Via ConvergEx's Nick Colas,
Would you rather have one “Share” of the S&P 500 at $2,124, or 41 barrels of crude oil, or 1.86 ounces of gold? Yes, they are all worth the same amount at the moment, but the price relationship between the three has shifted over the decades.
For example, the current ratio of 41.4 barrels of crude to one S&P 500 is 45% higher than the 30 year average of 28.5x. That means oil really should be at $75/barrel with the S&P 500 where it is. The short term (10 year) average is even lower – 17.7x – pointing to a “Fair Value” for oil at $120. Perhaps equity markets do have more room to run if this historic relationship is on hold for the moment, as slack global growth and shifting geopolitics keeps oil prices down and (hopefully) helps U.S. consumer confidence.
As for the stock/gold relationship, the current ratio of 1.86 ounces to 1 S&P share is pretty spot-on the 30 year average of 1.89. So why is gold breaking down even as stocks are melting up? Stocks are a proxy for confidence in everything from the financial system to human ingenuity’s ability to create a better world; gold’s +5,000 year record of value is essentially a reminder that nothing ever changes.
Warren Buffett hates gold as an investment, a fact that has perplexed me for years. Berkshire Hathaway’s own Borsheims jewelry store will sell you all the gold you want, provided you pay the premium over its intrinsic value to have it shaped into necklaces, bracelets, or rings. Somehow, silver is ok – Berkshire once owned 129 million ounces of the stuff back in the 1990s. Charlie Munger, Buffett’s partner of many years, famously told CNBC in 2012 “I think gold is a great thing to sew in to your garments if you’re a Jewish family in Vienna in 1939 but I don’t think civilized people buy gold”. Yep, that’s what he said…
The problem Buffett and Munger seem to have with gold is that it just sits there and looks pretty. Their model for investing is to buy businesses in whole or in part and essentially keep capital cycling through the global economic ecosystem. That’s essentially their version of a social contract – if you have more money than you need then you hand it back for others to use, hopefully for productive purposes. Fair enough – their balance sheets are much better than mine so it’s hard with their success using this paradigm.
The other side of the coin is that every single piece of gold ever minted by any government or made by private hands - anywhere and at any time - still has value. The modern financial system – banks, capital markets, the whole thing – have value in excess of gold when they do what they are supposed to do: channel human innovation and enable social progress. And when they fail in those goals, gold is the default investment until the next time around. Just consider that over the last 10 years – one very full cycle of economic expansion, severe contraction and then recovery – the performance of gold still far outstrips the S&P 500: 161% to 75%. Oh, and gold also beats the performance of Berkshire Hathaway (up 154% over the last 10 years), with a lot less volatility for most of that period.
Yet on a day when gold broke to a five year low while U.S. equity markets seem destined to make new all-time highs in short order, we need some more historical context on the relative value of each asset class to make a thoughtful case for what’s happening now. To do that, we have done a time series analysis back to 1970, dividing the value of the S&P 500 by the price of a troy ounce of gold. There are some handy graphs highlighting this calculus right after this note, but here are our key takeaways:
- Gold and stocks are fairly valued relative to each other right where they are. Over the last 30 years, the average ratio has been 1.89x, or that many troy ounces of gold for one S&P 500 “Share”. The current ratio is 1.86 (2124 divided by $1,144). The math back to 1970, before the U.S. shed the last vestiges of a gold standard, is 1.53x meaning that prices up to $1,388/oz are also “Fair value”.
- Gold goes through long waves of social favor/rejection, and it is better to view gold’s relationship to equity prices through that pendulum-mounted lens. Consider that the all-time low ratio was 0.17, back in the early 1980s, when investors clearly felt that the U.S. central banking system was broken and the domestic economy was stuck in a cycle of “Stagflation”. Yes, it took over 5 S&P 500’s to buy one ounce of gold. The relationship went through “Par” in the late 1980s – gold and S&P 500 at the same price – and hit a high of 5.5x during the dot com bubble of the late 1990s. It would be hard to find a time in modern economic history when there was more enthusiasm for the wonders of man’s creativity than Internet 1.0. Gold was something for a Gucci bangle or Rolex Submariner case, but that was it.
- You probably know the rest – gold and stocks revisited “Par” in January 2009 and stocks didn’t get the upper hand again until April 2013. Now the ratio is the aforementioned 1.86. From 1996 to 2007, the ratio never dipped below 2.0x, so that’s a proxy for where the relationship tends to go during periods of capital markets enthusiasm. And we clearly seem to be in such a phase.
- In the end, most investors own gold not strictly as an investment, but as a hedge. The math we’ve highlighted shows why. When humans get things wrong – central bankers, politicians, even overly enthusiastic equity investors – gold is a useful asset, uncorrelated to the rest.
We can also do this analysis for oil, which in many ways is a more “Useful” commodity than gold and looks very undervalued versus U.S. stocks. Again – graphs at the end of this note and summary below:
- The current ratio of oil prices to the S&P 500 is 41.4 (2124 divided by spot WTI at $51.31) and the 30 year average (using a blend of Brent, Dubai and WTI) is 28.5x. That makes the current price of oil deeply undervalued to the S&P 500. Crude really should trade at $75 if the historical average relationship held any sway. That is essentially 50% higher than current levels.
- Maybe the U.S. is less energy intensive now, so is the relationship is different? Nope – just the opposite actually. The 10 year average is 17.7x, so oil should be $120/barrel.
- The best thing you can say – and this is pretty good, actually – is that global geopolitics and oil supply fundamentals are conspiring to keep crude prices lower for longer than usual this late in an economic cycle. The math backs that up, and this should help U.S. stocks move higher from hopes that consumers will (one day) spend their savings at the pump.
The upshot of these two case studies is pretty clear: oil is cheap relative to stocks and the savvy investor should look at the beaten up energy sector for value plays. Oil doesn’t stay cheap forever – never has, any way. Gold is likely in for some more rough treatment, only because the pendulum of human confidence is still moving towards “Hope” and away from “Fear”. And that’s OK – history if full of such cycles. And gold has seen them all.