The golden bubble?

April 23, 2011

(The views expressed in this column are the author’s own and do not represent those of Reuters)

The spot price of gold crossed $1500/oz on April 22 and confirmed the belief that gold and, even more so, silver, are the best investments. In the last one year, gold gave a return of more than 30 percent; equity (Sensex) a mere 10 percent.

That was not always so. For more than 28 years before 2008, gold was a dead investment. The price of gold which peaked at $850 in 1980 dropped continuously to recover only in the last decade to cross the earlier peak in January 2008. What is surprising, gold was not even a hedge against inflation. Had gold prices increased at the same rate as CPI, gold today would have cost $2200/oz.

Gold has no intrinsic value except for some industrial uses. Hence gold accumulates as stock. New mining of gold is small and expensive. Of silver it is negligible. As such, prices of these metals depend entirely on demand.

Nearly a half of the world stock of gold stock is in jewellery, mainly in India and China; the other half is investment, mainly by the central banks and occasionally by private sector. The central banks no longer trade in gold. But to private investors, gold is one of the assets in their portfolio and therefore subject to swings.

Being one component of the asset portfolio, investment in gold depends on the return from investment in other assets. Gold is an anchor private investors hold on to when prospects for the rest of the assets appear dim. After 28 years, gold came to life because the world economy got into a crisis. Gold was once again in demand and gold prices shot up.

There are a variety of assets people choose to invest in. The two main assets are commodities and securities. The most competitive asset against gold is equity.

When the crisis came, investors lost confidence in stocks and reordered their portfolios with more gold and less equity. This exaggerated the rise in gold prices and fall in equity prices. When Dow Jones dropped precipitously about 50 percent in 2007-09 gold climbed 25 percent.

In spite of the stock market recovery since 2009, gold prices have also been rising. That is because the means by which the crisis was reined in, actually deepened the confidence gap in the market and the dollar.

There have also been other world events like the political upheavals in North Africa and Middle East which have resulted in high oil prices and sovereign debt defaults in the EU.

Presumably it will take time for the U.S. economy to recover to normalcy. It will be only after the Dow Jones Index crosses its earlier peak that the investor will abandon gold in favor of equity. That will be the time when gold prices may collapse.

In the meantime, prices may rise but not at the pace they have been since 2010, which has been due to excessive speculation. If they rise at the same rate as in 2008-09, the price of gold should not cross $1750/oz in another year.

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If the central banks no longer trade in gold to settle debts between them, then why do they want to stockpile gold? Why Libya’s gold is big news?

The website of Bank for International Settlements says, ‘Apart from fostering monetary policy cooperation, the BIS has always performed “traditional” banking functions for the central bank community (eg gold and foreign exchange transactions….’

Value is in the eye of the beholder.

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