Unless you have had your head in the sand recently, you know gold has been on fire recently. iShares Gold Trust ETF (IAU) is up almost 70% in the last 2 years. The narrative that seems to be driving the market is one of currency printing and debasement. To paraphrase Milton Freedman and Richard Nixon, “we are all MMT’ers now.”

I personally hold IAU and VanEck Vectors Gold Miners ETF (GDX) and I have been pondering the question, “How Far Can Gold Go?” In this article, I look at 1 way (not the only way) to try and answer this question.

Framework

Grant Williams in his Things That Make You Go Hmm newsletter has been pounding the table on gold for a long while. Grant is insightful and extremely funny. I highly recommend you take a look at his work.

In Grant’s most recent letter, dedicated to gold, he posted a chart of the “Real S&P 500.” That is, the price of the S&P 500 divided by the price of gold. This got me thinking, what if historic relationships hold between the prices of stocks and gold. That could give us a framework for understanding where gold might be going.

One of my issues with the “Real S&P 500” is that it does not account for economic growth. The economy grows and companies make more money — they are worth more. Gold, while perhaps a store of value, doesn’t produce anything. It is pretty to look at, though.

The framework for this evaluation then, will be to look at the historical series of stock prices, deflated for real GDP growth, and divided by the gold price. We will take the log of the ratio and will look at how this behaves through time. From that, we will set a couple of levels and look at the implied gold return.

All data used in this analysis is available in the FRED database, compiled and maintained by the St. Louis Federal Reserve.

  1. Wilshire 5000 Total Return Stock Index. This is the broadest basket of US equities with the longest history available on FRED. It includes dividend reinvestment.
  2. The 10am London Gold Fixing Price.
  3. Real US Gross Domestic Product.
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The Wilshire 5000 data goes back to December 1970. This is roughly the time at which Nixon closed the gold window and delinked the dollar from the price of gold. The analysis starts at this time.

Background

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In the nearly 50 years in the series history, Gold has returned 8.4% annualized. At the same time, the Wilshire 5000 has returned 10.8%. Over that time, $1,000 invested in gold would have turned into over $54,000. $1000 invested into the Wilshire 5000 would have turned into over $160,000. That extra 2% a year over 50 years really builds up!

It is worth noting that the monthly correlation between the two is only 0.017, which is statistically not different from 0 (p=.68). Gold and Stocks are uncorrelated over the long term and have positive returns. From a portfolio construction perspective, it really doesn’t get any better than that.

In the chart above there are a few things to look at:

  1. Stocks were in a bear market in the 70s. The low in the Wilshire occurred around September 1974 (that $1,000 invested was only worth about $840).
  2. At the same time, the US dollar was devaluing. Gold, no longer linked to the US dollar, went on an absolute tear. Gold hit a high in January 1981 of $843 turning that $1000 invested into about $15,400.
  3. Stocks remained in their historic bull market through 2000. During that time gold was in a bear market. It declined from that $843 high in 1981 into $250 at the low in 1999.
  4. From 2000 until the low of the GFC in 2009 stocks are back in a bear market. The low from the GFC wiped out all the gains in stocks back to June 1997!
  5. Stocks have been in a bull market ever since the GFC. While the current recession MIGHT mark the secular top, that has yet to be seen.
  6. Gold’s bull market ran from 1999 until 2011, where from one brief day SPDR Gold Shares (GLD) was the largest ETF by AUM.
  7. Gold back tracked for 4 or so years until 2015. Since then it has been moving higher.
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The key take away here is that both gold and stocks trend for long periods of time, both up and down. If gold started a multiyear uptrend in 2015, how high can it go?

The Stock/Gold Ratio

As mentioned above, we are not going to look at the simple ratio of stock prices divided by the gold price. We are going to reduce the price of stocks by GDP growth. Otherwise the ratio will trend upwards due to pure economic growth. Because gold should adjust with inflation, we will use Real GDP, that is GDP with inflation removed, to deflate the stock price.

That is, we take the current quarter ending GDP value and divide it into the starting GDP value from the analysis. That deflator value is applied to all stock values for the quarter.

Because the Wilshire series is indexed to 1 at the start of the series, it is much lower than the price of gold. We multiply by 100 to bring the value up at the same time we deflate for GDP growth. This will not change the result of the analysis, but it will make the numbers a little easier to look at.

After those adjustments, we calculate the natural log of the ratio as

Here is a chart of the final values:

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When the line is going down, gold is outperforming stocks. When the line is going up, stocks are outperforming gold. The value of this ratio gives us a good idea of the balance between these two asset classes.

You can see the same information as the chart before.

  1. Gold outperformed in the 1970s ending with the lowest value in the ratio (even though the Wilshire made it’s low in 1974).
  2. From 1980 to 2000 stocks outperformed with the ratio making its all-time high around the time of the tech bust. The ratio didn’t quite make it to the 2 reference line.
  3. Stocks’ bear market and gold’s bull in the 2000s brought the ratio down, bottoming with gold’s high in 2011, just going below the 0 reference line.
  4. Both gold and stocks have been rallying since 2015, but stocks have gone up more. The ratio has gone from the 0 line to just above the 1 line.
  5. Gold’s recent outperformance has brought the ratio to a current value of 0.814 (as of 8/5).
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The ratio changes with the change in price of both assets. Therefore, to answer the question of the gold value, we need to assume both a ratio value and a stock value. In the table below, and given the gold price of $2034 on 8/5, I look at the potential gold prices under the following scenarios.

  1. The ratio remaining at 0.81, and lowering to values 0.5, 0, -0.5, and -1.
  2. Stock returns of 20%, 10%, 0%, -10%, and 20%. These are returns in excess of real GDP growth.

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The 0 ratio value was last seen at the top in 2011. That is my base case for this bull run. A return to the 0 value line with no stock movement would put gold at around $4,600 an ounce. If this was the top in the stock bull market and we have a 20% drawdown, then the price would only be $3,675. A further reduction in stock values could mean a lower final gold price, based on the ratio.

If we have an inflationary event like the 1970s, the sky is the limit. The ratio hit -1 in 1981. In this scenario, gold easily tops $10,000.

Here is the same table, but expressed in % returns from current 8/5 prices:

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Final Thoughts

I do believe gold is in a bull market. The path may not be straight up, but I do think the path is higher. I am long IAU and GDX. I will be watching this ratio as we progress and will use it a signal for rebalancing my portfolios.

Disclosure: I am/we are long GDX, IAU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



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