Why gold may be looking cheap

Of all the asset classes, commodities, particularly gold, are arguably the most difficult to assess. They are generally the most volatile. Moreover, the lack of cash flow makes them difficult to value; as a result, commodities tend to trade more on momentum. With that as a caveat, it is worth asking the question: Is gold beginning to look “cheap”?

I discussed gold recently in June and back in November. In both posts I suggested that gold would struggle with rising real-interest rates and a stronger dollar. The takeaway was investors should consider owning less gold than they typically would. While both rates and the dollar are still potential threats, according to one crude measure, gold prices may already reflect these factors.

Although commodities are notoriously difficult to value, there are ways to tease out an approximate range. As it applies to gold, one measure I’ve found useful is the ratio of the price of gold to the U.S. money supply, measured by M2, which includes cash as well as things like money market funds, savings deposits and the like. The logic is that over the long term the price of gold should move with the change in the supply of money.

Over the very long term this has indeed been the case. Gold’s value has risen, fallen and risen again, but over a multi-decade period gold and M2 have tended to move together. In other words, changes in gold prices have equaled changes in the money supply, with the ratio tending to revert to one. We can think if this as the long-term equilibrium.

That equilibrium level is also relevant for future price action. When the ratio is low, defined as 25% below equilibrium, the medium 12-month return has been over 12%. Conversely, when the ratio is high, defined as 25% above equilibrium, the 12-month median return has been -6%. Today, gold is trading at a ratio of 0.73, i.e. 27% below the equilibrium level. This is the lowest point since late 2016 (see Chart 1).

Inflation is key

This measure can be refined further. Not surprisingly, gold tends to trade at a higher ratio to M2 when inflation is elevated. As many still view gold as an inflation hedge, investors are more inclined to buy when inflation is higher, particularly when interest rates are not keeping up with higher inflation.

U.S. inflation is still low by historical levels, but at 2.9% U.S. headline inflation is at its highest level since 2012. This supports the notion that gold looks relatively cheap. Based on this relationship, gold is approximately 10% undervalued.

Value, as I’ve said many times, is a poor short-time timing tool. To the extent the dollar continues to rise, gold is likely to struggle. That said, based on this metric gold is trading at the cheapest levels since the dollar last peaked in late 2016. To the extent it is even practical to discuss value and commodities in the same breath, gold prices are starting to look interesting.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

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