Gold prices: Bubble or fundamental

September 13, 2011

(The views expressed in this column are the author’s own and do not represent those of Reuters)

Suddenly all eyes have turned to the yellow metal. Some say that it’s a bubble while others give a lot of demand-supply reasons. Fall of the dollar and other economic reasons suggest that it has miles to go.

Let me try a more fundamental way to analyse this. But before that, I need to first take you through the basics of share price valuation. Why is that necessary? Hopefully the dots will be joined in due course.

Basic finance taught us that the value of a corporate is nothing but the present value of all its future profits, till infinity. Although this model has a lot of assumptions, conceptually this seems logical.

Simultaneously, a corporate also has assets — namely, its book value. That is nothing but the value of its existing contracts, fixed assets, inventory — to name a few. The third major component for the corporate is the total outstanding borrowing.

Just to summarise, we have now created 3 variables — the value of the company (P), the price of its outstanding debt (V), and the value of the existing assets (B).

Now imagine what happens when the expected future revenue of the corporate drops. The obvious answer — a drop in the market value of the company (i.e. P). What happens next? The people who have lent money start getting panicky whether the company will be able to repay the money they have borrowed. How will that affect the total value of outstanding debt? The answer can be given in two ways. For the technically savvy, it just means that the rate at which investors discount the bond increases (due to its lower credit-worthiness) and therefore reduces the value of V. For the intuitive guys, it means that the probability of the company defaulting goes up and so I, as a lender, am happy getting back a lower amount today rather than waiting till maturity and run the risk of getting nothing.

So this results in a reduction of both P and V. However B stays the same — since they are not future repayment capability or future profits, but is the value of the current stock of assets. So the ratio (P+V)/B falls.

So far, it’s basic finance principles, right? The reason why simple finance works in this case is because we assume that the company is a small one and therefore cannot influence its own outcome or value of equity and debt.

Now let’s try and complicate matters a bit. Think of the entire economic world as one single company. That is, imagine a single corporate which has various departments. Each department is one government, or one corporate, etc.

Let us now apply the same P, V and B concept.

But before that, a few questions to tingle your senses.

What is the total value of the bond market in the world? Estimates are that it is approximately $90 trillion where more than 70 percent is government issued.

What is the total value of the equity markets? While it has been gyrating all over the place these last few weeks, it is approximately $35 trillion.

Add to that the bank & non-bank loan market, and we should a total value in excess of $150 trillion. This number is nothing but the sum of P and V in our earlier example.

What are these? This total sum is nothing but the value that people have placed in the efficient functioning of governments and corporates, via debt and equity, effectively assuming a particular growth rate of future revenues. The growth rate is nothing but the world GDP growth rate. The governments will typically make money by levying various kinds of taxes, while the corporates will be earning profits by buying and selling goods and services. Both these components are obviously dependent on this one number — the world growth rate.

On an average, the world has been growing at 4 percent p.a. the last couple of decades. Based on the economic turmoil, specifically in the west, economists now have expectations that this growth rate is going to drop to around 2 percent. Therefore, we should expect, similar to the single company story, that of the P+V approximately half, i.e. borrowing should become significantly expensive, while equities should collapse to 50 percent of its earlier value.

However, if you look around, what is happening is quite the contrary. Due to the ultra low interest rates, the equity market is propped up, to nearly where it was prior to the 2008 crisis. Governments are raising more debt, first to bail out financial institutions and subsequently to provide fiscal stimulus.

So what is going wrong? Why is the total world not behaving like our small company? Because there is a fundamental difference — the world is not operating in a free-market capitalist world. There are a few big daddys — namely the big governments and large financial institutions who are all trying to “prop up” the economy using artificial mechanics. What kind? Well, now I think we are digressing, that can be the debate for another day.

Suffice to say, that although the world’s expected growth has dropped from 4 percent to 2 percent, the total value of P+V instead of halving, has actually increased. So the ratio of (P+V)/B is not dropping. But it has to right? So what else can happen — you guessed it right — B has to therefore increase to balance the number such that the principles of finance are maintained.

So what is B?

B is nothing but the value of gold held by the world, the value of the land, oil and other mineral resources, the infrastructure, etc. All of that now has to more than double. Which among this is the easiest to monitor and is homogenous to compare? Gold. So that is the first thing that is going up but eventually all real assets — commodities, land, real assets are bound to follow.

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