SINGAPORE (Nov 3): How does one value the price of gold without a coupon or dividend, and no expected earnings or book-to-value ratios?

To Juan Carlos Artigas, the World Gold Council’s director of investment research, valuing gold is “intuitive” in essence.

“[Gold] equilibrium price is where demand and supply meet. Understanding the underlying drivers and interactions of gold demand and supply should therefore give investors a robust framework to determine the value of gold,” says Artigas in the autumn edition of Gold Investor, which was published by the World Gold Council in October.

According to him, the reasons why most valuation models for gold pose challenges include: their primary use of US and Western driven variables; an overwhelming focus on investment demand; and a disregard for supply-side dynamics.  

“Even models that take into account economic growth and structural shifts still fail to include a basic (and quite important) premise: gold is scarce. Its availability is driven by just two factors: whether mines have the capacity to produce new gold, and whether investors or consumers are willing to sell existing gold,” he continues.

As such, Artigas believes a combination of a top-down and bottom-up approach is required to develop a more robust understanding and valuation of gold.

His recommended framework models physical demand/supply and derivatives markets using macroeconomic variables – and their interactions are linked through the price of gold using the following inputs:

Jewellery is negatively correlated to price, meaning that jewellery demand falls in response to price increases. However, the product category is positively related to income (and inflation, in some countries).

While electronic demand tends to increase as gross domestic product (GDP) grows, Artigas says there is a “substitution effect” with copper. The higher gold is priced relative to the relative price of copper, the lower demand for technology will be.

Bar and coin demand is driven by price and income growth, meaning that long-term income growth is positive for demand in terms of bar and coin; whereas ETF demand is driven by price and uncertainty. On the other hand, the demand for derivatives is driven by momentum, as well as inflation and monetary policy expectations.

Central banks:
Any increase in emerging markets’ share of global GDP will drive up gold demand by central banks about fivefold, says Artigas.

Mine production:
Mine production is driven by cost and persistence, meaning that increases in cost will lead to a reduction in mine production the following year. In the case of persistence, Artigas shares that for every 1% rise in mine production in one year, there will be a 0.5% increase in production for the following year.

Although recycling is positively correlated to price and negatively correlated to growth, i.e. GDP, it also tends to mean-revert. For example, a 1% rise in price encourages 1.1% more recycling – however, such an effect is largely reversed in the following year.

These inputs, says Artigas, can be used to predict each of the components of gold’s demand and supply as many of them are either lagged variables or forecasts.

Consequently, we can determine the change in price necessary for the market to be in equilibrium by examining the imbalance between demand and supply that would exist in the market, if the gold price were static.

“Put together, this framework allows investors to use current variables and easily available economic forecasts to form a consistent, self-contained and intuitive view on gold,” says Artigas.