According to Warren Buffet, “Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.” Gold’s main role is as a store value, so it needs to be scarce. And it is: all the gold produced throughout history could fit into a cube 25 meters a side, which is roughly a third the volume of the Arc de Triomphe or the Washington Monument.
Demand ultimately sets the price for gold and market sentiment is the principal driver—the darker the economic mood, the higher gold price. And once in a while, gold can embark on a sentimental journey that truly has a life of its own, untethered from fundamentals and common sense. Yes, even one of nature’s heaviest substances can form a bubble.
The last time a real gold bubble inflated was in January 1980, when it hit 850 US dollars per ounce and delivered a 100% annual return for 1978 and 1979. Despite setting a new all-time record recently at 1,064 US dollars an ounce, gold is still far away from matching that thirty-year-old bubble. Considering the purchasing power of 850 US dollars in January 1980, an ounce of gold would have to sell for roughly 2,360 US dollars to equal 1980’s punch, another 120% from its current levels.
While this comparison is certainly a useful one, we can even dig deeper by looking at an equilibrium value for gold. A word of caution first: unfortunately, unlike dividend discount models for equities, or purchasing power parity models for currencies, there is no universally accepted equilibrium model for gold.
But several economists have come up with an intriguing approach to modeling gold’s value: consider, they propose, the price gold would carry if US gold reserves were to cover completely America’s monetary base, i.e. all the dollars in public circulation and in commercial banks’ deposits with the Fed. The US possesses some 261.5 million ounces of gold and its monetary base is about 1.78 trillion US dollars. To back this base completely, the price of gold would have to reach 6,790 US dollar per ounce. Interestingly, at the time of the last bubble, at 850 US dollar an ounce in 1980, gold actually covered the US monetary base one–and-a-half times! To reach that dimension of coverage today, gold would have to ascend to a whopping 10,185 US dollar an ounce.
There is one caveat to this approach, of course: it is simply too US-centric. In the late 1970s, even in the aftermath of the Bretton Woods breakup, the old model still applied: every currency was backed by the US dollar and the dollar backed by gold. Today, the US monetary base is dwarfed by the size of foreign exchange reserves worldwide, so it might make more sense to take a global view in assessing gold’s fair value.
But first fasten you seatbelts because if global FX reserves were to be backed by gold, gold’s price would have to reach 8,830 US dollars an ounce. Shifting up a gear, in January 1980, at the peak of the gold bubble, global gold reserves covered the global exchange reserves two and a half times. Duplicating this today would lead to a gold price at a staggering 22,075 US dollars an ounce!
Needless to say, these numbers are neither forecasts nor price targets. However, we think they do put the current gold price in a useful context. If we are in a gold bubble, then we are still in an early stage.
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