Gold bars. Source: http://www.australianminesatlas.gov.au/education/rock_files/gold.jspUnless you’ve been hiding under a rock (or a gold nugget?), you’ve probably heard about the skyrocketing gold prices. As of this writing, gold is at $1425 USD! Only a few months ago, I don’t think most people other than a few gold bugs would have imagined prices shooting up so high, and so fast. Now it looks like $1500 is quite possible.

So, is gold in a bubble? What would make gold rise so fast, and is it time for the greedy to start becoming a little fearful? I’m going to revisit gold in this post, and look at some of the fundamentals and trends behind the recent moves in the price of gold.

What is gold?

Gold crystals. Source: http://en.wikipedia.org/wiki/File:Gold-crystals.jpgBefore we can analyze gold’s recent price moves, we must first understand what gold is, and how this relates to the supply and demand dynamics. Gold is a pure stable element which naturally occurs in nature, and can be found all over the world. It has been mined since ancient times both for its beauty and for its suitability as a form of money.

Over 165,000 tonnes have been mined in human history; an amount which is still largely in circulation and storage. If this amount was melted together, it would fill a giant cube a little bit more than 20 meters on a side. Gold’s flow, however, is much smaller: Only about 2,500 tonnes are mined per year. This is a supply increase of less than 2% per year.

If high prices remain, then more mines will be profitable, which will increase production down the road. On the other hand, environmental regulations and other restrictions will dampen this expansion, limiting the overall production increase.

What does this mean? Gold is a mineral with a very large stock, but a very small flow. This is only one of the many qualities that has made gold such an attractive form of money in the past, and is contributing to its demand today. A high demand for TVs can be compensated for by producing more TVs. A high demand for gold can only go into the price.

What are some of the reasons behind the recent price increases?

The U.S. Dollar is falling.

Image of a balance scale balancing the CDN$ and the USD$Gold has been in a bull market since the early 2000s, and this can be traced in large part to easy money policies.  The recent launch of the second quantitative easing program is contributing to this rise in the price of gold through a devaluation of the U.S. dollar. Through quantitative easing, the Federal Reserve has committed to effectively monetizing an additional $75 billion of U.S. deficit spending per month.

As of this writing, the U.S. dollar index, which compares the U.S. dollar to a basket of foreign currencies, was at 76.8. This is down from a high of 88 back in June. By this measure alone, the U.S. dollar has lost about 13% of its value against other currencies. The U.S. dollar index, however, does not notice when all currencies depreciate, as it is only a relative measurement, and many currencies are not included in the comparison basket.

It cannot be predicted exactly how the effects of this spending will reverberate through the economy, but nothing comes for free. Someone, somewhere, will pay the price; it might be the taxpayer, it might be everyone through higher prices for goods and services, and it might be foreign bondholders who will have to take a haircut on the value of their bonds.

For every loser, there will be a winner as well. It may be the banks and Wall Street executives who continue to receive large bonuses, it may be the public-sector that benefits from increased spending, and it may be large debtors who see the value of their debts reduced in real terms.

When we look at U.S. policy, we can see a clear trend toward a devaluing of the U.S. dollar. Although the link between gold and inflation is not so clearcut, gold nonetheless provides a form of money that cannot be debased nor politically manipulated as easily as paper money can. If all of the paper money systems collapsed, gold would still be there. That is where gold’s true value lies.

Sentiment toward gold is changing

Survivalist. Source: http://www.theplacewithnoname.com/blogs/klessons/p/0025.htmlUntil recently, gold has been considered as something fitting for jewelry, but something strange if considered as an “investment” or as money. In Western culture at least, the image of the gun-toting, food can stock-piling gold bug living in a cabin in the woods has not been an easy one to shake. The very term “gold bug” is derogatory, and these so-called “gold bugs” used to be the joke of the investment world as they saw the value of their gold holdings plummet toward the earth in the 80s and 90s, losing more than 4% of real value per year.

Things are no longer quite the same today. We can see all of the ads on TV talking about turning in your gold for cash, and some financial planners are even starting to recommend some exposure to gold in your portfolio. For us Canadians, Canadian Capitalist has made the point that if you are invested in a Canadian equity index, you already have about 20% exposure to gold equities.

Gold is no longer just for the Asians (who have always placed cultural value in gold, unlike Westerners who looked upon it as a “barbarous relic”) and the weirdos: Even the World Bank President is now talking about the value of gold in the international monetary system. This is a viewpoint that would have been unheard of only a couple of years ago.

Investors are moving down the pyramid of assets
Liquidity Pyramid. Source: http://www.runtogold.com/

Liquidity Pyramid. Source: http://www.runtogold.com/

Trace from Run to Gold has created this chart, which shows the flow down the pyramid as credit collapses. So long as overall credit is shrinking rather than expanding, this pyramid can also play a part in the overall movements of the gold price.

How has gold performed over time?

Now, gold is not an investment in the traditional sense: It does not spin off dividends, and it does not do any traditional work. In this respect, I agree with Warren Buffett that it would be kind of silly to sit on top of a pile of gold and to consider yourself rich, although you don’t have a bite of food to eat. Gold is actually wealth in the form of money, and therefore it has value because others also value it as money, and you can therefore trade it for real goods.

Nonetheless, it would be interesting to see how your money would have done had you placed it in gold versus the Wilshire 5000. Here are the results of annual investments in gold; see my post “Gold as an Investment: Performance over Time” for more details on the analysis:

Chart of gold versus the Wilshire 5000, nominal value, annual investments from 1975 to 2010.

As we can see, with equal investments in the Wilshire 5000 and in gold, our Wilshire 5000 investment would be worth about double. Gold was around $1100 and the Wilshire 5000 was around 41 when this chart was created, so at the current values of $1425 and 49, gold would be a little bit closer to the Wilshire 5000. Gold would have to double in value against the Wilshire 5000 in order to match its returns.

Chart of gold versus the Wilshire 5000, nominal value, annual investments from 1996 to 2010.

The story looks different for someone who started investing more recently. If we had started investing in 1996, then equal investments in gold would have far outperformed the Wilshire 5000, and at the current values of both, gold would be a little bit further above the Wilshire 5000.

So, where are these prices going to go?

Although gold looks parabolic within the last decade or so, this is precisely why you should exercise more caution in regards to gold. The time to buy gold for cheap was a decade ago when you could have bought it for around $300 an ounce or even less, not today. Any asset is vulnerable to over-bought situations, and gold is no exception. Whenever any asset starts to rise stratospherically, all kinds of people will be attracted out of the woodwork, including those looking to make a quick profit by flipping their investment on to someone else. Since gold is mainly price-driven, it is especially vulnerable to large swings in value.

That said, so long as the fundamentals do not change and easy money continues to be the order of the day, I do recommend that one keep some allocation to precious metals in both physical form and as other forms, such as pool accounts, allocated storage, or precious metal mining companies. Even the gold bear Jon Nadler recommends 10% of one’s portfolio in precious metals, and I think that 5% could be a decent place to start. Canadians: remember, you already have some exposure through the Canadian equity markets. It is up to you if you want to hold some physical as well.

Always remember Warren Buffett’s adage:

Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation…, they should try to be fearful when others are greedy and greedy when others are fearful.

Further Reading

So, reader, are you currently invested in precious metals? How do you feel about quantitative easing, and what do you think its overall effects will be on the economy?

Related Posts Plugin for WordPress, Blogger...

Get future posts delivered directly to your inbox!

About

Kevin has left the office, and he is currently fighting the rat race by working on his own business. He enjoys exploring unvisited places around the world and gaining new experiences. He believes that by properly managing our energy and time, we can learn to invest our lives wisely.

80 Comments Kevin on Nov 9th 2010

80 Responses to “Gold, Revisited: Is $1500 Near?”

  1. [...] on relative prices, 5% to 10% would go into here in the form of physical bullion. I simply like shiny coins, but I also feel that these metals represent a good alternative to [...]

  2. Why Gold Might Remain “Expensive” | 101 Centavos says:

    [...] of the yellow metal.  Kevin at Invest It Wisely has done a number of informative posts here, here and here, including a guest post from Trace Mayer, a noted commentator on precious metals.  Other [...]

  3. [...] The price of gold has recently been shooting through the roof. As of the time of this writing gold is hovering near $1870. It seems like only a short while ago when I was wondering if $1500 was near. [...]