Just How High Can Gold Climb?

Source: Thinkstock

Source: Thinkstock

From my analysis, gold is in a fundamental long-term bull market that will last for several years, and possibly a decade or longer. There are several reasons for this.

First, gold has largely lost its role as a monetary metal over the past 40 years or so. While this began to change somewhat in the wake of the 2008 financial crisis, many investors still view gold as an “alternative” investment when in fact it is a long term store of value — aka it has a monetary function. While many other assets have been given this role over the past several decades such as shoter term U. S. government debt, money markets, bank accounts (which are legally “loans” to the bank”), and even so-called “blue-chip” stocks, the fact is that these assets are overvalued relative to gold given that they no longer offer returns (or, yields) that justify the risk that comes with owning them.

Banks pay no interest but they are arguably riskier than ever. Stocks pay very small dividends because they are viewed as a superior alternative to cash earning virtually nothing in the bank. Government bonds also earn virtually nothing unless we go way out in the yield curve. Nevertheless, these assets are used as if it were money; banks and even individuals are allowed to borrow aggressively against them, which only serves to push their pries even higher. Gold, which used to be used as collateral, is now considered risky. I think that by the time the bull market is over, these two sentiments will be reversed.

Second, the money supply in the United States has been rising dramatically. While it has accelerated ever since the Federal Reserve’s Quantitative Easing Program has been announced, the fact remains that a rising money supply has been the norm for decades, and the price of gold simply hasn’t caught up given its 20-year bear market in the 1980s and in the 1990s. Even during the bull market, the money supply has been rising faster than the gold price, and in effect gold is cheaper on this basis now than it was back at the bottom in 1999.

Third — and this reflects the second point — the cost of mining gold makes the endeavor extremely difficult, and in many cases simply uneconomical. In 2013, if we consider all of the costs that miners incurred from digging up ore to processing it to taxes, interest payments, and so forth, it costs about $1,100 – $1,200 to mine an ounce of gold. Furthermore, this doesn’t reflect irrational mining of low-grade gold ounces, as this would be reflected in a significant increase in gold mining. But in fact, gold mining seems to have peaked out and it is expected to decline somewhat this year. When the bull market is over, we will see gold mining increase substantially.

But given these points, just how high can the gold price rise? After all, it is already trading 5-times higher than the 1999 and 2001 low. Bull markets, however, often generate gains that greatly exceed this amount. For instance, the bull market in the Nasdaq that began in 1974-5 and ended in 2000 generated a 90-fold gain; the low was about 55 and the high was about 5,000. If gold were to mimic this, we would see the gold price reach an astonishing $23,000/ounce (90 X $255 = $22,950)!

Let us look at another metric. The gold price rose from its officially pegged price of $35/ounce in 1971 to a peak of $850/ounce in 1980. This was a 24-fold gain which would put the peak in the gold price at over $6,000/ounce.

If we look at yet another metric, the gold price versus the base money supply, we find that the gold price peaked in 1980 when the value of America’s gold reached about 150 percent of the total base money supply. As of the end of February, the monetary base was roughly $3.85 trillion. The United States holds about 287.5 million ounces of gold, which would put the gold price at $20,000/ounce.

While these numbers — especially the first and the third — appear to be far-fetched, let’s keep in mind that this is the sort of price action we see in bull markets.

It doesn’t really matter which of these numbers, if any of them, reflects the true peak that is to come in the ongoing bull market. What is important for long-term investors to realize is that given these projections, it is very difficult to make a case that we saw a peak in the gold price at $1,920/ounce back in 2011. What we saw was most likely an intermediate top — the gold market had risen for 12 straight years and it was time for a correction. While it was violent and while it turned a lot of investors bearish, it by no means signaled the end of the bull market. Investors who are familiar with the history of the gold price will recall that we saw a similar correction during the 1970’s bull market that took the gold price down from about $200/ounce to about $100/ounce. While this move, too, generated a lot of bearish sentiment in reality it created an excellent buying opportunity for prudent investors — the price ended up soaring 8-fold in 4 short years after bottoming in 1976.

We may have seen the bottom in the gold market, or the price could turn downward from here and breach the $1,180/ounce double bottom hit in June and December. If it does fall further, this will almost certainly drive a lot of people out of the market and they will declare the bull market dead. But given what we often see in long-term bull markets and given the above price projections — as rough as they may be — we are far closer to the bottom than we are to the top, and gold should be purchased on weakness.

Disclosure: Ben owns gold coins and several gold mining stocks.