How high will gold go? $5,400, $6,216, $12,500, or even $20,000 an ounce

The price of gold has risen every year for the past 11 years and over that period the yellow metal has produced an average annual return of more than 17%. The bull market is now in its twelfth year and the outlook for gold is more bullish than it’s ever been.

We’ve got governments around the world announcing massive new programmes of QE (the biggest of which are unlimited in size and duration), we’ve got bullish technicals with gold breaking out of a year-long consolidation and the 50-day moving average crossing above the 200-day, and we’ve got bullish fundamentals with total supply in Q1 2012 of 1,058.7 tonnes and demand of 1,119.0 tonnes.

Add to this the fact that long, powerful bull markets such as this one almost always end in some kind of speculative mania, and it begs the question, how high will the price of gold go? This article attempts to answer that question.

Inflation adjusted high

Perhaps the most common way of calculating a target price for gold is to use the high of $850 an ounce that gold reached in the 1970 to 1980 bull market and adjust it for inflation. Using official US CPI data that number comes out at around $2,400 an ounce, however the way the CPI is calculated has been adjusted many times over of the years, the result being that inflation in the US is significantly underreported.

If we adjust the $850 an ounce figure for 32 years of US inflation using the true inflation figure, i.e. the method used to calculate CPI before all the tinkering took place, we get a target for gold of around $5,400 an ounce.

A 12 year chart of gold

A 12 year chart of gold

Note: The gold price used in this chart is the London Bullion Market Association (LBMA) London PM fix. The price quoted is in US dollars per troy ounce. Data courtesy of the World Gold Council.

Note: As those familiar with Dow Theory will know, bull markets typically have three phases, the third of which is the steepest part of the assent. It’s in this third and final phase that the general public enters the market, and this is when the price of the underlying asset gets bid up to extreme levels and sentiment becomes almost entirely one sided. This mania phase still lies ahead of us.

The 1970 to 1980 gold bull market

Another way of calculating a target price for gold is by comparing the current bull market with the last one. I.e. the one that ran from January 1970 to January 1980.

Between 1 January 1970 and 21 January 1980 the price of gold rose 2,328%, a 24 fold increase. So far in this bull market, however, gold has risen from $255.95 on 2 April 2001 to $1,760 an ounce today (24 September 2012) a rise of 587% and a 6.88 fold increase.

If it were to match the 24 fold increase of the last bull market, the price of gold would need to reach $6,216.

Gold to match US external debt

Gold is a monetary metal and as a result it maintains a close relationship with the supply (and therefore the value of) money. In fact, a recent study by Ray Dalio, founder of the world’s largest hedge fund, Bridgewater Associates, found that there is a 90% correlation between the global money supply and the price of gold. And because of fractional reserve banking and the fact that all currencies today are fiat, gold also has a close relationship with debt.

The chart below shows that there is a historical relationship between the price of gold and the value of US debt.

An 18 year chart of gold & US debt

An 18 year chart of gold & US debt

Chart courtesy of Bloomberg

It has been observed that in the past, during times of panic, gold’s value approaches that of America’s external foreign debt. According to the editor of 247bull.com, “If the ongoing global debt crisis develops into a full blown panic it could lead to a mass loss of confidence in the ability of governments and central bankers to save the system. Under this scenario gold could do what it has historically attempted to do in the past, which is to balance the balance sheet of the United States.” In order to do this gold would have to reach around $12,500 an ounce.

Dow to gold ratio

Calculating the target price for gold can also be helped by understanding the historical relationship between the yellow metal and the Dow Jones Industrial Average. This relationship is cyclical, and at the end of each cycle the Dow to gold ratio reaches one, in other words, one ounce of gold can buy the Dow. This happened when gold reached its peak in 1929 and again in 1980.

In this latest cycle the Dow bottomed in the year 2000 at about 43 ounces of gold. Today it takes 7.65 ounces of gold to buy the Dow, and the trend certainly suggests that at some point history will repeat itself and the two will converge. The question is at what price?

The editor of 247Bull.com, has long argued that the response to the global financial / debt crisis would be massive currency debasement which is highly inflationary, and we are certainly seeing more and more evidence of this. With inflation as a backdrop we can expect the nominal price of the Dow 30 stocks to have an upward bias from today’s level of 13,579 – not discounting any corrective move. As a result it’s fair to assume that should gold once again reach parity with the Dow, it would do so well north of $13,579 an ounce, perhaps as high as $15,000 to $20,000.

The bottom line

Gold has been one of the best performing assets for more than a decade; however it’s likely that it will continue to rise for many years to come. Further more, there is plenty of evidence to suggest that the biggest part of the rise is still ahead of us and that gold could easily reach $5,400, $6,216, $12,500, or even as high as $20,000 an ounce.

In my opinion every portfolio should contain some gold, how much you decide to hold will depend on your specific circumstances, and whether it’s your intention to get wealthy or simply stay wealthy. However, every investor owes it to themselves to find out about gold and with that in mind here are several ‘must read’ articles to get you started:

The single best reason to own gold

Why Gold Has Fallen & Why It Will Rise Again

How to profit from QE3 & the coming wave of liquidity

Why today’s system of fiat money is doomed to fail & what it means for investors

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