A Return To Highs
The authors also examined what would happen if gold went back to its previous highest real price. If that occurred, it means the price of gold would again have reached about $2,080.
Erb and Harvey then looked at what would happen to real and nominal returns on gold if we assumed inflation of 2 percent a year for the next 10 years. Why 2 percent? It’s roughly the difference between the yield on 10-year Treasurys and 10-year TIPS, as well as similar to the consensus forecast of economists gathered by the Federal Reserve Bank of Philadelphia.
They found that the golden constant value of gold would increase from $825 an ounce to $1,006 an ounce, and the “overshoot” price would rise from $350 an ounce to $427 an ounce. If, over a 10-year investment horizon, the price of gold fell from $1,096 an ounce to $1,006 an ounce, it would experience a nominal return of ‐0.9 percent per year and a real return of ‐2.8 percent per year.
If the price of gold dropped from $1,096 an ounce to its 10-year “overshoot level,” the nominal and real returns would be ‐9.0 percent per year and ‐10.8 percent per year, respectively. Keep in mind that, regardless of the future inflation rate, the real rate of return is ‐2.8 percent per year if gold falls to its golden constant fair value over the 10-year period.
Erb and Harvey concluded that, even though there is little relation between the nominal price of gold and inflation when measured over 10‐year periods, the evidence suggests that gold does hold its value over the very long run.
For example, in a prior paper, they presented historical evidence that the wage of a Roman centurion (in gold) was approximately the same as the pay earned by a U.S. Army captain today. They also showed that the price of bread (in gold) thousands of years ago is about the same as we would pay today at an upscale bakery.
The conclusion we can draw is that, while gold might protect against inflation in the very long run, 10 years is not the long run. As Erb and Harvey note: “In the shorter run, gold is a volatile investment which is capable and likely to overshoot or undershoot any notion of fair value.”
I’d add to that another insight that becomes important in the long term. While the laws of economics can be defied in the short term, history demonstrates that investors ignore them at their peril. For instance, a basic economic principle is that, over the long term, prices tend to move toward the marginal cost of production.
In its “2013 Outlook,” Goldman Sachs estimated that the marginal cost of producing gold is less than half the current price (around $750 an ounce). The financial services firm also observed that more than 80 percent of gold production costs less than $1,000 an ounce—or about 10 percent below the current price. Another important point to consider is that, unlike with other commodities, all the gold that’s ever been mined is basically available for sale today.
And, as Dimensional Fund Advisors’ Weston Wellington recently pointed out: “It’s also conceivable that a significant real price increase would encourage development of electrochemical extraction of the estimated 8 million tons of gold contained in the world’s oceans, dwarfing the existing gold supply.” That’s a lot of supply that could potentially hit the market.
The bottom line is that, while my crystal ball always remains cloudy, based on the fundamentals and the historical evidence, there doesn’t really seem to be a case that gold is likely to provide strong investment returns, even though it has already fallen about 40 percent from its peak nominal value (and even more in real terms). Forewarned is forearmed.
If you have been considering an investment in gold—perhaps you see the 40 percent drop from its high as a buying opportunity—hopefully the information in this article will enable you to make a more informed decision.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.