Investment Idea :
Worth Your Weight in Gold?

When was the last time you saw people queuing outside gold shops in Yaowarat? In one sense, gold's rise is part of a surge in commodity prices that has seen oil at USD 115 a barrel and rice breaking an all time high record of USD 1,000 per ton on supply shortages and rising demand from China's and India's middle classes. But gold is not a normal commodity. The forces of supply and demand, largely driven by the jewelry markets of Asia and the Middle East, are often overwhelmed by gold's role in investment markets. Due to its historic role as the basis for the global monetary system, many people see gold as a currency in its own right. In this article, we shall examine the key factors that historically have influenced the price of gold, assess whether these same factors are responsible for the precious metal's recent bull market, and hopefully offer some perspective on whether an allocation to this unique asset class may provide diversification benefits to a portfolio.

The characteristics that historically have influenced the price of gold have been different from the economic drivers that have determined the prices of most other assets, such as stocks bonds and real estate. Gold is a commodity, but unlike most commodities, such as oil or copper, the forces of supply and demand generally have not been the primary determinants of its market price. This is mainly due to the fact that annual gold production has only been a small fraction of the vast supply of gold already above ground, held in the form of central bank reserves, jewelry or other investment vehicles. Most of the gold ever mined is still around, as it does not get consumed like other commodities such as oil or rice. As such, incremental mining discoveries or modest increases in jewelry demand typically have had little influence on gold prices.

More importantly, gold derives its value from other qualities. In particular, gold historically has been used as a form of hard currency and been universally accepted as a store of value. Gold is an imperishable asset that has retained its purchasing power for centuries, serving as the economic foundation and a symbol of wealth for ancient European empires and as backing for modern currencies well into the 20 th century. Today gold remains the largest component of foreign exchange reserves in the central banks of many developed countries including the United States (76%), Germany (63%), Italy (65%) and France (55%). Given these properties, the price movements of gold historically have been most influenced by the following market dynamics: -

The US Dollar : Gold acts as an alternative to paper currencies and its price typically moves inversely to the value of the US Dollar. As the Dollar is the dominant global currency, gold appears to be acting as a hedge against the greenback (as it is often called); rising when it falls. As investors lose faith in the outlook for paper currencies, they often turn to gold. For example, when the dollar fell 38% from March 1985 to December 1987, the price of gold rose 60%. Conversely, as the dollar rose 22% between May 1995 and September 1998, the price of gold declined by 25% (Please see Chart 1 )

Chart 1

Inflationary fears are one of the reasons why gold prices are rising. While the value of bonds and cash is generally eroded by inflation, gold has tended to hold up against inflationary pressure quite well. For an instance, when US annual inflation reached 14% during the first quarter of 1980, gold prices hovered near historical highs of USD 700-800 per ounce. More recently, policy mistakes and/or constraints by central banks push up gold price even more. American Producers Price Index (PPI) rose by a whopping 7.4% in the year to January 2008, the highest increase since 1981, and headline inflation, as measured by the Consumers Price Index (CPI) is 4.3%, the Federal Reserve Bank is still committed to cutting interest rates in order to support the weakening economy.

Geopolitical Risks: Gold tends to rally during periods of rising geopolitical tension and heightened concerns about the global financial system. While stocks and bonds tend to fall during periods of geopolitical instability or global financial market turmoil, the price of gold often has risen due to its perception as a “safe heaven” investment and store of wealth. For example, gold prices reached historical peak of USD 850/troy ounce in January 1980, during the Iranian Hostage Crisis, record-high oil prices and the Russian invasion of Afghanistan amid the ongoing Cold War. The price of gold also rallied during the weeks after the US stock market crash in October 1987. Recently, the price of gold has also been gaining from risk-aversion among investors, who are worried about the instability of the financial system in the wake of the credit crunch. Gold coins and bars are being snapped in very large volume by investors, suggesting that people are so worried about the health of the banks that they would rather hold their cash reserves in solid form.

Due to its unique characteristics, it can be hard to pin down exactly what determines the price of gold at any given moment. Still all of the traditional primary factors mentioned above appeared to have some influence on gold's recent rally. More specifically, the value of the US Dollar has fallen 33% versus the Thai Baht (THB) since January 2000 (please see Chart 2 ) and 35% against other major world currencies since February 2002, while the price of gold has rallied 192%.

Among other factors, ongoing instability in Iraq and other issues of conflict in both the Middle East (Iran's nuclear programme) and North Korea's nuclear testing have continued to provide an undercurrent of heightened geopolitical tension in the post-9/11 era. At the same time, fallout from the recent US sub prime mortgage crisis has sent tremours that have reverberated throughout the global financial markets and future ramifications remain uncertain. In terms of inflation outlook, things are going from bad to worse particularly with rapidly rising commodity prices, such as crude oil, rice and wheat, soaring to record price levels.

Aside from the traditional influences, there is some evidence that supply and demand factors have played a larger role in pushing the price of gold to near record levels than they have been in the past. During the first half of 2007, total year-on-year (YoY) global demand for gold increased 24% in dollars terms, and was up 124% from the same period in 2003. Despite its sharp rise in price, demand for gold in terms of tonnage remained strong as well, increasing 11% on a YoY basis during the first half of 2007.

Demand for gold has increased for a number of reasons. Firstly, the proliferation of Exchange Traded Funds (ETFs) that invest in gold has been a significant new source of demand, opening up another channel for retail investors looking to invest directly in gold bullion. These pooled portfolios or the so called paper gold allow retail investors to buy gold without the bother of storing gold coins or bars and without the agency risk of buying shares in mining companies. During the past few years, ETF purchases of gold bullion increased as these vehicles have become more popular with individual investors (Please see Chart 3 ). In fact, total world demand for ETFs reached a quarterly record inflow of more than USD 3 billion during Q3 of 2007, when worried investors turned to gold as a potential safe heaven investment amid spreading turmoil in the financial markets. According to Morgan Stanley, an investment bank, ETFs now own more than 915 tones of gold-more than the European Central Bank.

Elsewhere, the strengthening global economy has provided a steady source of incremental demand for gold, primarily from rapidly growing developing economies such as India, China and the Middle East. The major source of incremental global demand for gold has been in jewelry manufacturing, reflected by a YoY increase of 27% in dollar terms and a 15% increase in tonnage. At least part of the explanation for this growing demand in these countries can be attributed to their booming economies, a strong cultural affection for gold jewelry and the increased middle class wealth experienced by these people in recent years.

On the other side of the economic equation, total global mine production (tonnage) has been roughly flat during the recent bull market run for gold with few major new discoveries (Please see Chart 4 ). More recently, mine output during the third quarter of 2007 was essentially unchanged from year-earlier levels.

The rise in the gold price has revived the prickly issue of whether central banks were right to sell their gold reserves earlier this decade. Central banks around the world can play a key role in the movement of gold prices because they account for about 20% of the above ground supply of gold in the world. Britain's Treasury recently admitted it had sold about 12.7 million ounces for USD 3.5 billion, at an average price of around USD 276. That gold would now be worth around USD 12.5 billion. This is a reminder that gold can be driven to speculative extremes. When it reaches those heights, investors need to be cautious of the argument that gold is a long term “store of value”; afterall, between 1980 and 2000, gold price dropped by two-thirds in nominal terms.

Due to its special characteristics, the long term performance of gold has had little or no correlation to other major asset classes, such as stocks and bonds and imperfect correlations with other commodities (Please see Chart 5 ). For this reason, allocating a small portion of one's portfolio to gold may be an effective way to achieve additional portfolio diversification benefits. Since November 2002, maintaining a position in gold would have provided a significant boost to the returns of a diversified portfolio, as gold soared nearly 153% while stocks (S&P 500 Index) and bonds (Lehman Brothers Aggregate Bond Index) gained 73% and 26%, respectively during the period ending November 2007. Investors should also take note, however, that there have been extended periods, such as the 20 years ending May 2002, when gold prices were relatively flat and thus an investment would have been a drag on portfolio performance. In other words, diversification does not guarantee a profit nor ensure against a loss, but it helps to reduce portfolio volatility.

During the past few years, the correlations between gold and other major asset classes have increased somewhat but they still remained low. What's perhaps the most pertinent factor for investors to consider regarding gold is that its long term drivers by and large have been different from other asset classes and therefore a small allocation may boost diversification opportunities for a portfolio.

The widespread rollout of ETFs has allowed individuals to invest directly in a security that closely reflects the price of gold bullion i.e. paper gold as it is often known and is actively traded on an exchange. Investing in an ETF focused on gold also helps investors avoid some of the barriers such as taking physical possession, storing and insuring a direct investment that historically may have prevented them from owning gold.

Another way to invest in gold in an indirect way is to purchase the stocks of gold mining companies. These stocks historically have been more sensitive to an increase or decrease in gold prices and thus have delivered a higher magnitude of performance, both in up and down markets. However, it's important to remember that company-specific and operational considerations can influence the share prices of gold mining companies. Whichever investment vehicle one chooses, it's important to recognize that gold prices can move significantly in a short period of time and therefore building an allocation through dollar cost averaging may be an effective way to minimize risk.

The multi-year rally in gold that began in the early part of this decade follows on the heels of an extended period, roughly two decades of negative performance. Despite its tremendous price gains over the past few years, gold still remains well below its 1980 peak on a real (inflation adjusted) basis, when gold reached more than USD 2,200 per ounce in today's dollars. Keep in mind that gold prices historically have been quite volatile and it can be quite challenging even for the most sophisticated investors to pin down exactly what drives its price at any given moment. Most investment experts consider gold to be a niche asset category that warrants at most a small allocation within a broader investment portfolio. Given its unique properties and imperfect correlations wit other asset classes, a small investment in gold can be an effective portfolio diversifier and insurance against potential events that may drive down the value of other financial securities.