Why gold could be worth $2,935 an ounce
As the world loses faith in paper currencies, gold continues to rise in value. But how high will it go? Bengt Saelensminde looks at the likely economic scenarios and comes up with a realistic fair price for an ounce of gold.
On Friday, we looked at how investors with a bit of vision can turn in tremendous stock market returns.
A successful visionary can see things that other investors miss. Usual valuation metrics are cast aside. Who needsp/e ratios when you can divine the future?
Visionaries are looking for a paradigm shift. They saw the internet revolution coming and many made fortunes out of it. Visionary investors in the 19th century foresaw great riches in railroad stocks as the early pioneers conquered the US too.
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Today, one group of visionaries are seeing something quite different. They are predicting great riches as the world shifts back to an old and forgotten way of financial life. It involves gold.
Visionary investors in gold are looking towards a new and different future. I want to show you what they see.
Gold on a risk-adjusted basis
Recently, I showed you my risk-adjusted approach to valuing investments. All you do is write down a list of different scenarios that could play out for your investment. Then you add in a price for the investment and the chances of it happening. For a reminder on how I put the table together just click here.
In that article, I suggested trying out the exercise on the gold price. Did you have a go? Here's my risk-adjusted calculation for gold over the next five years.
The way I see it, gold could already be worth $2,935! I'll show you how I got to that figure.
Remember, first we write down various scenarios that could happen with gold. Here are my various potential outcomes:
1. Faith in paper currencies is fully restored. Somehow the tremendous debt problems of the West are dealt with and gold falls back to around its lows at the Brown bottom.' I've given this a 5% chance of happening.
2. Faith in paper currencies isn't fully restored. But a solution is found that leaves gold trading around its average price since the financial crisis. I'm certainly not ruling it out, so I've assigned it a 15% chance of happening.
3. The world muddles along with its existing currency regimes. Gold falls back a bit, but remains high as central banks and prominent investors now recognise gold's currency reserve status. It cannot be printed!
4. Global debt markets continue to wobble. Gold gets more popular and hits $2000.
5. As above, but more serious. $3000 gold is quite achievable. Maybe gold is actively considered as backing for a new currency regime.
6. The early seeds of mania are sown. As well as central banks and prominent investors, gold hits the radar of the common investor seeking sanctuary from paper-based currencies. (Note: Although we write about gold a lot at MoneyWeek, the average guy on the street is just not involved yet.)
7. The mania starts to take hold. Suddenly the whole world sees what was previously the preserve of the visionaries. Everyone wants a bit of the action. People queue up to get some physical gold. Prices become meaningless It's a mania!
8. Full-blown mania pushes gold to stratospheric levels. By now the visionaries should have bailed out; they'll see something else coming.
In the table below, I've set out the different potential prices of gold for each scenario and the chances of it happening. In the fourth column, I've multiplied them to give me a weighting for each scenario.
When I add up all the weightings, I arrive at my risk-adjusted, fair value for gold.
| 1 | 5% | $300 | $15 |
| 2 | 15% | $800 | $120 |
| 3 | 20% | $1,500 | $300 |
| 4 | 20% | $2,000 | $400 |
| 5 | 20% | $3,000 | $600 |
| 6 | 10% | $5,000 | $500 |
| 7 | 5% | $8,000 | $400 |
| 8 | 5% | $12,000 | $600 |
| Row 8 - Cell 0 | 100% | Row 8 - Cell 2 | $2,935 |
Visionary investors may not plot out the scenarios in a table like I've done. But if they did, they'd be weighting their outcomes towards the bottom end of the table.
After all, valuation metrics don't bother them. Their imagination isn't encumbered by the knowledge of how financial markets work today.
There's no telling how high gold could go in a mania breakout
The scenarios and the prices I've used are, of course, personal guesstimates. And all I've given you here is a trimmed down version of events for each scenario. Some readers will undoubtedly say they're crazy ideas.
But if fears of contagion in global debt markets continue to ramp up, then I can see gold continuing to rally. And as central banks continue to build reserves, gold's credibility is on the rise.
At some point, price rises start to feed on themselves. That's a mania. We saw it during the internet boom and if we see it in gold, then you'll need to hold on to your hat for the ride! So far, we're nowhere near that. If you own gold, you're still in the minority. If it goes mainstream, even my estimate today could look conservative.
I've only put a 5% chance on a full-blown mania breakout. Maybe you see things differently? If so, please let me know your thoughts by leaving a comment below.
Also,I hope by now you've already read Dominic Frisby's Gold Profit Plan. For me, it's the best resource I've seen for anyone thinking about buying gold. It covers everything you need to know about how to construct a sensible, diversified portfolio of gold and gold-related investments. It also includes five listed gold stocks Dominic believes are undervalued. If gold continues heading up, any one of these could make serious returns.
This article is taken from the free investment email The Right side. Sign up to The Right Side here.
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Bengt graduated from Reading University in 1994 and followed up with a master's degree in business economics.
He started stock market investing at the age of 13, and this eventually led to a job in the City of London in 1995. He started on a bond desk at Cantor Fitzgerald and ended up running a desk at stockbroker's Cazenove.
Bengt left the City in 2000 to start up his own import and beauty products business which he still runs today.