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# somrh (86.13)

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August 07, 2012 – Comments (6) | RELATED TICKERS: GLD

This is a continuation of a series dealilng with the question: What is gold worth? The first blog I looked at the so-called Shadow Price of Gold and concluded that it is not a terribly good predictor of the price of gold. To the extent that it is, is due to the fact that M0 (the monetary base) is correlated with the price of gold.

There are fundamentally two ways to define inflation.

1) An increase in the money supply.

2) An increase in the price level.

We'll briefly look at both.

Gold and the money supply

There are a few ways to measure the money supply. One is the monetary base or M0 which turns out to have a nice correlation with the price of gold.

As can be seen there is a decent linear relationship between the price of gold and the monetary base. I included a zero intercept line which, although it does not fit as well, there are theoretical reasons why it ought to. The interesting thing is that the zero interecept line suggests that gold is fairly valued presently.

Gold and CPI

There is also a nice relationship between gold and CPI.

Although the power law was a slightly better fit than linear, the relationship is almost linear.
This model suggests that gold is substantially overpriced right now.

Conclusion

Looking at both money supply and consumer prices, it appears there is a nice correlation between the price of gold and inflation. There are, however, some concerns I have with using gold as an inflation hedge. But I will leave that for another post.

#### 6 Comments – Post Your Own

#1) On August 07, 2012 at 5:11 PM, somrh (86.13) wrote:

After taking a closer look at the Gold vs M0 chart, I suspected that the fit was largely driven by the few outliers. The data in that chart goes from 1971 (Nixon shock year) to 2012. If I go from 1971 to 2008, the r^2 is only about 0.32 indicating less of a (linear) correlation.

This all leads me to believe that the model is fairly suspect. One significant criticism to my approach is that I'm seeking to find relationships in one set of data without testing it on another set of data. Ideally I should be dividing up the data set into two parts so that I can find a relationship in part 1 and "test" the relationship in part 2. Unfortunately the data set is somewhat small so dividing it might cause more problems than it would help.

Nonetheless, there is still good evidence that there is a correlation between the price of gold and inflation indicating it can be utilized as an inflation hedge. Whehter any of the above can be used to actually model a "fair value" for the price of gold is suspect.

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#2) On August 08, 2012 at 8:36 AM, ryanalexanderson (< 20) wrote:

Gold is best thought of as a stagflation hedge.

The only stagflation hedge.

Oil and commodities are probably better pure inflation hedges.

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#3) On August 08, 2012 at 10:59 AM, somrh (86.13) wrote:

ryanalexanderson:

I'm curious as to what you mean by "stagflation hedge". The best I can come up with is that you suspect there's a relationship between the price of gold (or returns on gold) and the rate of unemployment. Unless you're referring to the "high inflation" aspect to stagflation. Perhaps you can clarify.

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#4) On August 08, 2012 at 12:02 PM, ryanalexanderson (< 20) wrote:

Yep, happy to elaborate.

There's no explicit employment relationship to my opinion. Basically, I picture my investment universe as a 2x2 grid: economy growing vs economy shrinking, and loose vs tight monetary policy.

Economy growing/tight monetary policy: great for stocks, dividend paying stocks in particular. Purchasing power is preserved, and you get all the upside.

Economy growing/loose monetary policy: great for commodities, which remain in demand despite their increasing sticker price.

Economy shrinking/tight monetary policy: Bonds! No risk exposure, and your purchasing power is preserved.

Economy shrinking/loose monetary policy: Gold. It's the only commodity that doesn't rely upon economic consumption for its value, but you can still hide away from reckless monetary policy.

Of course, the hard part is trying to guess the swings between the four corners of this universe!

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#5) On August 10, 2012 at 3:03 PM, somrh (86.13) wrote:

ryanalexanderson,

That's interesting. If you haven't seen this gold model (see here) David Merkel suggests that the "deflator" used in the formula is similar to average GDP growth. I'm wondering if the model could be improved by factoring in an actual (present) value for GDP growth.

My attempts to come up with something haven't amounted to much.

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#6) On August 10, 2012 at 10:17 PM, ryanalexanderson (< 20) wrote:

Thanks! A good read. Best of luck building a model around a GDP NPV value - sounds ambitious.

On another note, I like the takeaway points of the article that your link cited in its first sentence.

I agree whole-heartedly with every one:

----------------------------

The first and perhaps the most significant is that gold isn’t tied to inflation. It’s tied to low real rates which are often the by-product of inflation. Right now we have rising gold and low inflation. This isn’t a contradiction. (John Hempton wrote about this recently.)

The second point is that when real rates are low, the price of gold can rise very, very rapidly.

The third is that when real rates are high, gold can fall very, very quickly.

Fourth, there’s no reason for there to be a relationship between equity prices and gold (like the Dow-to-gold ratio).

Fifth, the TIPs yield curve indicates that low real rates may last for a few more years.

The final point is that the price of gold is essentially political. If a central banker has the will to raise real rates as Volcker did 30 years ago, then the price of gold can be crushed.

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