How High Could the Price of Gold Go?

A well-established proxy for the price of financial assets is the Dow Jones Index. In my view the single best proxy for commodities is gold. Their price ratio, the Dow-Gold ratio, tells us how many ounces of gold buy one unit of Dow Jones. If today the Dow is 7,000 and gold is $900, the gold-Dow ratio is 7.77. Thus, it takes 7.77 ounces of gold today to buy one unit of the Dow Index.

History tells that in long-term bull markets for stocks this ratio can get pushed up into the range of 20-50. During the last century, there were three such peaks, in 1932, 1966, and 2000. These three peaks were in the 20-50 range.

On the other hand, long-term stock bear markets usually coincide with long-term gold bull markets. At the long-term peak for gold, the Gold-Dow ratio is in the range of 1-2. 1900 recorded a low of 1.7; 1929 recorded a low of two; 1980 recorded a low of about one. This means that when the gold bull market peaks, the price of gold will roughly equal the Dow Jones Index.

So, how high will gold go? The correct answer is simple: as high as Dow Jones. It is important to understand that this method does not tell us now the end of the bull market. It could be five, ten, or fifteen years from now. It also does not tell us how high. It could be $2,000, or $10,000, or $50,000. But the important point is that it tells us when we are there and inherently keeps track of the macroeconomic environment.

Which is the most likely price target will depend on how Federal Reserve will fight inflation. Based on the Federal Reserve's reaction, there are three possible future scenarios: (1) deflation, (2) stagflation, and (3) strong inflation. I shall consider each scenario in turn:

The first scenario, deflation, implies a major contraction in the supply of money and credit, similar to the one during the Great Depression. Consumer and commodity prices would fall rapidly; the stock market and real estate market would collapse. At that time, stock prices and real estate fell roughly 10 times and gold rose only a little. If this scenario were to play out, then a reasonable forecast for the Dow will be about 1,000-1,500, while the gold price will be in the range of $800-1,500. This scenario is highly unlikely as the Federal Reserve will fight tooth and nail to prevent deflation from taking hold.

The second scenario, stagflation, is most likely. It should look similar to the 1970s. Back then, the Dow made its peak in 1966. It made little progress for about 15 years, so that in 1980 it was just about where it was in 1966, roughly around $1,000. Gold, on the other hand, rose from a low of $35 all the way to $850. This means that strong inflation during the period kept the Dow from falling, so it did not fall as it did during the Great Depression. On the other hand, inflation powered the price of gold about 25-fold. In this scenario, we chould expect the Dow to remain in the 7000 - 10000 range. Then, a gold forecast of $5000 - 7000 is perfectly realistic.

The third scenario, very strong inflation, is possible, although less likely than stagflation. This would mean a typical, commonly-observed inflation of a third-world country, may be 15-25% annually. This kind of inflation could easily power the Dow may be 3-4 times in the coming decade, may be all the way to 30,000-50,000. This could mean a $20 for a loaf of bread or a gallon or petrol. This would imply a gold price in the range of $20,000-50,000. Whilst this is a possibility, I think it is highly unlikely.

To summarise, I believe that both deflation and very strong inflation are not very likely. The likely outcome will be stagflation. Then a $5000 - 7000 price of gold is consistent with this view. This is my price target for 2015-2020. My recommendation is simple – stay with gold and you will do well in the long run.