click here

Gold – a tarnished metal

Jul 27, 2015

Here is a link to a pdf file of this post. Click here

July 27, 2015

Gold is not a safe asset. Gold is the last asset one should buy when the world economy is getting into deep trouble and the first asset one should sell when it is on the mend. Over a normal economic cycle the time period for which one should be long of Gold is quite short, perhaps 1/8th of the time of the full cycle. The rest of the time, 6/8th of the economic cycle time period, holding on to Gold is likely to not pay dividends. Gold is an interesting financial instrument to trade. But to trade Gold profitably is no easy task. One needs an understanding of the dynamics of the economy as well as the particular factors that impact the price development of Gold.


Gold is not a currency. Gold is very difficult to exchange it for goods or services. The value of Gold is often far more volatile compared with most major currencies and is often not correlated to any of them. The fact that Gold price is denominated in USD doesn’t makes assigning a future value to Gold even more complicated as one has to fathom the impact of supply and demand in the context of currencies. For example for South Africa the production of Gold gets less expensive in dollar terms when the dollar is stronger. One assumes that South African Gold will get cheaper when the dollar is appreciating. But over the short term, Gold is known to both appreciate and depreciate with a rising or falling dollar.


Gold does not maintain its purchasing power parity any more than the US dollar, GBP or the EUR has done. In the last couple of years, the price of oil may have somewhat kept up with Units of Gold, almost everything else has had little correlation. As energy prices are a big component of mining and refining, one can assume that lower oil prices should influence the price of other commodities. One assumes that the demand for commodities should rise when commodity prices are lower. This is not always the case. Final consumption is driven by many factors, including commodity prices. In a world of ample supply, it would be absurd to assume that demand can keep rising. In the current global environment, different types of cartels control supply. The prices are thus not market prices.


Gold doesn’t protect against inflation. It is not a very useful metal for industrial usage. Its desirability in Jewellery only remains elevated because of the vast amounts spent in advertising. Consumer habits are changing. In the new economy an iPhone is considered far more precious compared with a Gold necklace.


Central Banks hording Gold appears to be an outdated policy concept. Because Gold is a physical asset, emerging market countries hold it because there is little else that is liquid and can be traded internationally. But for developed countries Gold is much worse to hold compared with government bonds or other assets, such as ownership of Ports, Hospitals, Schools or Power Plants. Commodities in general are not a good asset class to hold because one has to pay for storage and yield is zero.


Only in emerging market economies that are poorly managed and are on a spiral of high inflation should Gold be considered an important asset to hold. Hard currency bonds maybe still better options, but not for countries which may be subjected to economic sanctions.


What influences the price of Gold?


Demand and Supply


Gold can end up being in high supply even at the best of times. Financial holders, who usually don’t take delivery, can dump the metal when prices rise. Central Banks can dump the metal when their priorities change. Old Chinese or Indian ladies can come out of the woodworks and the mining companies can make more of their stockpiles available. Mining companies can even sell forward the proven undug deposits. Given that all of the Gold ever mined and refined is floating around somewhere means that there is no shortage of physical Gold in the world. The hope for Gold is that as global wealth levels rise, Gold still remains part of investment portfolios and demand for ‘luxury’ stays relatively sound. What constitutes luxury can change. It is really the excess of cash after one has made purchases of real estate, nice cars, iPhones, expensive TV sets, stock portfolios and nice holidays that one considers meaningful investment in Gold.


One can argue the allure of Gold diminishes when there are a lot of investment choices.


China demand


These days the world wants to rely on China demand for everything. From Soya to Copper to Coal to Iron Ore to Gold, if China consumption is steady or on decline, then prices are susceptible to fall. We don’t focus on the fact that there is too much capacity to dig and deliver, to pump and pipe, to manufacture to meet global demand. One can argue that we are living in the age of excess for those who can afford and extra demand has dried up. Only much faster growth in the emerging markets and large scale renewal of infrastructure in the developed economies can we use up the supply of materials. China is perceived to be the cure and the curse for everything.


It doesn’t really matter what the real Gold reserves of China or Germany are. Whatever the level of Gold reserves, they are probably too high. What is the need for Central Banks to hold Gold? In particular what is the need for central banks of countries that are growing at 6 to 7 percent per year to hold Gold? China and India have excess foreign exchange reserves. If they need money if they borrow from the markets they pay interest. If they sell their Gold reserves, they pay nothing and can invest the proceeds. At minimum can expect to earn the GDP rates?


There are other arguments to hold Gold. The unpredictability of US foreign policy makes some countries vulnerable if they have large holdings of US government debt.


India demand


India, like China is expected to grow over the next decade or two at significant rates (perhaps also 6-8% GDP growth). The masses in India are opening bank accounts. There is online access to the local stock and bond markets. Bank deposits yield above 8%. There are no big risks on the radar from conflicts with Pakistan or China. The population (at least those with money) are getting better educated. Education helps to reset priorities. Do the young want to save up to buy Gold and store it? Or use that money to make a down payment on an apartment in Delhi or Mumbai? Do they want to buy a Gold trinket and have it hanging around their neck or set up a little stall? The choices are obvious. Indians are slowly but surely moving away from traditions of their grandparents and in a world that is more connected their aspirations are changing. Uncertainty is being replaced by hope. Gold is not an asset for the hopeful.


What should be the price of Gold?


In 1988 Gold averaged $370 per ounce. By 2006 Gold was at $750. In 2007 above $1000 and in 2011 it hit $1920. Today it is trading below $1100.


Assuming inflation rate of 2.67%, $370 of 1988 is now $753. This implies that Gold at around $1100 is still overvalued.


Inflation should not be the only variable used to determine the value of Gold. Digging Gold is still cheap compared with the current market price.  The World Gold Council estimates that the average cost of production is $1200 per ounce. The lowest cost producers manage it well below $400 per ounce.


Most important the figure of $370 per ounce in 1988 doesn’t tell us anything. Was Gold price too low or too high in 1988? The fact that the price rose subsequently tells us only about the dynamics of Gold in the context of polices, availability of alternative investment choices as well as the amount of money floating around during that period in addition to Gold inventories etc. It doesn’t tell us if Gold was absolutely a bargain even at $370 in 1988.


UK House price vs Gold


The average price of a home in the UK in 1988 was GBP 60,000. At $370 that means one needed 162 ounces of Gold to make that purchase. The average price of a home in the UK in 2015 is GBP 272,000. This requires 247 ounces of Gold using the current price of $1100 per ounce. You can do the calculation on how much that home would have given in additional returns in rent. Gold’s value on that score is now even lower. One cannot rule out that Gold will not get cheaper still.


One can use art, yachts, vintage cars, rare books, stamps, or even intangible assets such as education to compare the relative value of Gold between different periods. It is hard to think against what asset class Gold has done well. Perhaps the cost of data storage!


Using the imprecise concept of inflation one can estimate that $370 of 1988 is equivalent to around $753 today. But one can easily look at money differently. Having $753 today is not the same as having $370 in 1988. Personal income has probably grown by at least 2 times the rate of inflation. Put in another way, the amount of money that is circulating in the system, including the assets of the rich and the amount of financial assets that have been created since 1988, that $370of 1988 is probably equivalent to $2000 of today. Gold on that measure is also cheap.


As we have argued the concept of ‘absolute value of money’ is quite complex. It is even more meaningless when we start comparing historical prices with current prices. Both the relative value of the dollar and the relative value of the commodity is changing. Also, because of the rise in living standards (real economic growth) and impacts of wealth redistribution, in the way Thomas Piketty has educated us, means that some sections of society have much more compared with the past.


Changing preferences


The key difference between 1988 and 2015 is also the choices and thus our habits in how we consume our money have expanded and changed. We are as likely to spend money on some virtual experience as on a real asset such as Gold. This leads to the conclusion that Gold serves a smaller need in the overall consumption patterns. Fifty years ago Gold was an insurance against bad times, because insurance was under developed. In the current reality, people can buy insurance rather than having a pendant hanging around their necks – a pendant that might get lost or stolen.


Gold in Money Laundering


Because Gold is a physical asset, it use as a money laundering or as a medium of exchange that cannot be easily traced should not be underestimated. However, some version of the Bitcoin is likely to replace or supplement it sooner or later.


Is Gold now cheap or expensive?


No one can know if Gold is now cheap or expensive. What one can say is that our financial system doesn’t know how to price assets such as Gold. The price was incorrect when it was at $370 in 1988. It was incorrect at near $2000 in 2013 and it is probably incorrect now.  There is no such thing as a fair price. There is of course a market price. But the mechanisms we have to determine that market price (a market place to buy and sell) is so imperfect that on a given day the price can jump up or down by 2 to 10 percent.


We can be sure that the price of Gold will change and at some point in time it will reverse direction from its current downward spiral. No one can know if the change will be sustainable.


What we can say is that the price of Gold has some loose correlation to:


  • Level of interest rates – rising rates, less reason to hold Gold – very high interest rates good reason to sell the metal.
  • Lower the dollar, higher the price of Gold.
  • Better the environment for stocks, lower the demand for Gold as a financial asset. One can argue that the rich hold assets that yield, the poor hold assets on which they have to pay.
  • The higher the geopolitical risks (also economic risks), the more demand for Gold. Russia on sanctions is likely to hold physical Gold instead of US Treasuries, which can be frozen.


Since economic trends generally last for quite a while, one can assume with slightly greater certainty that Gold price declines when global economy is doing well and rise when it isn’t. But other factors such as Central Bank policy, level of inventories, amount of leverage in Gold assets and level of speculative activity and often the sheer wall of money in the hands of some players’ influences prices more than any fundamental drivers. Trading or markets are not rational. It is Dog eat Dog.


There are no guarantees that Gold will go up in the long term. In the very long term measured in diluted dollar terms, Gold notional price should rise. Whether an ounce of Gold will buy you the equivalent of then latest version of the iPhone is guess work.


Unless we find unique applications for Gold where the metal gets scattered as waste and becomes a commodity of genuine value, it is likely that as humanity progresses Gold will lose its sex appeal. Perhaps we should stop digging more of it up. There appears to be plenty to go around.


Technical analysis


Over short periods Gold prices are influenced by technical factors. Understanding technical factors can be as much art as it is science. One can argue that on average, like in any game, the sharpest minds and the most agile systems will win. Large hedge funds and institutions that see the flow of buys and sells and those who can front run other traders are more likely to win.


Algoam has models which trade Gold using short term technical indicators. Our models have the objective to try and outperform benchmarks over the medium to long term on a risk adjusted basis. The methods attempt to use multi-variables to identify price development and have risk-management discipline built-in. Still, there are no certainties that any approach will continue to work.


Gold in asset allocation


For long term passive investing, we can show that Gold can add diversification benefits to an already diversified portfolio. .

It is better still to use the Algoam Gold Strategy to the Algoam Asset Allocation Models – which consist of multiple Algoam strategies on different liquid asset classes.

Please have a look at:

Algoam’s systematic approach can provide good insights for traders, holders or investors in Gold.

Those insights are good even when the systematic approach is not working!

No comments

Leave a Reply

Your email address will not be published. Required fields are marked *