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Central Bank Balance Sheets Put Gold at $1900!

  • Written by Syndicated Publisher 47 Comments47 Comments Comments
    March 21, 2012

    Given the extremely high correlation between central bank balance sheets and the price of gold, it is possible to determine the implied price relative to current debt levels. In doing so, we calculate gold’s “central bank balance sheet value” at around $1900 an ounce.

    Gold has had quite the wild ride over the last nine months in which we’ve seen several triple-digit swings. It had a quick and sharp bear market last September with a 20% decline followed by an 18% snapback rally into November and then a 15.5% decline into the end of the year. Then, gold’s volatility carried over into 2012 as it rallied from December 2011’s low to a high at the end of January for a 17.6% positive swing. Lastly, we witnessed yet again another triple-digit swing when gold declined to the March 14th low of $1634.53/oz for nearly a 10% correction.

    Right now, we have the second most oversold reading since 2008 and, as of yesterday’s low, gold appears to be selling at a discount of $255/oz to its average price. Thus, as I show below, gold investors are currently presented with yet another oversold and undervalued buying opportunity.

    Second Most Oversold Reading In Four Years

    Our firm has developed a technical indicator for gold based on several variables which we aggregate and then convert to corresponding z-scores (or standard deviations) to get a statistical reading of how overbought or oversold gold is relative to its historical performance. As shown in the figure below, gold is one standard deviation below its 12-year average (average taken over gold’s secular bull market) which is the second most oversold reading since 2008. Readings below -1.0 have often marked significant bottoms and the current reading should be seen only 15.9% of the time or, conversely, readings above -1.0 should occur 84.1% of the time.

    gold and pfs group intermediate term gold indicator
    Source: PFS Group

    Gold Selling for a $255/oz Discount to Theoretical Price

    Because gold is no one’s liability and can’t be created out of thin air like fiat currency, it is seen as a store of value and a hedge against global currency debasement. Gold has served this role exceptionally well over the last several years which has seen trillions upon trillions of dollars dumped into the global financial currency pool.

    Proof of gold serving as a hedge against currency debasement is well illustrated in the graph I present below, which plots reserves for the five biggest global central banks (in dollars) alongside the price of gold. As you can see, the correlation between the two is unmistakable.

    u.s. ecb. boj. boe. pboc reserve
    Source: Bloomberg

    Running a regression analysis shows a 91% correlation between April 2009 to the present and the linear equation for the regression can be used to derive what the theoretical price (TP) for gold should be. Using the regression equation and the current value of the combined big 5 central bank reserves gives a current TP for gold of $1905/oz. Any time gold is above the regression line it can be seen as overvalued relative to its TP while values below the regression line indicate gold is undervalued. Gold’s price as of this morning is shown by the red box, which is clearly well below the linear regression line.

    gold vs the big 5 central banks
    Source: PFS Group

    Since 2009 gold has roughly maintained a steady $100/oz trading range to its TP until recently exhibiting massive volatility, both to the upside as well as to the down. Shown below is a multi-panel chart which plots gold and its TP in the top panel while the deviation of the spot price to its TP is shown at bottom.

    Last summer it appears gold was discounting a rapid increase in central bank reserves to combat the European crisis and got way ahead of itself by trading nearly $300/oz above its TP. Gold sold off sharply in September 2011 and had a bear market in a single month alone before rallying into November. The decline in December 2011 pushed gold well below the $100/oz deviation from its TP in which gold did a 180 degree turn by selling off from nearly $300/oz above its TP in August 2011 to nearly $300/oz below its TP by the end of the year.

    gold reversal
    Source: Bloomberg


    When reviewing our gold technical indicator and the “central bank balance sheet value” for gold, we see that it is both strongly oversold on a four-year basis and has an implied price of $1900 per ounce, around $250 above its current reading.

    Image:; Flickr (licence attibution)

    About The Author

    Chris graduated magna cum laude with a B.S. in Biochemistry from California Polytechnic State University, San Luis Obispo. He joined PFS Group in 2005 and is currently pursuing the designation of Chartered Financial Analyst. His professional designations include FINRA Series 7 and Series 66 Uniform Combined State Law Exam. He manages PFS Group’s Precious Metals Managed Account, Energy Managed Account, and Aggressive Growth Managed Account. Chris also contributes articles and Market Observations to Financial Sense and co-authors In the Know—a weekly communication for Jim Puplava’s clients only—with other members of the trading staff. Chris enjoys the outdoors.