Growing numbers of investing experts have been declaring that gold is a bubble: an insanely overvalued asset whose price is bound to burst.
There is no basis for that opinion. And understanding why can help point an investor toward clearer thinking about frenzied markets.
Sure, gold seems expensive. At its recent price of $1,813 an ounce, gold is off only slightly from the record high of $1,912 touched on Sept. 6 (unadjusted for inflation). Gold is up more than 40% over the past year, largely on fears that paper currencies like the dollar won't retain their value.
But that doesn't mean it is overvalued. Unlike bonds, which provide interest income, and stocks, which produce dividends and earnings growth, gold generates no cash flows. As John C. Bogle, founder of the Vanguard funds, told me two weeks ago, gold "has no internal rate of return." As a result, there isn't any reliable way to tell what it is worth.
So the people who say gold is in a bubble might well be right. But the people who think gold is heading for $2,500, $5,000 or $10,000 also might be right.
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Folks on both sides would be more intellectually honest if they admitted that they are just guessing what gold is worth. With no measures like price/earnings ratios or bond yields as benchmarks of value, figuring out whether the precious metal is cheap or dear is like trying to solve a Rubik's cube while you are blindfolded.
Decades ago, the great investing analyst Benjamin Graham pointed out that there is no such thing as a "good" stock; every company is good at one price (when it is cheap) and bad at a higher price (when it is too expensive). But try asking a gold bug at what price he would sell, and you are likely to get an answer somewhere between $6,000 and "never." Ask a gold skeptic at what price he would buy, and you be met with silence, followed by "never" or a quavering "$900, maybe?"
Precisely because I don't know how to determine its fundamental value and have never been able to identify anyone else who can, I haven't written about gold for years.
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But there is one aspect of gold investing where it is possible to make rational estimates of value: the stocks of gold-mining companies. And, by historical standards, they seem cheap—based not on subjective forecasts of continuing fiscal apocalypse, but on objective measures of stock-market valuation.
"We haven't seen [low] valuations like these since 2008," says Joe Foster, gold strategist at Van Eck Global. But financially, gold miners have "never been in better shape." Van Eck's Market Vectors Gold Miners (GDX - News) exchange-traded fund holds 30 mining stocks.
Several big gold-mining companies—among them, Barrick Gold (ABX - News) and Newmont Mining (NEM - News) —are trading around 14 times their earnings over the past four quarters, virtually matching the Standard & Poor's 500-stock index at 14.5 times earnings. Even with gold at record highs, the shares of gold miners are trading at an industrywide average of roughly 18 times earnings, at 2.4 times "book" or asset value (versus 2.0 times for the overall stock market) and at one of the lowest ratios on record to the price of the metal itself.
Yet mining companies have rarely if ever been more profitable, and should be able to generate high returns so long as gold stays above $1,500 or $1,600, points out John Hathaway, manager of the Tocqueville Gold Fund.
Gold stocks aren't a low-risk play; like the metal itself, they can burn you, especially if you expect to get rich quick. And gold mining has been the classic boom-bust industry, with managements squandering money on acquisitions and bad investments during the fat years and retrenching during the lean years.
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"The industry has done terrible, asinine things," says John Tumazos, an independent metals analyst in Holmdel, N.J. "I own 23 or 24 gold stocks, and I probably have a loss position in half of them even with gold at $1,800," he adds. "One of them I bought when gold was at $300." Smaller gold companies can be particularly risky.
Still, Mr. Tumazos and others say a new generation of management in the gold industry is less tarnished, and that rising dividends are likely. As Caesar Bryan, manager of the Gamco Gold Fund, puts it, "We think they will be returning capital to investors instead of taking it from investors, which is what they've historically been good at."
Of course, if gold goes back to $900, these stocks will go right down with it. But if the precious metal holds steady or keeps going up in price, gold shares could pan out, too.
— email@example.com; twitter.com/jasonzweigwsj