In August 2015, Erb and Harvey updated their paper. They begin by examining the argument that gold is an inflation hedge, or what they call a “golden constant.”
The authors explain: “One way to think about the golden constant perspective is as a collection of statements that assert that: 1) over a very long period of time the purchasing power of gold remains largely the same; 2) in the long run, inflation is a fundamental driver of the price of gold; 3) deviations in the price of gold relative to inflation will be corrected; and 4) in the long run, the real return from owning gold is zero.”
The study covered the period beginning in January 1975. The authors found that, over the period, the average real price of gold is 3.46 times the U.S. Consumer Price Index (CPI). In June 2015, the CPI level was 237.8. Multiplying gold’s average real price by the current CPI (3.46 x 237.8) delivers a price of approximately $825. This represents what the nominal price of gold should be today—if we assume the real price of gold is constant.
Of course, over time, prices have strayed far from the golden constant. And, as Erb and Harvey note, the golden constant isn’t a fact, just a hypothesis.
But if your reason for buying gold is that it’s an inflation hedge, your expectation should be that gold will revert to its golden constant over time. And despite haven fallen from its peak of almost $1,900 in September 2011 to stand at about $1,100 as I write this, it’s still about 20 percent above the golden constant.
When Gold Deviates From Its Constant
Erb and Harvey then asked: If the golden constant provides a guide to the value of gold, what typically happens when the price of gold is above or below its golden constant value? They found that the high real price of gold has been about 8.73, the low real price of gold has been about 1.47, and that the current real price of gold is about 4.63.
The charts they present show that while there is a tendency to revert to the golden constant, the price of gold can vary greatly from the golden constant, and stay well above or below the constant for a long time. And as they note, there is no way of knowing if the “future high and low real prices of gold may be more or less extreme than in the past.”
The authors add: “The high and low real prices of gold highlight that even if there is on average a golden constant the real price of gold has strayed, and probably will stray, far from this possible central tendency. It is also possible that the future will be unlike the past.”
They thus warn that if the “real price of gold falls, the golden constant level is not a floor—a protective line in the sand that the real price of gold will not cross.” With this caveat, they did go on to examine the outlook for gold returns given where the price is relative to the golden constant.
Expected Returns To Gold
Erb and Harvey examined what happened to the return on gold when prices were above or below the golden constant. As you might expect, they found that “below average real gold prices have been followed by above average 10-year real gold returns and above average real gold prices have been followed by below average 10-year real gold returns.” Because the real price of gold is currently above its historical average, this “suggests that over the next 10 years real gold returns could be below average.”
Erb and Harvey also looked at the downside risk of owning gold. To do so, they asked the question: How low might the price of gold go if the previous low real price of gold is revisited? Given the value of the U.S. CPI for June 2015 and the previous low real price of gold, a possible low price for gold is about $350 an ounce.
This, of course, does not mean that the price of gold will immediately decline to $350 an ounce. Rather, it’s a suggestion that, given the volatile history of real gold prices, because the real price of gold once fell to 1.47, it could fall to that level again.