Have Gold Prices Peaked?

The question on everyone’s mind with respect to gold is: Is the precious metal expensive or is it cheap? In other words, will gold prices move up from here, or is the run in gold over?

Before we get to a possible answer, let’s first discuss what an investment in gold really is. Gold has a very long history as an investment. Because it has been such an important part of human history, gold is a globally recognized store of value.

Gold is unlike most investments in that it does not pay a dividend or interest. It doesn’t produce anything. Stocks, bonds and real estate can pay interest or dividends; they also grow in value based on what they produce, or based on the change in income that they pay. Gold, on the other hand, is a commodity and its price changes based on supply and demand. Demand is not driven solely by changes in supply. As with most commodities, demand can be driven purely by speculation -- speculation about any number of issues like inflation, currency prices, or economic activity.

There are a number of ways to invest in gold. Some investors buy gold mining stocks. Others buy gold futures. Some investors prefer to own gold bullion or gold coins directly. One of the easiest ways to invest in gold and track the movement of gold’s price is through an exchange-traded fund whose value is based on the price of gold by storing gold bullion.

Back to the question on everyone’s mind. Where is gold headed? Since no one can know for sure, we should look at gold from two different perspectives. First let’s look at it from a historical perspective. The price of gold, adjusted for inflation, peaked around 1980 at the equivalent of around $2,400 per ounce. At today’s price of around $1,335 per ounce, we are still a long way off gold’s historic high. That being said, its current price is the second most expensive since the U.S. dollar came off the gold standard in 1971. So, from a purely historical pricing perspective, gold cannot be considered cheap.

Next, let’s look at the price of gold relative to the price of another investment. Let’s use large-capitalization stocks as represented by the Dow Jones Industrial Average. For this comparison, I would like to reference a chart from The Draconian, a newsletter produced by Draco Capital Management in Reno, Nev. The chart shows the price of the Dow industrial average in terms of gold rather than dollars. The chart includes a trendline that cuts through it. Below the trendline, gold can be considered historically expensive compared to stocks. Above it, gold is cheaper than stocks. Today, we are below the trendline but not by the margins seen in 1980.

Looking at gold in these two ways, it is clear the commodity is not cheap. But can we conclude that it is expensive and is at or nearing the end of its run? I think we should leave that for the speculators. The reason to invest in gold is for its lack of correlation with your other investments. (Indeed, another article by the Draconian points out that gold is one of the only investments not correlating these days.) Holding somewhere between 2% and 5% of your portfolio in gold is good for your diversification -- and diversifying your portfolio should be your primary focus.