Is Gold Still Underpriced?

Gold has been the heart of monetary systems for 5000 years, and gold’s purchasing power has remained stable for 5000 years. The future value of gold is based upon the following mathematical realities:

1)		The purchasing power of the dollar. 1972 dollars will now purchase only 20cents worth of goods and services. Since the Federal Reserve System was founded in 1913, the value of the dollar has lost 98% of its purchasing power (meaning that today’s dollar will only buy 2 cents worth of the goods that the 1913 dollar would buy). A continuation of the depreciation of the value of the dollar will provide for a continuation of an increase in the value of gold relative to the dollar’s purchasing power.

2)		The supply and demand situation of gold. Much of the gold mined around the world is mined in countries with unstable governments. That already has, and will continue to, affect the supply side (the availability) of gold. The World Gold Council estimates the current new global gold supply to be 3,859 tonnes annually. Demand is estimated by them to be 3,754 tonnes annually providing a surplus of 105 tonnes of gold. Orientals love gold, and they are far and away the largest current consumers of gold. China has a dollar surplus in their monetary reserves of $1.2 trillion, and the surplus is growing at a rate of more than $200 billion annually. China is intent upon becoming a world power. Even though their GDP is only the size of the state of California, China’s dollar currency reserves put them in a position to begin backing their currency by gold, through the use of those reserves, by purchasing gold. If the price remains stable at $700 an ounce, and if China used only $200 billion annually to purchase gold, in five years China would accumulate more than 50,000 tonnes of gold. The U. S. gold supply is currently 8,200 tonnes representing 25% of the world’s monetary gold supply. In the 1940s the U. S. gold supply was more than 30,000 tonnes. While it is not realistic to assume that spending $200 billion a year would yield China more than 50,000 tonnes of gold in five years, large purchases by a country like China would rapidly increase the price of gold. In five years China, even with increases in the price of gold, might be able to pass the U. S. as the largest owner of monetary gold reserves in the world. No country in history has become a world power without a dominant position in three things: trade, gold and military. Purchasing gold by China would be a very smart move because that would add an element of stability to the value of their currency which does not currently exist. Their situation is comparable to what Japan faced in the 1960s before Japan started to accumulate large positions in gold with their excess monetary reserves.

3)		The math of our monetary system. In the 1930s and 1940s the U. S. owned 60% of the world’s monetary gold. Each dollar in our money supply during those times could be converted into gold on a dollar for dollar basis. If one divided our entire M3 (money supply) into our gold supply, the dollars could be converted to gold on a one to one ratio. Now with the money supply (M3) at $10.8 trillion, and with 8,200 tonnes of monetary gold in the U. S. supply, each ounce of gold would represent $49,889 ($10.8 trillion ÷ $216.5 million ounces of monetary gold).

To summarize:

Number one, above, should alone account for a relative increase in the value of gold. Number two is probably happening. China set up the Shanghi Gold Exchange because of an increasing demand for gold two years ago. If the public realizes what has happened to their currency by the government, and if the public ever understands the math in number three above, the potential for a stampede to purchase gold and silver could reach frenzied proportions.

Question: What is the upside for gold per ounce?
Answer: $50,000.

Question: Huh? Is that realistic?
Answer: In a monetary panic, yes. Under present day circumstances, $2,500 an ounce to $5,000 an ounce, is realistic.

Question: Why is it “realistic” that gold might go as high as $5,000 an ounce?
Answer: Three things have happened in the history of money: (1) monetary conditions remain stable as they were in this country from the 1792 Currency Act to the creation of the Federal Reserve System in 1913; (2) there is a currency “bust” in the economy (which would produce the $50,000 value per ounce of gold mentioned above); (3) a balance between stability and panic. Gold is the anchor. When monetary systems have historically found themselves in trouble, there has always been a sudden focus upon gold to provide stability. If one believes that a ratio of gold of one ounce to $50,000 is in balance, the price of gold will remain as it is today. If the consumer/citizen feels an imbalance in the credit backing of his country’s currency, man has always chosen to return to gold and silver. Based upon the doubling of the gold price in the last few years, there is strong evidence that the citizen/consumer is purchasing gold and silver for storage. When acquired for storage, one is said to be “hoarding” money. Hoarding money takes it out of the economic system for use on a daily basis. That increases the demand for gold and silver and bids up their prices. A shortage of currency circulating in the economy because of hoarding means less cash circulating for business purposes. A shortage of cash can create panics which further drive up the value of gold and silver. So for this country to reach a “balance” in the security behind its currency, one could see an increase in the price of gold to $3,000, $4,000 or $5,000 an ounce.

What’s happening to the stock market?

The market is very strong and in a persistent uptrend. Persistent uptrends are created by continuous record increases in an index like the Dow Jones Industrials on a daily basis. We now have a run of persistent increases that’s staggering. In the month of April, so far, the Dow Industrials has closed at a new record high in 18 out of the last 20 sessions. There has never been a series like this before.

Question: Isn’t this like stacking building blocks on top of each other? When too many blocks on top of each other forces the Dow to crash, how far down will it go?
Answer: Good question. There will be a sell off. Like the value of gold mentioned above, equilibrium in the upward pace of the market will cause it to level off and rest for a while. It is interesting to note that from these values in terms of price earnings ratios and current dividend yields, we are in a market similar to 1998. There was a rapid acceleration in the Dow in 1999 and 2000 until the Dow reached it’s apex of 11,722 points before selling off. If we are in a similar market condition to 1998, the market’s values are currently at the beginning of a run to more than 14,000 points. As pointed out in previous articles, for the 11,700 point market that existed in 2000 to be adjusted for inflation, the market would be revalued to just over 14,000 points. A market frenzy like 1999 and 2000 would push the Dow well beyond 14,000 points.

Question: The Dow has had a rise of 850 points to 13,100 from 12,250 points when this run up started. If we had a sell off now, what could we expect?
Answer: It’s common for the Dow to lose half of that increase of 850 points. That would put the market in the 12,700 point category. That is known as the “floor” in Dow Theory Analysis. Dow Theory Analysis says to watch that 12,700 point area and see if the market can hold above it. If the market proceeds to remain at or above that point of 12,700 on the Dow, a floor is established for a climb to higher levels.

April’s market has been an upward explosion. The world economy has enjoyed great prosperity and growth the last 20 years. India and China alone, representing 1/3 of the earth’s population, are sources of growth for the next 20 years, or more. The U. S. economy is the engine that drives this machine, and U. S. must therefore not fall into recession. Dr. Ben Berneke, the new fed chairman, has engineered an increase in the money supply, coupled with low interest rates, that favors continued economic prosperity. The fact that all three Dow Averages (industrials, transports, and utilities) continue to record new record highs clearly points to the new primary trend of the market as being bullish. The bear market is over.

The dollar has been sinking rapidly. Our major cities are full of foreigners on shopping sprees because their money goes so far in the U. S. Construction is booming in the major cities around the world, particularly the Far East.

In the midst of all this prosperity and this rosy economic outlook, we do have these situations: large federal deficit spending; record trade imbalances causing the dollar to go down in value relative to other world currencies; a dependency upon borrowing the world’s savings (last year we borrowed 80% of the world’s savings to cover our spending deficits); a hurting housing industry; and threats of a recession.

It would be wise when purchasing stocks in this market to continue to purchase well known companies with world markets that pay a good dividend and have a record of increasing dividends.

It’s also wise to further narrow one’s expectations in purchasing stocks by looking beyond just the dividends, and picking only A-rated companies with historically low price earnings ratios.

Carpe Diem.
George Rauch
April 27, 2007

....