What should gold buy?

Apr 3, 2013

Buenos Aires, Argentina

Dear readers ask about gold. Is it time to sell? To buy? To forget about it?

Gold fell $25 yesterday; it now stands at $1,575. The price could break all the way down to $1,000. But we don't expect it. Gold is not in a bubble.

As you have seen, gold is neither over-priced nor under-priced. It buys about what it should buy. Maybe a little less. Maybe a little more.

How do we know what gold "should" buy?

We don't really. But gold is a natural thing. It is pulled from the earth by people, using the technology and resources available to them. As their productivity in other areas goes up, so does - generally - their ability to extract gold from the ground.

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If GDP goes up 10%...the quantity of gold usually goes up about the same amount. If the economy goes into a decline, so does the gold mining industry...reducing the rate of growth of the gold supply.

For these reasons - that gold production usually is in sync with other production - the supply of gold is usually more or less in sync with the supplies of other goods and services. And the exchange rate between gold and other goods and services is usually stable.

This was also the observation of Roy Jastram who wrote "The Golden Constant" in 1977. Jastram looked at 500 years of English history. He found prices - in terms of gold - were remarkably stable.

And here we see that prices for stocks, too, were also stable...as long as gold - rather than an economist - stood behind the currency.

You can see for yourself, prices for stocks only went haywire after the US formed the Federal Reserve System, and then the world went off the gold standard during WWI. It was partly the struggle to get back on the gold standard that set off the bubble of the '20s.

Then, there was another big run up of stock prices - in terms of gold - in the '50s and '60s...and again in the '80s and '90. The chart also shows the Dow/gold ratio heading down for the last 13 years...with no clear sign that it has reached the bottom.

But wait. Hasn't most of the profit for gold buyers already been made? Takeo da Silva explains:

    In response to that, the Pareto Principle suggests that 80% of the gains are found in the final 20% of the bull market. As it currently stands, the dow/gold ratio is sitting at roughly 9-to-1. A move to a 5-to-1 ratio, would require a $2907 oz. gold price, a 3-to-1 ratio $4845 oz., and a 2-to-1 ratio would require a stunning $7268 oz. gold price.

    A 2-to-1 ratio move from here equates to a 400% move higher in gold, and of course, a 1-to-1 ratio ($14,500 oz.) would equate to an over 900% move left remaining in the gold bull market.

Mr. da Silva does not say so, but the Dow/gold ratio could come down in another way. Gold does not have to go up in price; stocks could fall. If the Dow were to slip to 8,000, for example, this would be equivalent of a 5-to-1 ratio.

When the stock market cracked in 2000...and gold continued to rise...we thought the two were headed for an historic conjunction. Perhaps at 2-to-1. Perhaps at 1-to-1. Where would the two meet? We guess it would happen at about 5,000. Gold would rise to $5,000...and stocks would fall to 5,000.

Or, at 2-to-1 the Dow could fall only to 10,000...while the gold price rose to $5,000.

Who knows? But there is no reason to think that things have changed in any fundamental way. Gold is still real money. It is still brought forth only with much effort and investment. And the Dow stocks represent a certain group of assets, from which you can expect a certain income stream. There is no reason to think that the basic relationship between the Dow stocks and gold has been altered in any fundamental or everlasting way.

For practically the entire 19th century, and many years of the 20th century - and as recently as the early '80s - the Dow's income stream was capitalized at fewer than 5 ounces of gold. Will it once again trade for 5 ounces of gold or less? Almost certainly. And it will probably happen before this historic drop in the Dow/gold ratio has reached its final bottom.

Hold your gold. Sell your stocks. Floss your teeth. And be happy.

Bill Bonner is the President & Founder of Agora Inc, an international publisher of financial and special interest books and newsletters.

Disclaimer: The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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2 Responses to "What should gold buy?"

Shashidhar S.M.

Apr 4, 2013

Mr, Bill bonner, What do you say about this repected article posted on seekingalpha:



R N Gandhi

Apr 3, 2013

There is a definite link between inflation and the gold price. I have been observing that years back a middle class family of 5 could live in Rs. 250/- per month. And I distinctly remember the gold price then was Rs. 250/- per 10 gms. Today middle class family requires Rs. 30000/- to live and the Gold price also rules around Rs. 30000/-.

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