By Mark Hulbert
New research sees gold lagging U.S. inflation by more than 7% a year over the next decade
Gold (GC00) as an investment is likely to lag U.S. inflation by more than 7% a year over the next decade. That's the implication of new research titled "Is There Still a Golden Dilemma?" from Claude Erb, a former commodity-fund manager at TCW, and Campbell Harvey, a Duke University finance professor.
The two researchers also published a groundbreaking report in 2012 proposing a fair-value model for gold. Based on that model, gold was extremely overvalued at the time and therefore likely to be a below-average performer going forward. From gold's high in 2012 to its low in 2015, the real (inflation-adjusted) price of gold dropped more than 40%.
Recently, gold's fortunes have changed. The yellow metal has shattered its previous all-time high, soaring above $2,400 an ounce. Yet according to the Erb/Harvey model, gold is as overvalued now as it was in 2012.
The model is based on the ratio of gold's price to the U.S. consumer-price index. Erb and Harvey note that if gold were a perfect inflation hedge, this ratio would stay constant. If the CPI rose 10%, gold would too - and the ratio wouldn't change.
In fact, the gold/CPI ratio fluctuates wildly. This is illustrated in the accompanying chart. If the gold/CPI ratio had stayed constant over the years, gold's price would have followed the red line as opposed to the blue line, which plots gold's actual price.
Gold vs. stocks
For example, at gold's 2015 low, the gold/CPI ratio stood at 1.14, barely half the 2.0 ratio that prevailed at the 2012 high. From that 2015 low to now, gold has produced a real (inflation-adjusted) 6.3% annualized return, and 9.9% before inflation. The S&P 500 index SPX including dividends, meanwhile, has gained 10% and 13.7%, respectively.
Over the past five years, gold's real return has been 8% annualized and 12.5% before inflation. The S&P 500 is up 9.1% and 13.6%, respectively, over that time. On a 10-year comparison, there is no contest: Gold's real return is 3.1% and 6.1% before inflation, while the S&P 500 is up 9.5% and 12.6%, respectively.
The implication of the Erb/Harvey model is that whenever gold deviates from fair value, it eventually will return, and history supports this. Consider the correlation between a given month's gold/CPI ratio and gold's real (inflation-adjusted) return over the subsequent decade. Since 1975, which is when gold began to trade freely in the U.S., the r-squared of this correlation is 29% - which statistically is quite significant. It means that changes in the gold/CPI ratio explain or predict 29% of changes in gold's subsequent 10-year performance.
Erb said in an email that an econometric model built on this correlation predicts that gold over the next decade will lag inflation by 7.5% annualized.
What has caused gold to become so overvalued?
Erb and Harvey devote the bulk of their new study to exploring the various justifications that goldbugs give for gold's rising price. Though some of these rationales have some plausibility, Erb and Harvey in general are skeptical. As Erb noted in an interview, "Every time gold's price rises to a new high, the siren song of 'this time is different' stories come out of the woodwork."
Inflation is unable to explain gold's bull and bear markets.
The oldest of rationales is that gold is an inflation hedge. But it's been evident for many years that inflation is unable to explain gold's bull and bear markets, and the past several years provide yet more evidence. The CPI's 12-month rate of change topped out at over 9% in mid-2022 and is barely one-third that today. Yet gold is $500 higher today than then.
Another widely cited narrative has been that gold's price had become a function of the bullion held by gold-owning exchange-traded funds. Erb and Harvey acknowledge that, for a while, this narrative was supported by a lot of circ*mstantial evidence: Gold's price's gyrations were closely correlated with changes in the holdings of gold-owning ETFs.
This correlation has seriously broken down over the past couple of years. According to the World Gold Council, gold-owning ETFs collectively hold 21% less gold today than they did in October 2020, and yet the price of gold is more than 20% higher.
China and gold prices
A newer narrative that Erb and Harvey explore at some length is that the Chinese government is acquiring gold as part of its strategy to challenge the U.S. dollar's dominance. This narrative has some plausibility, since the gold reserves held by the Chinese central bank - at least what it reports to the International Monetary Fund - have been steadily increasing since late 2022.
Erb and Harvey acknowledge that gold's price would most likely skyrocket if China seriously embarked on a plan to acquire enough gold to replace the U.S. dollar DXY as the world's reserve currency. That would entail purchasing many orders of magnitude more gold than what China says it has purchased over the last couple of years.
Nonetheless, some skepticism is in order. Erb notes that economic data from the Chinese government are usually met with incredulity by outsiders. Why should we now believe that China is accurately telling us how much gold they're acquiring?
After all, if the Chinese government were actually intent on acquiring huge amounts of gold, they would have a powerful incentive to keep their plans secret so as to not push up gold's price. Erb speculates that, in telling the world that it's acquiring gold reserves, China may have an entirely different strategy in mind - one that may or may not involve actually purchasing huge amounts of gold in the coming years.
The bottom line? There's no way of knowing whether the Chinese government is pursuing an aggressive gold-based de-dollarization strategy, and in any case there's far too little data to even suggest the existence a correlation between Chinese gold reserves and the price of gold.
In the meantime, the speculation that China is the source of gold's recent runup to new highs has no more credibility than any of the myriad other hypotheses about why "this time is different" that materialize when markets hit new highs.
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 [email protected].
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-Mark Hulbert
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05-11-24 1344ET
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