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Gold: Price versus Value?
by David Stanowski
30 April 2006

The best way to determine a baseline value of an investment, with no earnings history, is to compute a long-term moving average of its price. As the name implies, this "moving average" is the average price that investors have been willing to pay, over a reasonably long period of time, so it provides an approximation of a more stable "value" with which to compare current price levels. History shows that current prices are sometimes far removed from real value, which makes them vulnerable to a correction back towards the baseline.

For the purposes of this article, weekly closing prices of gold were used to compute the 156-week moving average. As this moving average is calculated each week, it represents the average price that investors were willing to pay for gold, looking backward three years from that week.

Studies of the prices of most investment vehicles, versus their long-term moving averages, tend to show repeatable patterns. During strong up moves, prices stay above their moving average for long periods of time, but then eventually peak, and move lower until they meet their moving average, and  usually move below it, for a fairly long time.

During strong down moves, the relationship between prices, and their moving average, tend to do just the opposite. Sustained sideways moves produce flat moving averages that allow prices to cross above and below them much more often.

These common patterns highlight times when there are buying and selling opportunities, but NOT precise entry and exit points. When an investor identifies times when prices are far above their moving average, he can view them as selling opportunities. This is because history shows, that as the differential grows, price is strongly diverging from value, so a reversal of prices back towards the baseline value becomes more and more probable. Likewise, when prices are very far below their moving average, they are so far below value that a reversal, and rally is a high probability.

Figure 1 shows the price of gold versus its 156-week MA from the week of 21 August 1978 up to the week of 28 April 2006.

Figure 1

The graph starts during the great bull market of the 1970s, which peaked above $800 the week of 14 January 1980. After prices
(red line) peak, they head back toward, and then substantially below their moving average (green line). Then for the next two decades, prices move sideways to lower, and cross their MA on several occasions. Finally, on the week of 03 December 2001, prices broke out above their MA, and have stayed above it for over four years! 

Figure 2 plots the percentage difference between the price of gold, and its 156-week MA over this same period, which makes it easier to see the extremes in divergence.

Figure 2

The graph clearly shows that the current divergence isn't nearly as extreme as that in 1980, BUT that it is more significant than any since that time!

The percentage divergence between the price of gold, and its moving average is a very helpful indicator, but it provides only one dimension in this two dimensional story. This standard indicator tends to over emphasize times when there are quick price run ups, or spikes, and fast collapses in prices; but the amount of time that prices remain above or below their MA should be nearly as important.

For example, if prices spent 6 years between 5% and 10% above their MA, the divergence between price and value could be just as extreme as prices spending 2 years above their moving average with one price spike to a 30% differential!

Another simple indicator could be devised to compute just the number of consecutive weeks that prices stayed above or below their moving average, and then it could be used in conjunction with the indicator shown in Figure 2.

Rather than doing this, I have developed a new indicator that combines both studies! The "Excursion Summation Index" is a new technical analysis tool that resets each time prices cross their MA, and then creates a running sum of each week's percentage difference from its MA. This indicator combines both the number of consecutive weeks that prices have been above or below their 156-week MA, with the percentage difference each week!

Figure 3

The Excursion Summation Index clearly shows that the current gold rally has created the most extreme differential between the price of gold, and its baseline value since the 1980 peak, when BOTH price and time are considered! This means that there is a very high probability that gold is nearing a major reversal, and a small probability that it will continue to climb, pushing the indicator towards 1980 levels.

However, the current message from the Excursion Summation Index will be far more compelling if a case can be made that the conditions in the 1970s were very unique, and highly unlikely to be repeated.

In 1933, FDR banned the private ownership of gold in the U.S.. By 1971, post WWII inflation had become so bad that Nixon stopped converting Dollars into gold for foreign countries. Finally, in 1975, the U.S. ended fixed exchange rates with other currencies, and it became clear that the Dollar was now "backed" only by the paper that it was printed on!

This same year, American citizens were finally allowed to own gold, again, for the first time in 42 years! As more and more people became aware of the depreciation of the Dollar, the pent up demand for gold exploded! However, after prices collapsed from that 1980 peak, the price of gold stabilized for a quarter century.

Figure 4

Figure 4 shows the value of the Dollar from 1954 to 2004 expressed in milligrams of gold. The crash in value into January 1980 is very clear, as is the relatively stable value since then. It would probably take a collapse of this magnitude to create a gold price-value divergence as great as the one in 1980, again. This could happen, but there is very little evidence that anything like that has begun at this time.

30-Year Treasury bonds react quickly to any depreciation in the Dollar, by dropping in price, so that their interest rates rise. Bond holders demand higher yields anytime they think that the value of their principal is depreciating. Figure 5 shows T-Bonds yields from 1977 to 2006 (yellow line). They were paying 15.5% in 1981, as the inflation of the 1970s was winding down, and have been rising the last few months, but now offer an interest rate of only about 5%; hardly an indication that the Excursion Summation Index is likely to shoot up towards 1980 levels!

Figure 5

So what do the graphs of "just" the last quarter century, a period that excludes the price spike of 1980, show us?

Figure 6

Figure 7

Figure 8

They seem to indicate that gold is in an excellent selling zone! While acknowledging that this conclusion is far from certain or foolproof, this analysis does offer a much more objective method to try to determine if the price of gold is more likely to go higher or lower from this point, than that offered by gold market bulls who merely cite the inflation of the money supply, and the fear of possible catastrophic world events as the reasons that gold HAS TO continue to go up! They are expressing the same emotional hysteria, and belief in the "certainty" of the outcome, that was part of the market in 1978, 1979 and 1980! 

The awareness of monetary inflation, and the fear  of possible world events have existed since 2001, and are very likely already reflected in the price run up of the last four years! M
erely pointing a finger to the sky, and dreaming up higher and higher price targets is not a substitute for a valid attempt to derive the relationship between the current price of gold and its underlying value!

So what is the current value of gold? $431.97; the current level of the 156-week MA. Therefore, if prices do reverse near today's price of $654.50, they would have to drop 34% just to reach the current value, but major moves usually meet, and then cross the moving average before a major bottom is formed, so a drop of about 50% from here would be a typical outcome!

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