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Two researchers place gold in the centre of the "Fed Model" that matches yields on on Treasury notes to stock market returns.Tim Wood
NEW YORK (Mineweb.com) -- Two researchers from New York state recently set out to disprove the commonly held view that the gold price was not correlated with much beyond inflation and currency exchange rates. They have succeeded, in print at least, in overturning the mainstream view by showing that gold prices can be interpreted through other asset classes in combination with forex rates and inflation indicators.
Dr Christophe Faugère and Julian Van Erlach recently published an academic paper explaining their "gold asset pricing theory that treats gold as a store of wealth." Importantly, they develop empirical linkages between the gold price and broader equity valuations.
Overall, the two researchers are attempting to prove that the "market" acts according to "unavoidable mathematical relationships" rather than irrationally. By introducing gold, the research makes a critical connection with Wall Street's favoured "Fed Model". So named by Prudential's Dr Ed Yardeni rather than the Federal Reserve itself, the model hypothesizes a relationship between returns on 10-year treasury notes and the S&P 500 earnings yield. Where the yields diverge, over and under valuation are said to be in effect.
Faugère and Van Erlach write: "We. . . demonstrate that these relationships are not accidental since they are inextricably tied to the macro economy and the ultimate driver of wealth and the human standard of living: global real productivity per capita."
The inverse correlation between the yellow metal and general equities is certainly not foreign to gold investors, especially not those who follow Dr Martin Murenbeeld's gold price modelling which factors in equity valuations. Likewise, we have pointed out before that a regression analysis of the US dollar index (DX00Y), 10-year US Treasury yield and the S&P500 produces a very satisfactory gold price predictor with an R-squared result of 0.875. Murenbeeld's model, which contains many more variables, is far more precise at around 0.92.
Gold investors are a rare breed though and the general market remains ignorant or distrustful of assertions of a link.
Faugère and Van Erlach are expecting that fears of a resurgence of inflation in the United States will revive interest in both gold and gold mining stocks because of their hedging reputation; already established when the world went in search of non-dollar yields after the bubble and 9/11, finding gold, commodities and commodity currencies useful.
"Our research shows that stocks and gold are directly linked together," the two write.
They add: "While we recognize that currency swings do at times affect the domestic nominal and real price of gold, the relationship of the real gold price and the E/P is remarkable even without regard to currency value changes." This is illustrated in a striking graph from 1986 which shows the forward earnings to price (E/P) ratio on the S&P500 and real gold prices moving in tandem. It would be useful to see this model applied to the Wilshire 5,000 to get an even broader assessment.
"The immediate implication of these linkages is that if inflation expectations push up bond yields, then through the 'Fed' Model association, the E/P must rise, thus pushing down the P/E of the market. Meanwhile, real and nominal gold prices will rise," Faugère and Van Erlach write.
That's clearly good news for gold stocks as well, especially if companies stop fiddling with "preservation margins" - they should be high grading in periods of high metal prices to maximize profits and store up cash for the downcycle, reverting to the reserve grade in low price periods.
If there is a net decline in the overall price-to-earnings ratio then the researchers expect gold and mining shares to out-perform both stocks and bonds in a "reappearing-inflation scenario."
The gold price research is part of the authors' attempt to define a unified valuation theory, principally through their "Required Yield Theory (RYT)". RYT predicts that equities are valued to generally yield a real, after-tax yield based on expected earnings and inflation equal to the long-term rate of real, per-capita productivity.
They believe the success of their research should be a boon for policymakers trying to make head or tail or what's going on in their economies. Indeed, it may, but that does not mean they will be more predisposed to owning gold.
Faugère is Assistant Professor of Finance at the State University of New York at Albany Business School; and Research Associate at the Center for Institutional Investment Management. Julian Van Erlach, MBA, is CEO of Nexxus Wealth Technologies, Inc. You can download their paper "The Price of Gold: A Required Yield Theory" by clicking on the icon below.
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