Sent: 05-10-2010 11:04:02
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The Gold Debate
Gold has been a poor investment. It has failed to outpace returns from other commodities and has not risen enough to compensate for inflation.
Despite the cheer squad for gold being passionate, well organized and ubiquitous, individual investors still need to deal with some critical questions on which the promoters are less forthcoming.
One of the common features of the radio news bulletins waking us up each morning is a comment about what has happened to gold prices overnight. The same happens throughout the day despite there rarely being a move of any significance during Australian trading hours. And, at the end of the television news in the evening, the presenter asks "And so, Tom, what about gold?" feigning a deep understanding of the global financial system.
On these occasions, the price might be up by only $2/oz but the newscaster will still say something like "the surge in gold prices continues".
No other single investment is promoted so heavily. Tens of millions of dollars are spent every year by the industry and the other spokespeople assembled by the World Gold Council to hype gold as an investment.
Many of the most vociferous supporters of gold base their arguments for investing on their loss of faith in the world's central banks to safeguard currency values. Those same gold supporters rely almost wholly on the central banks they so vehemently criticize to support the value of gold. They are prevailed upon to occasionally declare their commitment to hold large quantities in their vaults to keep the price aloft.
Gold prices have risen by 215% since the end of 2003 for a 18.5% annual rate of return.
One of the most important influences on this outcome has been the radical change in global monetary conditions over this time.
Lower interest rates make gold a relatively attractive investment opportunity. Combined with other forms of quantitative easing, lower interest rates create liquidity. At the bottom of an economic cycle, policy creates more liquidity than is needed for the ongoing operation of the real economy. Gold (and other commodity investments) benefit.
Once economic activity starts to grow more strongly pushing economic output closer to capacity, the liquidity fueling gold prices will be withdrawn. This will be an important challenge for gold investors: the risk of a significant reversal in prices as the Fed starts to tighten (or as markets anticipate the commencement of a tightening cycle).
Some upside in gold prices probably remains before this possibility looms larger in the current cycle. It is stretching credulity, however, to say that gold prices will continue to rise no matter what the underlying economic conditions and no matter how aggressively policy makers are moving to contain a cyclical increase in inflation. The historical connection between gold prices and monetary conditions suggests otherwise.
The same is true of commodity prices generally with one important qualification: price variations in the other commodities will also be influenced by variations in physical market balances. In contrast, movements in gold inventories are generally uninfluential: nearly all the gold ever produced remains available for use.
Recent gold market returns also belie returns over longer periods of time.
Since the beginning of 2004, the median monthly gain in gold prices has been 1.9%. However, the median monthly movement in gold prices during the 13 years prior to 2004 was a minus 0.2%. The sharp acceleration in prices has played into the hands of the promoters of gold investments but leaves some uncertainty as to which period was more representative of this market. That is another critical judgment that needs to be made by a gold investor.
Gold prices have not compensated for inflation since 1980. Nor have they represented superior investment options in the context of broader commodity markets. The purchasing power of gold measured in terms of either oil or copper is lower in both cases. The quantity of oil bought by a troy oz of gold is currently below the average quantity it has been capable of buying for the past 25 years. Similarly, gold is able to buy just under the average amount of copper it has been able to buy over the same period of time.
Market gains have also been typified by occasional sharp adjustments and lengthy periods of more subdued or negative returns rather than steady increments in value.
Over the 81 months since the beginning of 2004, there have been seven months during which the gold price has risen by 10% or more. Excluding these seven increases, the annual return since the end of 2003 would have been 5.9% rather than 18.5%. The increase in gold prices over the 20 years between 1990 and 2010 would have only been 19% (or less than 1% a year).
That is not to deny the increase. The point, in this context, is that the gold market is typified by prolonged periods of poor returns punctuated very occasionally by sharp adjustments.
To take advantage of the return pattern, an investor needs to be either very patient ( and prepared to ignore lengthy periods of investment underperformance as he retains his gold position) or very nimble ( so as to capture the occasional large rises before returning to more mainstream investment options where the ongoing returns will be more attractive).
This email is general in nature only and does not constitute or convey specific or professional advice. Legislation changes may occur quickly. Formal advice should be sought before acting in any of the areas discussed. Be aware that the information in these articles may become innaccurate with time. Responsibility is disclaimed for any inaccuracies, errors or omissions. Particular investments are neither invited nor recommended and hence this publication is not "financial product advice" as defined in Section 766B of the above legislation. All expressions of opinion by contributors are published on the basis that they are not to be regarded as expressing the official opinion of any other person or entity unless expressly stated. No responsibility for the accuracy of the opinions or information contained in the contributor's articles is accepted by any other person or entity. Copyright: This publication is copyright. If you wish to reproduce this article you require a license, which can be purchased here, to do so.