2005 Paper On Fair Value Of Gold

Posted over at Zero Hedge, with a recommendation to read though it, the paper is entitled "The Price Of Gold: A Global Required Yield Theory." It presents gold as a hedging asset, as a way to maintain wealth when P/E ratios are falling (largely due to global inflation.) The authors claim an 88% explanation rate for gold prices, and a 93% explanation rate for gold returns, for their theory over the 1979-2002 period. It's expressed in built-up equations.

Their findings gibe with Vitaliy Katsenelson's range-bound market theory. In his book Active Value Investing, he presented a cycle of P/E bull markets and bear markets, with each phase lasting 15-20 years. [The Great Depression was a notable interruption of the cycle.] In a secular P/E bull market, the average P/E ratio expands over time. The bull ends with an outright bubble where expectations run wild. At that point, expectations for earnings growth are too high and so are P/Es.

This overvaluation ushers in a secular P/E bear market, which typcially translates into a long-term range-bound market in terms of stock prices. The market needs years to shake off the overoptimism built into the latter part of the P/E bull; that takes years. As was the case on the P/E expansion, the contraction goes too far. The cycle gets launched anew.

Put the two together, and some long-term decision rules can be extracted:

1. Secular bull markets in P/Es for stocks and gold are mutually exclusive. A bull market in one accompanies a bear market in the other.
2. At the beginning of a secular bull market in P/Es, like the one that started in 1982, move into stocks. This bull market will last for 15-20 years.
3. When fifteen years have passed, watch the market for signs of a roaring bubble. There likely will be one.
4. Get out of the stock market during the bubble as expeditiously as possible. [Obviously, the timing of such is going to be a huge challenge.] Stay in cash until the equity bubble bursts. [Think 1999-2000.]
5. When the bubble bursts, shift into gold to take advantage of a new secular bull market in the metal.
6. Watch the stock market P/Es contract over time, holding onto gold or gold-based investments in that timeframe.
7. Watch for bubble action in gold while P/E ratios become historically low. That drop is largely due to inflation, which government tries to use to keep the economy afloat.
8. When the bubble in gold is in full flower, get out [as best as you can] and go again into cash. Since real interest rates tend to jack up during this stage, short-term and/or floating-rate debt should be used as a parking vehicle.
9. When the end of the road is reached for the secular bear market in P/Es, shift back to stocks and wish gold goodbye for the nonce. The gold bubble bursting is the cue to watch the stock market for the beginning of a new secular expansion in P/E rations.
10. Go to item #2.

This plan is a long-term one, and only cane be followed three times at most in a lifetime. Most people get two cracks at the full cycle in their investing lives. We're at item #6 right now, although item #7 is coming up.


What makes the existence of this cycle make sense from an economic perspective, is the fact that it takes far too long to equilibrate away. People beome habituated to its phases, and persistance of habit explans why each phase goes father than it should. There's too much to be gained by riding the overreaction though; consequently, there's too much opportunity cost in trying to arbitrage it away. So, the cycle remains.


I have to confess that I wish I knew about both after the tech bubble cracked. Had that been so, I would have been involved in gold right around the "Brown bottom."