Feeling nervous? Brighten up your portfolio with bullion

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“What will my likely return on capital be?” is probably one of the questions most often asked by investors. But in a global investment environment faced with increasing uncertainty and the potential of low or negative equity returns, investors should perhaps rather ask about the return of capital (i.e. the preservation of capital).  

It will not surprise me to see investors switching some relatively overpriced and high-risk assets over the next few months to an asset class that has value-storing capacities as well as good investment merit. Gold might just be the asset class meeting these criteria.

In determining whether the current price of an ounce of gold is cheap or expensive historically, I have compared gold firstly to its traditional commodity yardstick, crude oil, and secondly to US equities as an alternative asset class.

Crude oil
The methodology is simple – how many barrels of Brent crude has one been able to purchase for a single ounce of gold bullion since 1970? It is interesting to see that this ratio has varied tremendously, from a peak of about 43 barrels per ounce in mid-1973 to a low of just 7,5 barrels per ounce in 2005. 

Since this is a relative calculation one must be careful about how to interpret the findings. For example, at a ratio of 43 barrels per ounce of gold in 1973, did this mean that oil was very cheap or that gold was very expensive? What conditions prevailed in the market at the time that affected these two commodities individually? Similarly in 2005, is the explanation behind the seemingly relatively low ratio of 7,5 barrels per ounce identifying the fact that oil was very expensive while gold was, relatively speaking, very cheap? Or is the real answer perhaps somewhere between these two extremes?  

My interpretation is that simple intuition points to the fact that the market seems to have allowed this ratio to become unusually stretched in 2005. The historical average of 17,4 barrels per ounce since 1970 provides a good starting point for simple arithmetic. Using a current gold price of $644 per ounce and Brent crude of $61 per barrel, we arrive at a current ratio of 10,6. Let’s assume that from its current level this ratio starts to revert to its long-term average and the oil price stays where it is, then gold should fairly be valued at around $1 061 per ounce (61 x 17,4).  This equates to a return of 18,1% per annum over a three-year period – a figure that does not strike me as particularly unrealistic. 

Conversely, if gold stays where it is right now and mean reversion of the ratio occurs, then oil would need to drop back to $37 per barrel (644 ÷ 17,4). This outcome seems somewhat unlikely from my current vantage point.  

Only the future knows what the end-game will be, but facts show the gold price underperformed the oil price from 1988 to the end of 2005. I believe that we are in the midst of the early stages of a trend reversal favouring bullion. 

US equities
Based on the historical evidence, bullion also still appears to be very cheap relative to US equities, notwithstanding the fact that gold has been outperforming equities consistently since 2001. 

It is important to keep in mind that the relative chart can move higher in one of two ways: as a result of gold increasing faster than equities or gold falling less than equities. Should the Dow Jones Index stay exactly where it is, and the ratio moves back to the long-term average, it implies a gold price of approximately $1 941 per ounce (12 133 x 0,16). However, should the ratio overshoot the average and go back to its 1980 peak, bullion will be a cool $9 342 per ounce (12 133 x 0,77)! These levels seem quite unlikely from where we stand right now, even for the heftiest of gold bulls, but as a minimum there certainly appears to be very little downside based on the historical ratio.  

The pictures tell a thousand words … Compared with both oil and US equities, my guess is that gold might be the winner on a bumpy road ahead, especially for investors placing an increasingly stronger focus on capital preservation in future.


Gold price (US$) relative to Dow Jones Industrial Index

More on this topic (What's this?)
Has Gold & Silver Finally Bottomed?
Gold Price Gravitating Lower Towards $1000
Read more on Gold, Metals at Wikinvest
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