Study: If gold drops below fair value as it did in mid-1970s, it can hit $350/oz

The situation is “no longer whether the gold bugs can live with gold at $825 an ounce — it’s whether they can live with $350,” a famous analyst says.

Gold bugs, who have just begun to digest bullion’s more than $100 fall over the past month, need to brace for the possibility of an even deeper fall.

This is what Claude Erb predicts. Erb is a former commodities manager at fund manager TCW Group, and co-author (with Campbell Harvey, a Duke University finance professor) of a mid-2012 study that predicted a plunging gold price. MarketWatch reporter says they deserve to be listened, as it was them who forecast a long-term gold bear market when it was emerging.

Earlier this week, Erb announced that the gold community now needs to consider the distinct possibility that gold will trade for as low as $350 an ounce.

He bases this prospect on two premises:

1) gold’s fair value, which is currently $825 according to the formula proposed in Erb and Harvey’s study.

2) the likelihood that, whenever gold does eventually drop to fair value, it will overshoot and drop to a much lower value.

If gold plunges below fair value to the same extent it did in the mid-1970s and the late 1990s, bullion would trade around $350 an ounce.

Many gold bugs will find such a prospect outrageous, if not simply incomprehensible. But why should gold behave differently than any other asset, each of which fluctuates markedly from the extremes of over and under value?

The analyst refer to the five well-known stages of grief to characterize where the gold market currently stands. Those include denial, anger, bargaining, depression and acceptance, and he argues that the gold-bug community currently is in the “bargaining” stage.

In mid-2012, Erb continues, the gold bugs were in the denial phase.

His and Harvey’s prediction of the metal around $800/oz was met with almost complete distrust. At the moment, with gold more than $500 an ounce lower and predictions of sub-thousand-dollar gold now relatively spread, the gold bugs have passed through the anger phase and are now bargaining.

The situation is “no longer whether the gold bugs can live with gold at $825 an ounce — it’s whether they can live with $350,” Erb opines.

Erb points out that this is just similar to equities, which, according to the formula championed by Yale professor Robert Shiller, have been overvalued at least since the early 1990s.

What else needs to be mentioned is that Erb and Harvey’s research contains some good news for gold believers: over the very long term, gold does keep up with inflation, which is measured, however, in terms of many decades, if not centuries.

Over shorter terms measured in years you must take seriously the possibility that gold won’t just drop below $1,000 an ounce but, eventually, to a far, far lower price as well, the research says.