What is depreciated value
What Is The Intrinsic Value Of Gold?
Jul. 27, 2015 5:31 AM
- Perception rules.
- Gordon Brown and the Brown Bottom.
- 1980 and 2011.
- Intrinsic value for gold in 2015 - rising dollar and divergence.
- Gold's bottom is still a long way below.
Intrinsic value is a term we hear a lot in financial markets these days. Intrinsic value is in essence a philosophical issue and the term is often misused. Philosophers refer to intrinsic value as the value something has in itself, for its own sake or in its own right. Extrinsic value is therefore, the value that is not intrinsic. In the world of options, intrinsic value is simply the in-the-money portion of an option. A gold call option with a strike price of $1000 and a premium of $120 has an intrinsic value of $90 when gold is trading at $1090. The extrinsic value is $30. Options offer a clear and definitive example of intrinsic and extrinsic value. When it comes to the price of gold itself, the waters become a bit murky.
In a recent article, about the prospects for the price of gold on Seeking Alpha, a reader by the name of Peter Palms commented, "Gold prices significantly understate the intrinsic value". He went on to compare the price of gold to the sized of global debt. It was certainly an interesting comment; it was Peter's perspective, perhaps Peter's own principle when it comes to the yellow metal. I would argue that when it comes to the price of gold, intrinsic value equals nothing more than a collection of each individual's perspectives. Therefore, as beauty is in the eyes of the beholder, the intrinsic value of gold depends on to whom one is speaking at any given time and the price is merely a matter of mass opinion.
Any asset price has intrinsic and extrinsic value and those values change dramatically over time and even during the trading day on a minute-to-minute basis. A market price for an asset is the price where buyers and sellers come together in an open and transparent market place. The last price where a buyer and seller transacted is best definition of the current price. Market prices result from the perception of those actually buying and selling the asset. If the price drops to a level where one participant thinks it too cheap, they will buy lifting price. If it rises to a level where another participant thinks it too expensive they will sell, thus causing the price to fall.
When it comes to the price of gold, perhaps the asset with the most history as a means of exchange, perception determines its value. The current price for an ounce of gold is a combination of the perceptions of all buyers and sellers of the yellow metal in the world. Therefore, the gold price is in essence, the result of the wisdom of crowds. Over the course of history, one or more parties can influence the price of this precious metal, at least for short periods. Anyone who has a huge amount of gold to buy or to sell can certainly dictate price for a while. A great example of this is what happened back 1999 and continued until 2002.
Gordon Brown and the Brown Bottom
Central Banks around the world hold gold as part of their foreign currency reserves. Many consider their gold holdings as part of their national treasure. These nations or those who are in charge of their assets assign a great deal of intrinsic value to the yellow metal. However, some do not. In 1999, Gordon Brown the UK Chancellor of the Exchequer must have thought the intrinsic value of gold was very low. So low, that Brown sold approximately half of the United Kingdom's gold reserves, which amounted to some $6.5 billion worth of gold, in a series of auctions at very low prices. The gold sold was approximately half of the UK's $13 billion foreign currency net reserves. The quarterly chart of the COMEX gold futures price highlights the effect of Brown's gold sales. (click to enlarge) As the quarterly chart of the COMEX gold futures price illustrates, the price of gold dropped to lows of $252.50 per ounce in 1999 and remained depressed as Gordon Brown auctioned off half of the UK's gold reserves until 2001. That low in gold became the "Brown Bottom". Gordon Brown sold the lows in gold and perhaps in an effort to get him away from the rest of the UK's national treasure the nation made him Prime Minister subsequent to his sales. Maybe they thought he was safer in another position away from the country's checkbook.
Brown's sale is an example of how the perception of the UK government in 1999 affected the intrinsic value of gold; there have been other examples where mass perception has driven gold in the other direction.
1980 and 2011
Inflation caused the price of gold to skyrocket from $101 per ounce in 1976 to highs of $875 in January of 1980. As the price of gold rose, perception caused the intrinsic value of the yellow metal to increase. What ultimately causes a market to rise is when there are more buyers than sellers. This was the case during that period. After the highs in early 1980, the price of gold continued to fall over two decades reaching its nadir upon the establishment of the Brown Bottom in 1999.
After the U.K. finished selling gold a journey began that took the yellow metal to dizzying heights. Market perception changed once again and the value of gold rose. One decade after the Brown Bottom gold reached $1,920.70 per ounce in July of 2011. Since then the gold price has come back down to earth. Gold has a dual role as a currency and a commodity. Many commodity prices peaked in 2011 and have since moved lower.
Gold has followed suit closing on Friday, July 24, 2015 at $1098 per ounce. The price level is still some $845.50 above
the Brown Bottom but is $822.70 below the 2011 highs. For now, the yellow metal is right smack in the middle of the decade long trading range. The intrinsic value for gold is higher than it was in 1999 but lower than in 2011.
Intrinsic value for gold in 2015
Currently the price of gold is under siege and its value has depreciated. Recently gold fell below weekly support at $1130 and the price traded all the way down to lows of $1072.30 last Friday before recovering to $1098. Physical demand for gold has been tepid due to economic weakness in one of the biggest gold buying countries in the world, China. Additionally, the prospects for higher interest rates in the U.S. make gold a less attractive asset.
Gold rose during a period of ever decreasing interest rates. When rates rise, gold becomes less attractive as it pays no interest or dividends to its holders. The U.S. dollar is the international pricing mechanism or benchmark for gold. Historically, there is a strong inverse correlation between the value of the dollar and the price of gold. A stronger dollar has added to weakness in gold thus far in 2015.
Rising dollar and divergence
The U.S. dollar rose from under 80 on the active month dollar index futures contract in May of 2014 to highs of over 100 in March 2015. (click to enlarge) The spectacular rise in the greenback made gold rise in other currencies attracting selling into the market. Therefore, gold dropped in U.S. dollar terms. At the same time demand for the precious metal, which has done nothing but move lower since 2011, has been weak which has caused the price to move lower.
Moreover, the price action in other precious metal markets has weighed heavily on the price of gold. Silver and platinum are industrial precious metals. Global economic weakness has caused the price of these metals to fall dramatically along with other metals and commodity prices in general. In fact, these two precious metals have been consistently weaker than gold over the past few years. While many consider the current price of gold weak, as it has declined over 40% from the 2011 highs, the price of gold is today very strong when compared to the price of both silver and platinum on a historical basis.
Over the past forty years, the price of platinum has usually traded at a premium to the price of gold. Platinum is a rarer metal with a higher production cost. Throughout history platinum has been "rich man's gold". The premium for platinum over gold has averaged around $200 per ounce. In 2008, platinum traded at over a $1200 premium and in 2011 and 2012, it traded at a $200 discount. On Friday, July 24, platinum was trading $110 below the price of the yellow metal -- clearly it is not rich man's gold these days. However, the historical price relationship between the two metals tells us that at current prices, either platinum is too cheap or gold is too expensive.
The silver-gold ratio leads us to the same conclusion with respect to the current value for gold. The long-term historical norm for this relationship is 55:1 or 55 ounces of silver value contained in each ounce of gold value. Today this relationship stands at around 75:1. This means that on a historical basis, either silver is too cheap or gold is too expensive at current prices.
The platinum-gold spread and silver-gold ratio are both telling us that gold is too expensive at today's price level for the yellow metal. Add to that the stronger dollar and the prospect for rising U.S. interest rates and gold starts to a lot worse. As a bonus, I have prepared a video on my website Commodix that provides a more in-depth and detailed analysis on gold to illustrate the real value implications and opportunities provided by the current level of this precious metal.
Gold's bottom is still a long way below
Silver closed last Friday at $14.67 per ounce. The long-term average of the silver-gold ratio thus implies a gold price of $806.85 at 55:1. Platinum closed Friday at $988.80 per ounce. The long-term average of the platinum-gold spread thus implies a gold price of $788.80 at a $200 premium for the price of rich man's gold.
Gold broke through long-term support at $1130 earlier this month. It is now trading at more than five-year lows. Technically, the trend is lower in the gold market. The dollar remains strong and interest rates have nowhere to go but higher in the long run. After making yet another new low at $1072.30 last Friday, gold rallied to close at just a shade under $1100 per ounce. While gold recovered nicely from the lows and many will say that a bottom is in for the yellow metal, there are too many factors pointing to a much lower price for the yellow metal.
Today, the intrinsic value for gold is lower than it was last week, last month or last year. The price of gold continues to make lower highs and lower lows since 2011. Therefore, I am a seller of rallies in the yellow metal given all of the factors that signal new lows on the horizon. Gold just simply has very little going for it these days and a lot going against it. Do not forget to check out my podcast on my website on gold.
Meanwhile, the intrinsic value of gold is a matter of perception and beauty is in the eyes of the mass beholders.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.
Additional disclosure: The author always holds a percentage of his portfolio in precious metals. That percentage varies and depends in market conditions.Source: m.seekingalpha.com