Inflation is not nearly high enough to justify gold’s recent rise to a new all-time high. That’s the conclusion I draw from research conducted by Campbell Harvey, a Duke University finance professor, and Claude Erb, a former commodities portfolio manager at TCW Group. Their study, entitled The Golden Dilemma, was published a decade ago in the Financial Analysts Journal.
The researchers started with the core idea made famous by Roy Jastram in his book “The Golden Constant” — that gold
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over long periods of time maintains its purchasing power. That is, its real price over the long term will be constant. Therefore, when gold’s real (inflation-adjusted) price surges over shorter time periods, odds are good that it will eventually come back down. Likewise, when gold’s real price declines significantly it eventually will rise again.
Harvey and Erb developed these insights into a model based on the average ratio of gold’s price to the U.S. Consumer Price Index. In their model, it is this ratio that exerts a gravitational pull on gold’s real price: When the ratio is well below that average, gold is undervalued and expected to rise in real terms. And when the ratio is well above that average, as it is today, gold is overvalued and expected to decline.
Since 1975, the average ratio of gold’s price to the Consumer Price Index is 3.9 to 1, Erb said in an email. That is far lower than the current ratio of 6.5-to-1. Instead of its current price of around $2,000, bullion would be trading at $1,190 an ounce if gold were trading at its average gold-to-CPI ratio.
The chart above plots gold’s historical price along with similar calculations of gold’s fair value for each month since 1975. Here are the three past occasions in which gold was more overvalued relative to inflation than it is today:
- The early 1980s
- 2011
- Late 2020 and 2021
Harvey and Erb’s study began circulating in academic circles in 2012, soon after the second of these three occasions. Over the subsequent three years, gold’s real price fell by nearly half.
The implication of this research is that, at a minimum, gold investors should at least prepare for the possibility that gold’s fate in coming years will be similar.
Other ways to value gold
You may disagree with the assumption that gold’s price is a function of inflation. But none of the other models that Harvey and Erb analyzed fared any better than their gold/CPI model, and many performed far worse. Readers are directed to their study for a more extensive analysis of those other models; below is a list of those they analyzed:
- Gold is a hedge against currency devaluation
- Gold is an attractive alternate to assets with low real (inflation-adjusted) returns
- Gold is a safe haven during periods of geopolitical stress
- Gold should be held because the world is moving towards a gold standard
- Gold is “underowned” and will appreciate as more investors decide to allocate some of their portfolios to gold
You shouldn’t be surprised that gold has become so overvalued relative to inflation. All assets, not just gold, experience wide swings between periods of over- and undervaluation. Now just happens to be one of those times in which gold is overvalued.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com
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