Is Gold an Overpriced Commodity?

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

NEW YORK ( Insider Monkey) -- Gold stocks are quite popular among hedge funds these days, and for good reason.

John Paulson, who is very bullish about the precious metal, made $5 billion by betting on gold in 2010.

As of Dec. 31, 2011, the largest position on the 13F filing for his Paulson & Co. was the gold exchange-traded fund SPDR Gold Trust ( GLD), in which Paulson had more than $2.6 billion invested.

Besides Paulson, there were 55 other money managers bullish about SPDR Gold Trust. In total, they had $8.2 billion invested in the position.

Another gold ETF, Market Vectors Gold Miners ETF ( GDX), was also popular with hedge funds last year.

It was held by 41 hedge funds at the end of last year. In addition to ETFs, hedge funds were also bullish about companies engaged in producing gold, such as Barrick Gold Corp. ( ABX) and Newmont Mining Corp. ( NEM).

There were more than 40 hedge funds with these two positions in their 13F portfolios at the end of 2011. For instance, David Einhorn's Greenlight Capital had $60-plus million invested in Barrick while Jim Simons' Renaissance Technologies had nearly $90 million invested in Newmont.

Other gold stocks with significant hedge fund interest are Goldcorp ( GG), Kinross Gold ( KGC), Allied Nevada Gold ( ANV) and AngloGold Ashanti ( AU).

But is gold truly worth investing in? Or is it overpriced relative to other commodities? Let's compare the historical price of gold with commodity indices.

We are going to use spot gold prices and two commodity indices: S&P GSCI (formerly the Goldman Sachs Commodity Index) and the Thomson Reuters Equal Weight Continuous Commodity Index, or CCI.

S&P GSCI is a broad-based index mainly weighted in energy (80%), agriculture (10%), industrial metals (6%) and precious metals (2%).

CCI is comprised of 17 commodity futures that are continuously rebalanced to maintain equal weighting. Unlike GSCI, which can overweight the energy sector, CCI provides relatively even exposure to all commodity subgroups (energy 18%, metals 24%, soft commodities 29% and agriculture 29%).

Gold vs. GSCI

We collected daily data points of spot gold prices and GSCI from Jan. 8, 1991 to March 23, 2012 and plotted the values we obtained.

Gold prices and the GSCI tracked each other closely before late 2008. After that, the price of gold went up rapidly while GSCI grew at a relatively slow pace. As a result, the ratio of gold prices to the index has gone up to a higher level in recent years. As of March 23, 2012, the ratio is 2.37. Although that's 25% lower than its peak of 3.18 on Feb. 23, 2009, it's still 35% higher than the historical average of 1.75.

Gold vs. CCI

Gold looks a bit overpriced compared with other commodities when using GSCI, an index that has a higher weight on energy. Now, let's compare gold prices with an equally weighted commodity index, CCI.

We collected daily data points of gold prices and CCI from December 29, 1978 to March 23, 2012. Gold prices rose to abnormally high levels of about $850 an ounce in January 1980 because of high inflation, high oil prices, and the termination of the direct convertibility of the dollar to gold.

Since late 2008, the price of gold has also gone up much faster than the CCI. The ratio of gold prices to the CCI reached a peak of 3.02 on Dec. 7, 2011. It hit 2.93 on Jan. 21, 1980. As of March 23, 2012, the ratio is 2.89, which is 74% higher than the historical average of 1.66.

Overall, the price of gold has been on an uphill trend over the past decade, but it grew much more rapidly than other commodities only in recent years.

Gold supply is pretty inelastic, which makes it a good long-term play on inflation. This may be one of the reasons why investors preferred gold over other commodities.

Our calculations showed that gold is overpriced relative to other commodities.

Considering that there were no supply side shocks after September 2008 that would explain the 100% increase in gold prices relative to commodities, we think investors would be better off by betting on commodities and shorting gold.
This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.