Friday, 4 December 2009

Gold in Terms of the S+P

The chart[1] shows the value of Gold in terms of the S+P index (Gold / S+P) and the long term perspective shows clearly that Gold was at its most valuable(relative to the stock market) both in the deflationary 1930s and inflationary 1970s . Gold is not just a hedge against inflation; it’s a store of value in many difficult periods. Looking at Gold versus the dollar is only part of the story. If the dollar is weak then a strong Gold may simply represent that phenomenon and so comparing Gold to a basket of currencies is more illuminating. Gold relative to the S+P is a way of judging how well Gold compares to other paper assets (It would be better to look at Gold versus a world stock market index , denominated in a basket of currencies, and that may be studied later.)

When Gold was at its strongest , it was roughly 4-6 xs greater than the S+P.

1932 S+P 4.5 Gold 20.67
1938 S+P 8.5 Gold 35
1980 S+P 110 Gold 800

When Gold was at its weakest, it was 1/3 or 1/6 of Gold

1966 S+P 110 Gold 35
2000 S+P 1500 Gold 250

We are at the half way point, roughly at 1:1 i.e. Gold 1200 S+P 1100

If you believe that the crisis has further to go, irrespective of it being a deflationary or inflationary environment, Gold does have the potential to climb considerably higher relative to stocks. Whether that means Gold at 3000 and Stocks at 700 or Gold at 700 and S+P at 175 I have no idea, but in historical terms Gold is merely at an average valuation.

Deflationary Scenario

This is not so problematic. You simply hold gold and cash pay down debt and wait it out .Jonathan[2] Wilmot has written an excellent piece arguing that the fears of a large monetary overhang are greatly exaggerated. It can take many years for this to play out but the motto is simply stay out of the market

Inflationary Scenario

In principal this is much tougher for several reasons. Everything is going up and Gold will outperform stocks but of course the gains will be subject to taxation. It will be hard to have an after- tax real gain. More importantly, if we were to move into hyper inflation then the exit strategy from holding gold is far more complicated. The hyper inflation in Germany ended in 1925 when Germany rejoined the Gold Standard with a new currency of 4.2 Reichsmarks to the dollar. It had left the Gold Standard in 1914 with the same exchange rate of 4.2 Deutschmarks. If you had held gold, you would have had huge profits in local currency but if you hadn’t exchanged the gold for hard assets before the new currency, all you would have been left with is a lump of gold. This is the key point. In the unlikely, but still frightening scenario, of wild money-printing , Gold only acts as a stepping-stone. At some point it will be necessary to sell the Gold and buy property or land, otherwise when a new currency is introduced all you will be left with is Gold valued at an exchange rate commensurate with several years earlier. In that environment, as in Germany 1925, there was a great shortage of the new currency and so Gold was not nearly as valuable as rent – producing assets. It was the industrialists and “insiders” who survived the inflation, because they owned land , property and factories and borrowed at artificially low interest rates from the central bank.

Simon GILLIS 4 xii 2009

Other references.

T.J. Sargent, The end of four big inflations’, 1986
C.P.Kindleberger, A financial History of Western Europe 1993

[1] Bloomberg
[2] CSFB Market Focus-Long Shadows ; The Sequel Nov 30, 2009

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