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Gold looks expensive

Here are some charts that put the current price of gold ($1750/oz.) in perspective.

In nominal terms, gold is very close to its all-time high of $1900/oz. Since its low of $254 in early 2001, gold has risen at a compound annual rate of 17.8%. That's almost hard to comprehend, until you compare it to AAPL, which has posted an even more incredible 42% compound annual growth rate over the same period.

In constant dollar terms, gold today is below its all-time high set in early 1980. But relative to the average real price of gold over the past 100 years, gold is trading at a premium of 230%.

It's not a coincidence that periods of strongly rising real gold prices have corresponded to periods in which Federal Reserve monetary policy was "easy," and falling real gold prices only occurred when the Fed was "tight." When individuals perceive that the Fed is oversupplying dollars to the world by keeping real interest rates very low, they tend to react rationally, seeking out and paying a premium for gold for its ability to maintain its purchasing power over long periods. In contrast, when money is tight and real interest rates are high, gold loses its luster as investors prefer financial assets.

This chart compares gold to a basket of non-energy industrial commodity prices. Note that gold and commodities tend to track each other over time. But note also that the right-hand y-axis of gold prices spans a range of 250 to 2000—a difference of 8 times—while the left-hand y-axis of commodity prices spans a range of 200 to 800—a difference of only 4 times. Gold prices have been far more volatile than commodity prices.

When we compare gold prices to crude oil prices, however, the two are very close to their long-term average relationship, in which one ounce of gold buys about 19 barrels of oil. Using Arab Light crude prices, the ratio today is one ounce to 15.4 barrels, which means that gold is a bit cheap relative to crude. But that is mainly due to the fact that Arab Light crude is trading at a substantial premium (about 27%) to American crude as traded on NYMEX because of geopolitical concerns. The ratio of gold to NYMEX crude is a little less than 20 today. On balance, let's just say that gold and crude oil are trading fairly close to their long-term average relationship.

If the Fed continues its massively accommodative monetary policy, gold prices conceivably could move higher. But I think that would require some evidence that inflation is picking up, and that evidence is still lacking. In my view, gold is essentially priced to a significant increase in inflation already. The premium that investors are willing to pay for gold today (defined as the amount by which today's price exceeds the average historical real price) is almost as much as it was in early 1980, when inflation had already attained double-digit levels.

By this same logic, if the Fed were to even suggest that it is contemplating a reversal of its quantitative easing (which could be accomplished by raising the rate it pays on reserves, or by draining reserves), then gold would be quite vulnerable to losses. Gold today is a very expensive inflation hedge.

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