the financial system: Derivatives Collapse.com

    (the $1/2-1 QUADRILLION derivaties bubble).


    On Dec 02 07:20 AM Roger Knights wrote:

    > That last paragraph, and those last sentences, were surprising in
    > the context of the rationalism that had preceded them, and indicate
    > a wholesome respect for a possible black swan on the horizon.
    Reply | Link to Comment
  •  
    Dec 02 03:50 PM
    I had a thought about FRB that I'd like to pass along for comments. Why do we have deflation when loans are repaid under FRB? Ans: Because the money goes back to where it came from, nothing. But what if the money was instead DISTRIBUTED pro rata to every checking and savings account in THAT money (e.g. dollars for the US)? This would, in effect, repay the source of the purchasing power of those loans with no contraction of the money supply. No more business cycles. Instead we would have increases in the money supply equal to the amount of bank loans a year. This is equivalent to creating new money equal to the loans as they are made, distributing it pro rata among the current holders (except currency, alas)and then loaning it out immediately afterward. As the loans are repaid money is shifted from the borrowers to the original owners of the new money. In case of defaults, the collateral would be sold and distributed in the same way repaid money is.
    Would this be inflationary since the money supply always increases? Maybe, if the increased supply of money chases the same supply of goods, for instance. But even so, no one would suffer since every money holder is proportionately repaid as the loans are paid off. At most, increased prices that all the money holders now have the money to pay.

    I guess when FRB was invented these details were considered prohibitive.
    Reply | Link to Comment
  •  
    Dec 02 04:29 PM
    "But what if the money was instead DISTRIBUTED pro rata to every checking and savings account" - moonbat

    Trades one problem for another. New pro rata deposits not only increase the money supply, but also the base upon which FRB can leverage. Money supply would increase exponentially in no time.

    Initial deposits = 100, Initial loans = 900, loans repaid, deposits = 1000

    Next round of loans = 9000, loans repaid, deposits = 10,000,

    Etc. etc.

    Money supply has grown 100 fold in two rounds of loans. Zimbabwe here we come.
    Reply | Link to Comment
  •  
    Dec 02 05:14 PM
    Smarty,

    I was about to say "What would limit new loan and thus new money creation? Good question."

    I don't think this system needs FRB since it allows for new PERMANENT money creation while FRB creates temporary money. I always think in terms of 100% reserves anyway by default. No FRB for me.

    Thank you very much for that comment.
    Reply | Link to Comment
  •  
    Dec 02 05:29 PM
    Smarty,

    A kinda of a bust today in my thinking today (caused by a previous unsustainable boom). But I thought I would throw out that banking idea anyway lest it perish with me.
    Reply | Link to Comment