If the US economic recovery keeps its present pace, goldbugs and miners can expect bad news
by Barry Norris. 14th July, 2013. Daily Telegraph.

Gold divides investor opinion like no other asset: either it is a worthless investment without yield and utility, or an insurance policy against unscrupulous central banks that should be bought irrespective of price.

Both views are, in my opinion, flawed. Gold is a legitimate asset class: a capacity-constrained and widely accepted currency which has protected purchasing power over many centuries.
But this does not mean that it should be bought on the basis of a lazy narrative that does not attempt to calculate a fundamental value – and the problem with gold is that all reasonable attempts to value it point to its chronic over-valuation.
So although gold is now a third off its 2011 high of $1,897 an ounce, I fear there is worse to come for gold, gold miners and goldbugs – particularly if the US economy continues to recover at its present pace.
Gold’s role as an investment is to protect investors against the loss of purchasing power in money that can be printed by central banks, which, although accepted as a medium of exchange, has no intrinsic value. Recently, asset purchases funded through new money created by central banks – quantitative easing – has stoked fears of hyperinflation.
Yet inflation in the real economy continues to be negligible.
Since 2000, core inflation in the USA has averaged just 2.5pc per annum (an increase of 38pc) while gold (measured in US dollars) has returned 12.4pc per annum (an increase of 356pc), nearly five times the loss of purchasing power in the dollar.
This fundamental disconnect between inflation and the price of gold cannot be sustained indefinitely: either inflation has to rise dramatically or gold has to fall.
In 1968, gold became freely tradable, having previously been fixed by the US government to the price of the dollar at $35 an ounce. Since 1968, the most credible measure of US inflation – the core consumer price index – has risen by 578pc, an average of 4.4pc per annum, suggesting a loss of purchasing power in the dollar of 85pc. This shows clearly why investors should be concerned about their wealth being eroded by inflation.
However, if we multiply the price of gold in 1968 of $35 per ounce, every year since, by the annual US rate of inflation, then we can calculate a fundamental value of gold based on purchasing power.
Such a calculation results in a fair value for gold today of just $240 an ounce, only a fifth of its current price of $1,280 an ounce. On any fundamental analysis, gold is a grossly overvalued asset. Investors should be concerned about inflation, but more wary of the price of gold.
There is another problem for gold, which accounts for the timing of its descent into a bear market, namely that its antithesis, the US dollar, should inspire greater confidence in the world’s financial markets. US home prices are now increasing at a double-digit pace year-on-year and the country’s unemployment rate, at 7.5pc (down from a peak of 10pc), is falling toward an acceptable equilibrium. The debate on US quantitative easing – in contrast to Europe and Japan – has therefore shifted to the timing of less stimulus, rather than more.
This should return the US dollar to its status as undisputed global reserve currency, particularly as the dollar may pay a more attractive interest rate in the future than the recent past. In a world of US dollar economic and financial hegemony, last seen in the 1990s, investors will choose the greenback over gold.
If we are cautious on the prospects for the yellow metal, we have to warn of the implications for the gold miners themselves. The decade-long boom in the price of gold has encouraged them to extract much lower grade ores. This has resulted in significantly higher costs, with the expected boom in industry profit margins failing to materialise.
The world’s leading gold miner, Barrick Gold, believes that the entire industry’s all-in sustaining costs of production are now $1,200 an ounce, up from $300 in 2002. With the gold price at $1,280 today, the gold industry as a whole is only marginally profitable and close to haemorrhaging cash.
The gold industry will respond to this crisis by cutting higher-cost production (mining only higher-grade ore) and mothballing capacity. As mines are closed, orders for mining equipment will dry up and second-hand equipment, such as excavators, trucks, grinders and drills, will be dumped on the market. This will have calamitous ramifications for those companies reliant on gold miners’ investment plans.
Many gold-mining companies also have significant financial debt, which will result in significant corporate bankruptcies or at the very least generate a need to raise equity to recapitalise their balance sheets for tougher times.
Normally, the marginal cost of production of a commodity acts as a floor to the commodity price. There are a number of reasons why this is not relevant to gold. Gold is unique. It is not consumed. Indeed, all the gold ever mined remains in existence today. In essence, this above-ground stock represents its supply. The World Gold Council estimates this stock at 175,000 tonnes.
This year, annual mined production is expected to be 2,900 tonnes or just 1.5pc of total supply, and thus is not material in influencing the price. Moreover, if no gold were mined, unlike the production of other commodities, it would not prevent the global economy from functioning perfectly well. Those who argue that the marginal cost of production of $1,200 an ounce should act as a floor on the gold price are deluded and should be ignored.
Today, gold looks like the ultimate high-risk, low-reward investment rather than the low-risk, high-reward commodity it is commonly seen as being. In the absence of a meaningful pick-up in inflation, its price needs to fall another $1,000 an ounce before offering a buying opportunity. Gold is not worthless, but it is chronically overvalued.
Barry Norris is CEO and Fund Manager of Argonaut Capital Partners

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