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By Ben Johnson, CFA | 09-22-2011 05:06 PM

Why Gold Prices Are Misleading

Common gold-valuation metrics, which measure several ratios, are likely to be wrong because gold doesn't have a core value, says State Street's Chris Goolgasian.

Ben Johnson: Hi. I'm Ben Johnson, Morningstar's director of European exchange-traded fund research. I am here reporting from Morningstar's 2011 ETF Invest Conference. Today, I am joined by Chris Goolgasian. Chris is a portfolio manager with State Street Global Advisors, and he shared with us today his team's thoughts on the outlook for gold, something they've worked on quite extensively and actually recently published a really high-quality research report on. So, I am going to ask Chris what he thinks about gold and what his team thinks about gold, the outlook, and how gold can be used within investors' portfolios.

Chris, thanks for joining me.

Chris Goolgasian. Thanks Ben. It's pleasure.

Johnson: So, the topic on everyone's mind, or the question on everyone's mind is, is gold in a bubble right now. What do you think?

Goolgasian: It is. So, I think that's one of the three key questions we've heard and wrote the paper about, primarily, how do you value it, are we in a bubble, and then how much should I own? The question of are we in a bubble, I think my answer is "not yet," and there are a couple of reasons for that. One is, if you look at classic bubbles, there is always a major increase in supply to meet the demand of whatever that asset class that's bubbling is. So, if you look at the tech bubble, in the year 1999 there were 300 some odd IPOs, tech IPOs that year. So, it's like six or seven a week; and to put that in perspective, the year before there were around 100, and two years later there were about 20. So as the tech market rallied, the marketplace tried to meet that demand and put out more and more companies, some of which probably shouldn't have been IPOed and you had this huge supply of tech companies come along.

If you look at housing; in 2004, the housing market had doubled housing starts from the prior 14 years. That's a cycle that had never been repeated or never happened before. Two years later, housing starts were halved and were back to the level of 14 years ago. So, housing inventory rose to meet all the great demand.

What's the analog here for gold? Gold has rallied from $200 to $1,800 in the last decade, and as we showed today in the presentation, the gold supply chart is like this (flat). It hasn't moved. And the reason is that it's very hard for these miners. Even in the face of this growing tremendous rising price, they can't meet that demand with more and more supply. Every commodity cycle tends to end with more and more investing and capital spending. If you get the supply up, the price comes back down. In the gold market they are unable to bring the supply up to meet this demand.

Will it happen someday? Potentially, but it hasn't happened yet. So, that's one angle of why we think we're not in a bubble. Then the sentiment angle is the other one. On the sentiment side, we see--even in the last two weeks with this little downtick in gold--just massive rampant skepticism about gold. If you read the headlines or watch TV, you'll see the adjectives that are used to describe 2% moves: "Gold's Crashing," or "Gold's Cratering." When we're in a bubble, you won't hear any of that, right. You'll just have a bunch of people advocating and supporting and believing that it's just going to keep going up and up and up. We're not there yet and so there is massive skepticism at this level out in the press and out in conferences like this. And that's all good. I think to me that's very bullish. It means we haven't hit that period where everyone's a believer, and when you are in a bubble, everyone's a believer.

Johnson: And your team, as you've shared, doesn't believe in some of the conventional metrics that people used to "value gold," things like the inflation-adjusted gold price, the Dow/gold ratio, or the oil/gold ratio. Why aren't those useful? Then maybe if you could touch a bit more on some of the qualitative factors that you regularly monitor, which of those do you think are the most important and how are those trending right now?

Goolgasian: Right. So, you're taking something, it's like a piece of art or a house and saying, "What is that worth?" Well, it's only worth what the buying market is willing to pay for it. Picasso has no value itself. Your house has no value except what that market will pay. We put gold in that same class. It has no value in and of itself; what's the market willing to pay for it?

Wall Street though came up with a way to value gold, as they always will for any asset class, and Wall Street said, "Let's look at past ratios and past relationships and then support X price." For example, an inflation-adjusted price from 1980 would support that gold today should be $2,500 or gold relative to the Dow or gold relative to the monetary base.

The problem with all of these metrics is that they were picked from prior highs, applied today, and say, "This is what the price should be today." And my answer to that would be this: If we're going to use that line of thinking then we should take the fact that the S&P sold at 40 times earnings in 1999 and that should be our bull case today for equities. The S&P should at its best case trade at 40 times earnings, right? No, that's completely untrue.

But that's effectively what you're doing when you take best-case scenarios for historical prices for gold. And by the way, when I say this it's not as a gold bear, I am saying those prices could be too low. It's not that they are necessarily too high. They could be too low. They could be wrong on either side. The point is that they are likely to be wrong because they are just measuring ratios. They are not measuring a core value because gold doesn't have a core value. So we've applied ratios, we as an industry, not we at State Street.

Johnson: I think the analogy you used earlier, and I thought it was an apt analogy, was that they have effectively shot an arrow at the side of a barn and then subsequently painted the target around it.

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