The price of gold, the value of the U.S. dollar and inflation are all closely tied, and this can make it difficult to figure out whether the current bullion price is high or low based on history.
The good news is that this problem can be solved by adjusting the gold price for inflation. The bad news is that once this is done, the future does not look bright for gold investors.
Monday's closing gold spot price was $1,317.11 (U.S.) per ounce. To pick an example from history, the closing gold price for July 7, 1980, was $667.50. The nominal dollar difference is big, but that doesn't mean much until we adjust for the difference in spending power of the U.S. dollar caused by rising prices.
Because of inflation, the spending power of one U.S. dollar has been more than halved since 1980. So just comparing the nominal price of gold then and now makes no sense. In effect, these are different currencies.
To assess whether gold is more or less expensive now, it is necessary to calculate an inflation-adjusted gold price using the same currency. The Federal Reserve's preferred inflation index is the PCE (personal consumption expenditure) Core Index, which measures all historical prices in 2009 dollars.
To calculate the inflation-adjusted value for gold, the bullion price is divided by the PCE Core Index. The PCE Core Index was 0.43 in 1980, so the inflation-adjusted gold price on July 7, 1980, was $667.50 divided by 0.43 or $1,552 per ounce.
Using the same technique for the current market, using the current PCE Core Index of just over 1.07, the gold price is roughly $1,230. Despite what it looked like at first, the gold price was far higher in 1980 compares with today once inflation is taken into account.
For investors, there is a consistent and important relationship between the inflation-adjusted gold price and forward returns. Unfortunately for precious metals investors, the current gold price suggests minimal returns over the next five years.
The accompanying chart shows gold's average five-year rise or fall following all inflation-adjusted gold prices since 1975. For example, the bar on the far left shows that when the inflation-adjusted price of gold was between $150 and $200 per ounce, the average cumulative rise in the bullion price in the following five years was 237 per cent.
The bars on the chart are generally trending shorter, moving left to right. This shows that the higher the inflation-adjusted price of gold, the smaller the return investors can expect.
Inflation-Adjusted Gold: Average Forward 5Y Cumulative Return %
SOURCE: Source: Scott Barlow/Bloomberg
At $1,230, the adjusted bullion price is firmly in the range that, based on the past, suggests negative returns for gold investors in the next five years.
One caveat: The outlook may not be quite as dire as the chart suggests. There have been so few periods where inflation-adjusted gold has traded above $1,000 (we can't use any instance after July, 2010, because there isn't five years of forward performance data yet) that it's risky to generalize on what might happen. There aren't enough precedents.
That said, the legions of precious metals fans argue that the potential for a collapse in the global financial system and the U.S. dollar means the gold price deserves to go higher from here. This is theoretically possible, but it requires an "it's different this time" outlook that has hurt portfolios in the past.
Precious metals investors should feel free to hold bullion as insurance – a hedge against potential catastrophe – but shouldn't depend on significant capital gains in the years ahead.
Follow Scott Barlow on Twitter at @SBarlow_ROB.