Gold is regarded by pundits, financial advisors and mainstream commentators as a commodity, and evaluated as such. However, in the humble opinion of Yours Truly, Gold is an asset with intrinsic value, constant marginal utility and no counterparty risk, making it money and not a commodity. And this begs the question, how should we value and trade Gold if we consider it to be a currency?
Since this issue is widely miss-understood even by self declared financial experts, I’d like to explain six different complementary approaches to measure the price of gold, which I personally use to allocate my assets properly.
1. Adjusted to classic inflation
The simplest way to valuate Gold is against the M1 Currency Supply, or in other words, adjusted for classic inflation, which is the increase of the currency supply, and not rising prices. Rising prices are the symptom of inflation, not the other way around.
A price chart adjusted to the M1 Currency Supply will display the price of Gold in such a way that each bar is adjusted for the amount of US Dollars in circulation, and thus, weighting the price of Gold against the available currency to bid for it.
To plot the Gold price adjusted to the M1 Currency Supply, just go to Trading View and plot the following formula on a Weekly or Monthly Chart: XAUUSD/M1.
Using this approach, we express the price of Gold in constant dollars instead of letting inflation skew the picture: the value of the US Dollar is ever changing and we need to adjust for that fact. Gold can very well be at nominal all time highs and still be cheap, it all depends on how much currency is circulating.
The inflation adjusted price of Gold is near all time lows.
2. Measured against Oil
The second approach is to calculate how many barrels of Oil we can buy with an ounze of gold. This method provides valuable information because energy producers get paid for their exports in US Dollars, but don’t hold them for very long. Instead, they redeem those US Dollars for physical Gold in the Futures Market, which timely deliveries are guaranteed by the US Treasury.
To plot the Gold price in barrels of Oil, go to Trading View and plot the following formula on a Weekly or Monthly Chart: XAUUSD/USOIL. You’ll find out a clean and predictable trading range going back forty years.
Since big energy producers want to hoard Gold and not US Dollars, any sustained increase in the price of Gold will cause energy producers to raise prices for their exports, thus perpetuating this relationship.
We can safely assume these ratios to time our bullion purchases.
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- XAUUSD/USOIL at 20 Gold is fairly priced relative to Oil
- XAUUSD/USOIL > 20 means Gold is overpriced relative to Oil
- XAUUSD/USOIL < 12 means Gold is cheap relative to Oil
At the time of writing, the price of Gold relative to Oil is somewhat expensive.
3. Measured against Silver
Measuring Gold against Silver is something every trader does, regardless his knowledge about Gold as a monetary asset. We just have to divide the price of Gold by the Price of Silver to come up with the Gold to Silver Ratio, currently sitting at 85.40. Go to Trading View and pull up a symbol called “GoldSilver”.
Gold and Silver are mined out of the ground at a 1:10 ratio, however they don’t trade that way because Gold has a strict monetary demand while Silver has both industrial -fluctuating- and monetary demand. But also because the Paper to Silver Ratio is twice the Paper to Gold Ratio, meaning that more physical deliveries are made for Gold than for Silver, and this artificially depresses the price of Silver, as twice the amount of outstanding contracts are settled in cash.
At the time of writing, Gold is expensive relative to Silver. I would place the mean Gold to Silver ratio at 60. This, however, could change dramatically if the world loses confidence in the US Dollar.
4. Measured against US Treasury Gold
This approach involves calculating the ratio between the US Treasury Gold holdings (at market price), reportedly 261,5 million ounzes, against the FED Liabilities, which is the M1 Money Supply.
To understand this approach you need to know some basic accounting. For an institution or company to be solvent, it needs to possess more assets than liabilities. In the case of the Federal Reserve Bank, its liabilities are the Federal Reserve Notes (US Dollars) issued, and its assets are the US Treasury Gold holdings. US Dollars are actually IOUs of the Federal Reserve!
In light of this, you can perform basic math to find out how many ounzes of Gold the FED has backing up the IOUs it has issued, and come up with the Gold price needed should the FED announce a return to a Gold Standard this weekend.
Some of you might say that the FED has other assets in the balance sheet, and I’ll concede that point. However all other assets are expressed in IOUS which the FED itself issues, and accounting rules and common sense make crystal clear that you can’t owe anything to yourself. For all intents and purposes, All other assets in the FED’s balance sheet should be ignored.
So, this is how we calculate the price of gold needed to restore a Gold Standard:
\[ \frac{M1CurrencySupply}{TreasuryGoldInOunzes} \]
At the time of writing, the M1 Currency Supply is 3,875,600,000,000 US Dollars, or 3,875.6 billion Dollars, and it claims to have 261,500,000 ounzes of Gold. All we need to do now is run the above formula to come up with the required price of gold to restore a Gold Standard.
\[ \frac{3,872,600,000,000}{261,500,000} = 14,809.17 USD \]
Therefore the monetary price of Gold at the time of writing is 14,809.17 USD.
Other way to explore this same relationship is to calculate how much of the existing M1 Currency Supply could the FED cover with its Gold holdings at the current market price, expressed in percentage points. The resulting ratio can be understood as the assets-to-liabilities ratio of the FED, or the amount of financial leverage the market is allowing the FED to operate with.
\[\bigg(\frac{TreasuryGoldInOunzes*GoldSpotPrice}{M1MoneySupply}\bigg)*100 \]
At the time of writing, the price of Gold is 1,487$ per oz and the M1 Currency Supply is 3,872,600,000,000 US Dollars, so let’s find the actual solvency of the FED using the formula above.
\[ \frac{261,500,000 * 1487}{3,872,600,000,000} * 100 = 10,05 \]
Therefore the FED could cover only 10,05% of the M1 Currency Supply with its current Gold Holdings, at the current market price.
Using this ratio has yet another advantage: we can plot it in Trading View as a custom chart and extract historical conclusions. The FED did not always have 161,5M ounzes of Gold, but this chart will be accurate from the 1980’s. Go to Trading View and plot the following custom chart: XAUUSD * 261500000 / (M1*1000000000) * 100.
The above chart coincides with our manual calculation of 10,05%. These calculations could also be made against the amount of paper money in currency in circulation, instead of the M1 Currency Supply. However, I contend that bank call deposits are just as readily available as cash for Gold purchases and prefer to run this calculations with the M1 Currency Supply only.
At the time of writing, Gold is extremely cheap relative to the M1 Currency Supply.
To run these calculations yourself, get the M1 Currency Supply from here.
5. Measured against the National Debt
If the M1 Currency Supply represents the current amount of circulating US Dollars, the US National Debt represents the future amount of circulating US Dollars. The US National Debt is a promise of future inflation, because the dollars needed to pay it do not yet exist.
Please note that I am using the classic definition of inflation, which is the increase in the money supply. The possibility of productivity keeping up with the increase of the money supply does not invalidate the fact that the money supply will increase.
Just as we did before, we are going to calculate the Gold price needed for the US Government to pay off the National Debt with its current Gold Holdings. At the time of writing, the US National Debt stands at 22,504,300,500,000 US Dollars.
\[ \frac{USNationalDebt}{TreasuryGoldInOunzes} \]
\[ \frac{22,504,300,500,000}{261,500,000} = 86,058.51 USD \]
At 86,058.51 USD per Ounze, the US Govt could pay off the US National Debt in full. Of course, if this ever happens, the creditors will experience a loss of purchasing power equivalent to a default. What of what magnitude? Let’s find out.
Other way to look at it is to calculate what portion of the US National Debt could the US Government settle today, liquidating it’s Gold Holdings, expressed as percentage points. At the time of writing, the price of Gold is 1,487$ per oz.
\[ \bigg(\frac{TreasuryGoldInOunzes*GoldSpotPrice}{USNationalDebt}\bigg)*100 \]
\[ \frac{261,500,000 * 1487}{22,504,300,500,000} * 100 = 1,72 \]
And we have our answer. The US Govt would be able to pay off just 1,72% of the National Debt with its Gold Holdings. Fashionably, we can also plot this ratio on a custom chart. Go to Trading View and plot the following custom chart: XAUUSD * 261500000 / 1000000 / GFDEBTN*100.
This chart speaks to the magnitude of a National Debt default or re-structuring: 98.24% of the principal would be lost by the creditors. Every time the price of Gold ticks higher, it amounts to a partial default of the National Debt.
At the time of writing, the US Government has lots of credibility on its National Debt, making Gold extremely undervalued relative the the outstanding National Debt.
6. Measured against stocks
There is an invisible pendulum that swings relentlessly throught the ages from quality money to quantity currency, across multiple civilizations. The pendulum is there and yet it swings so slowly that entire generations forget about the nature of money and financial assets. Eventually currency becomes so worthless that holding financial assets no longer makes sense, as saving to manufacture or renew capital goods becomes impossible, and productivity slowly collapses.
Nothing captures this pendulum better than the Gold to Stocks Ratio. All we need to do is measure the price of Gold in shares of different stocks indices. For example, the DJIA 30, SP500 or Nasdaq 100.
Take for example the Gold to DJIA30 chart posted below. To examine this chart for yourself in Trading View, bring up a custom chart and calculate “XAUUSD/DJI”.
This particular chart is eye opening about where is the aforementioned pendulum located right now. Gold has never been this cheap relative to stocks, except for the period between 1997-2003.
Conclusion
The value of Gold can be calculated using many different and complementary approaches, assuming one considers Gold to be a currency. At the time of writing, everything points to Gold being severely undervalued.
Do you think Gold is cheap or expensive? Post your thoughts in the comments section below.
Thanks! At this point in time, the best strategy for gold is just buy physical and stack it. Keep buying. Don’t trade gold to make dollars, it makes no sense given the marginal utility of the dollar at this point.