Is Gold Cheap Enough to Yet?

July 5, 2013 at 08:06


You’re cheap. You’re so cheap that your clothes went out of style in the Roosevelt administration. Teddy Roosevelt’s administration. Cheap. When someone asks you for three cheers, you only give two.

So when you look at the price of gold and notice that it’s nearly 35% off its record high, you’re intrigued. Is it cheap enough to buy yet? While there are several ways to answer that question, the answer is probably “not quite yet.”

Gold currently sells for about $1,242 an ounce, down sharply from its 2011 high of $1,895. Whether that’s cheap or not is hard to say, because putting a price on the intrinsic value of gold isn’t easy. Unlike stocks or bonds, gold doesn’t pay any interest or have any earnings, which is how people evaluate many investments.

Gold is prized for its beauty and rarity, one reason it’s been used for centuries as a medium of exchange. All the gold on the planet would fill an NFL football stadium to a depth of about five feet. Gold is also easy transported, something that other pretty and rare things, such as whooping cranes, can’t claim.

In theory, gold becomes more valuable when the value of paper money declines, typically, through inflation. In practice, the argument hasn’t held up that well. In 1981, when inflation raged at 10.4%, gold ended the year at $398 an ounce. In 2009, when the nation endured falling prices, or deflation, gold ended the year at $1,088, up 30% from the year prior, according to the World Gold Council.

Gold’s most recent tumble occurred during a period when the Federal Reserve has been purchasing securities with what is, in essence, freshly printed money. If anything should produce inflation, the Fed’s quantitative easing policy should do exactly that. But the consumer price index, the government’s main measure of price increases, has risen just 1.4% the past 12 months, the price of gold has swooned, and the value of the dollar has risen on international markets.

One way to try and value gold is to consider its average value over a long period of time, since prices tend to move around their long-term average, or mean. If prices are far above average, you can expect that they will eventually revert to their mean by falling. The same is true if they are far below average, except that they will revert to the mean by rising.

Gold has averaged about $532 an ounce since 1978, again using figures provided by the World Gold Council. We can adjust those prices by inflation, even though that ignores the fact that gold prices should adjust themselves for inflation. Doing so gives us an average price of about $812 per ounce, still well below current levels. Normally, a reversion to the mean has to start from a place far below the mean — not $400 above it.

We can kind of get to an undervalued level if we assume that gold has gained an average 7.5% or so a year since 1978, and its tumble from its 2011 top has been severe, to say the least. On a short-term percentage basis, if you squeeze your eyes and wish really hard, gold might be undervalued. On the other hand, it may simply be backing off from a strong, sharp rally. It’s not that hard to look at a five-year chart of gold and be reminded of a five-year chart of the Nasdaq from 1996 to 2001.

You can also argue that gold is a good deal now because of future expected inflation, which means that you’re smart and the gold market, the bond market and the currency market is dumb. This may be true, but it’s not a proposition you should stake your retirement on.

If you’re a hard-core bargain hunter and have money you can afford to lose, you might take a look at gold mining stocks, which is a bit like sorting through week-old peaches to find which ones are still edible. Many of them are, indeed, cheap, at least by conventional measures.

Consider Barrick Gold (ticker: ABX), the world’s leading gold producer. The stock sells for less than its book value, which is the value of its assets minus liabilities and some squishier assets, such as goodwill — the value of a company’s reputation. Most companies sell for somewhat more than their book value. Most gold miners, Barrick included, sell for less than book value.

The company is also cheap relative to earnings: It sells for 4.7 times its estimated 12 months’ earnings. PE is a measure of how cheap or expensive a stock is: Lower is cheaper. A 4.7 PE is exceptionally cheap.

Cheap stuff tends to have worrisome problems, and most gold miners have problems. The main one is, of course, that it’s hard to find and extract gold — and expensive, too. Barrick expects to produce gold for about $950 to $1,050 per ounce this year, which is swell when gold prices are $1,600 and rising. When they’re $1,242 and falling, investors start to get worried that the company’s cost of production will exceed the price of gold. Shutting expensive mines costs money, and re-opening them isn’t cheap, either.

Gold miners have another problem, which is that they, like gold, haven’t behaved as predicted. If you can produce gold at $1,000 an ounce, then your earnings should double if gold rises from $1,200 to $1,400. Stock prices are supposed to follow earnings. But gold mining stocks lagged gold’s spectacular rise in the earlier part of the century.

For patient stock-pickers, gold mining stocks may have some prospects. It’s certainly better to buy them when they’re beaten down than when they are on the rally. The question is whether or not they have been beaten down so much that they’re candidates for reverting to the mean. Right now, the stocks may be cheap, but the metal itself might not be cheap enough yet.