Gold Valuation Models

7 min readSep 12, 2020

A tourist’s take on gold valuation

First some disclaimers:

this is not investment advice
I have no licenses or certifications
this is for entertainment purposes only

Ever since the GFC and what I perceive to be the profligate era of monetary policy, with near 0 (or below) rates and quantitative easing, I’ve been somewhat of a gold bug. I don’t like to be bearish on US equities, but I keep feeling like equity valuations are so high as to be a major risk. And on the other side I intuitively felt that central bank balance sheet expansion would inevitably lead to inflation, and higher prices for hard assets, such as gold.

Fast forward 12 years and we all have learned that 0 rate policy and QE has not been inflationary, quite the opposite. Over the last couple of years I’ve been more engaged with understanding the monetary system, and trying to understand why policy has resulted in deflation rather than inflation. The following are some thoughts, which I might be generous in calling a framework, but it’s starting to help me get a sense for what is cheap and expensive both for equities (covered very briefly at the end) and for hard assets.

One hypothesis I have is that inflation is not a function of money supply. Inflation is a function of economic productivity. I believe that 0 rate policy and QE has compromised the free market’s ability to allocate capital, thus stunting growth and preempting any possibility of inflation. I owe this hypothesis mostly to Dr Lacy Hunt, who has forgotten more about economics and theory than I will ever know in my life. As he says, there is no escaping the production function.

Another hypothesis I have is that the price of financial assets (including equities and precious metals) is a function of money supply. Meanwhile the change in value of assets is accelerated or throttled by real interest rates on US treasuries. Lyn Alden has been speaking about valuing gold based on money supply for some time, and I may have subconsciously been influenced by her work. I have done my own work though, and I have some insights to share.

Note that the following charts run through the end of 2019. The projects at the end of the article offer projects based on more current data.

First, the price of gold and M3 money supply:

This chart just sets the context. If you chart most any asset on a very long term chart against money supply, it shouldn’t be too surprising that they trend together. What if we chart the price of gold relative to money supply (again M3)?

There’s a bit more information here. You can see the massive cup and handle pattern for gold going back to 1980. I also like that you can get a bit more of a sense for how cheap or expensive gold is relative to historic ratios with the money supply. 1980 looks like a bubble on this chart. It also seems like gold is poised to shoot past the historic average, and that it could reasonably follow through with a standard deviation move above the average.

However, the stock of gold has changed over time. We should probably be looking at the market cap of gold relative to money supply.

Suddenly gold is not looking as cheap. Based on momentum, and the classic cup and handle chart pattern, you would still expect gold to go up from here, but having done this analysis I found I was less bullish than before.

So what about inflation, and the influence of real rates on the price of gold?

Here’s the same data, but with the inflation rate represented with a 5 year moving average (using the January rate):

Looking at these charts, I’m less focused on the price of gold, more focused on the price movement. There seems to be some influence in the 70s, but other than that, gold has gone up, or down, with inflation moving both up and down.

What if we look at the year over year change in the price of gold? Maybe we can get a bit more signal?

Not really.

What about real yields on the US 10 year?

Now we might be on to something. If real yields are below their 1970–2020 average of 2.24%, gold tends to rise in price. The trend in real yields is also a factor.

So what are real yields doing?

The gold bull market of the middle of 2020 makes a lot of sense in light of this chart, as does the interruption of the bull market in August.

I think real yields stay low if fiscal policy gets more loose, which would be good for gold. Throughout 2020 deflation has not kept up (gone down) with the decline in nominal yields, thus the real yield is going down. If deflation kicks in, real yields could rise, and this would be challenging for gold. If fiscal policy ramps up and actually causes inflation, conventional wisdom is that the Fed will want to keep rates low, thus causing real yields to stay down or decline further. This could be doubly good for gold if fiscal policy causes inflation while yield curve control keeps rates low.

I’ve also done some projections of the price of gold based on expansion of the money supply. These projections assume:

The ratio of gold market cap to money supply levels off at +1 standard deviation above the 1971–2020 time period average (.71, near where it sits today)
Money supply grows at the average annual rate (a conservative projection given current challenges) of 6%, the 2021 money supply value used in the below figures is current money supply ($18.16T) plus 6%.
Gold stock to flow continues to be 62 (used for the gold market cap calculation)

Projections for the price of gold:

Jan, 2021: $2,128
Jan, 2022: $2,220
Jan, 2023: $2,316

For some upper bound projections: if the ratio of gold market cap to money supply moves to +1.25 standard deviation, and money supply grows at 10%:

Jan, 2021: $2,364
Jan, 2022: $2,559
Jan, 2023: $2,770

My overall takeaway is that there is still reason to be bullish on gold, but I think we are already at a pretty high valuation relative to money supply.

Good for gold:

Loose fiscal policy (expansion of money supply)
Yield curve control (low real yields)

Bad for gold:

Deflation (because real yields probably rise)
Low growth and low inflation (“Goldielocks” — no trigger for gold to rise)

While I’m still holding gold, I’m shifting to be more bullish on gold miners at this point, which have strong balance sheets and strong economic tailwinds with the rise in the price of gold over the last two years coupled with access to cheap capital.

Other Assets

I’ve looked at other assets a bit, and have a couple of quick points.

Bitcoin’s current ratio of market cap to money supply is .01. If you believe that the price of scarce assets is determined by their stock to flow, you should be very, very bullish on bitcoin. Bitcoin presently has a stock to flow almost the same as gold (56). To have the same market cap to money supply ratio as gold, the price of one bitcoin would have to rise to $700,000.

The same exercise changed my mindset on equities being overvalued. The ratio of the S&P market cap to money supply actually seems somewhat reasonable (still high) compared to historic levels.

At the S&P bottom on March 23rd at $2,192, the ratio of the S&P market cap to money supply was around .86 (with very imperfect estimate for the S&P market cap at that time, as I couldn’t find a good data source). With the benefit of hindsight and a better model for valuation, this was a historic buying opportunity.

References

Some other materials I found to be very intelligent on gold valuation:

https://www.bloomberg.com/opinion/articles/2020-08-26/record-gold-prices-real-yields-aren-t-really-responsible
https://www.lynalden.com/reasons-to-buy-gold/ (includes a detailed treatment of the impact of real yields on gold)

Data:

Gold Valuation Models

Other Assets

References

Written by Gabriel Doliner