Gold prices are down about 17% year to date, while the S&P 500 is up about 13%. Before you plunge in to buy on the dip, let’s take a closer look at whether (as Bob Barker would say) the price is right.
How can you measure gold’s true worth?
In a previous post, I explained how commodities can be difficult to value because of their lack of conventional cash flows. For example, gold doesn’t pay interest, dividends, earnings, or rent. In fact, if you buy gold bullion, you’d actually incur costs to store and protect it. This makes traditional discounted cash flow analysis techniques pretty much useless.
A simple and intuitive alternative is to just compare market prices to an inflation-adjusted trend price. As a scarce and valuable resource, gold prices should at least keep pace with inflation (all else being equal, of course).
With that in mind, take a look at the chart below. It plots nominal gold prices from 1950 to the present (in blue).
Also included are three hypothetical trend lines:
- Trend 1 (in red) shows what gold prices would be if they simply grew with annual inflation.
- Trend 2 (in green) shows what gold prices would have been if they grew at a real annual growth rate of 1%.
- Trend 3 (in purple) shows what gold prices would have been if they grew at a real annual growth rate of 2%.
Historically, the average real annual growth rate for gold has been around 200 basis points. Based on that norm, gold prices still look high.
Keep in mind that even a small change in assumptions can make a big difference. For example, plotting a real 3% trend line would make current prices look low. The point is that fair value estimates for gold can be highly subjective and sensitive to assumptions. That said, having some point of reference is better than none, and is certainly more informative than simply looking at market price by itself.
How to play gold’s latest moves
Whether you think gold prices are high or low, there are a number of ways to gain exposure to the precious metal. One of the most popular choices is the SPDR Gold Trust (ETF) (NYSEMKT:GLD) exchange traded fund. This ETF is designed to track the price of gold bullion. While many commodity exchange traded products use derivatives to create synthetic asset exposure, this ETF is backed by physical gold bullion. This minimizes tracking error concerns and makes the SPDR Gold Trust (ETF) (NYSEMKT:GLD)fund a pure play on gold.
Another choice is the Powershares DB Precious Metals Fd (ETF) (NYSEMKT:DBP) exchange-traded fund. This ETF is designed to track the performance of the precious metals market. It tracks the futures prices of both gold and silver, the two most prominent precious metals. This is a less concentrated play on gold compared to the SPDR Gold Trust (ETF) (NYSEMKT:GLD). And as noted above, the use of derivatives means that this Powershares DB Precious Metals Fd (ETF) (NYSEMKT:DBP) fund may not always mirror the price movements of the underlying metals.
One additional choice is the SPDR S&P Metals and Mining (ETF) (NYSEARCA:XME) exchange-traded fund. This ETF is designed to track the performance of the metals and mining industry. It holds 40 stocks of companies that have exposure to the mining of precious metals. Of the three funds, this one is the loosest play on gold. However, the stocks included in this fund are clearly impacted by gold prices, and thus should provide indirect exposure to the precious metal.