gold buggers

Too much has been said about gold: store of value; hedge against inflation; asset of last resort; and more: show of wealth and prestige; symbol of recognition; and more: investment opportunity.

 

There have been too many experts (economists, analysts and the like) who emphasize the importance of having gold in one's portfolio. And there are those who sit back and say gold is a useless asset, almost. I am sure the former category outnumbers the latter by a wide margin.

 

The demand is out there

Everyone buys gold: the governments, banks, trusts, institutions, investment funds, and the public. The aura of this yellow metal is simply majestic.

 

To see why we need to go back to history. Gold has a bright yellow color and luster traditionally considered attractive, which it maintains without oxidizing in air or water. It represents wealth and prestige and symbol of recognition. Gold has been the single most admired commodity dating centuries.

 

Gold was the medium of exchange for a long time. Gold coins served the purpose everywhere.  The gold standard monetary system required currency to be backed by gold. Even now gold is being stocked up by the governments and central banks.

 

We know the demand is out there, in abundance. It is estimated that annual production of gold is about 2800 tonnes. The major producers are: China, Australia, US, Russia and South Africa. The dominance of South Africa has undergone a significant change since the rise of China. Since demand is more than supply, consumption has been equal to production.

 

Gold consumption has been predominantly in jewellery (50%) and for investment purposes (40%), with only about 10% for industrial purposes. The major consumers of gold are: India, China and US.

 

The inventory is out there

It has been estimated that an aggregate of about 170,000 tonnes of gold has been mined (and consumed) to date. This translates into about 5.5 billion troy ounces. Since gold does not beget more gold or any other thing for that matter, almost all, say, 85% or more of it, is still out there somewhere with some banks, institutions and people in the world. At a price of $1725 per t.oz, the 4.7 billion t.oz stockpile is worth over $8 trillion.

 

India, a major consumer

India is the world's single largest consumer of gold, contributing about 25% of the world consumption. Let's not talk about gold production in India. It produces a dot (an interesting 0.5%) of its annual gold consumption. Over the past decade, Indian household gold consumption increased at a cagr of about 20%. Everyone owns gold here, from the poor farmer to the rich businessman. For Indians primary investment vehicle is gold and property. Annual demand is about 900 tonnes (over $50 billion). While RBI holds about 558 tonnes of gold, Indian households have over 18000 tonnes. The value is over $1 trillion at the current price. 

 

And an importer

As importers of gold, Indians put a heavy dent on the country's foreign exchange reserves. A significant amount of reserves is depleted and too much of gold is brought in. As the currency weakens the cost of gold rises even when the dollar price is kept constant; a sharp double edge.

The price
The price of gold is determined by market forces primarily through trading and derivative markets. 

 

Historical returns

With this background, let's have a look at how gold has fared in the past.

 

From 1969 to 2012: cagr of 9.25%.

 

 

  

From 1992 to 2012: cagr of 7.77%.
 

   

 From 1997 to 2012: cagr of 10.15%. 



 

From 2002 to 2012: cagr of 17.91%.

  

 

 

From 2007 to 2012: cagr of 17.85%

  

 

  

From 1969 to 2005: cagr of 7.57%.

 

 

  

From 1980 to 2005: cagr of (-0.55)% - a dud.

 

 

From 1969 to 2012, gold has gone up from a low of $35 to $1715. But where are the returns?
 

Whatever has contributed to that very-long-term return of 9.25% has largely been due to the rush from 2005 onwards. Barring 1980-81 when it peaked at $850 the prices have been flat until 2005 and later.

If the long-term graph has to say anything it is: gold has not returned enough for an investor except for that weird rise from 2005 onwards.

 

Safe haven fallacy
Generally, whenever there has been a period of uncertainty such as war, inflation or currency crisis, gold prices have gone up. Gold prices went up in 1980 due to higher inflation in most countries; strong oil prices. Since 2005 and later from 2008 global financial crisis and recession, investors have been flocking to gold like no other. How far this craze is going to continue is anybody's guess.

 

All prices and no value

Gold itself is produced from mines but once mined that gold does not produce anything. A pile of gold today is the same pile that was 100 years ago and is going to be somewhat the same pile in another 100 years. There is nothing much we can do about it. Gold is not a source of income for it does not provide any cash flows. Due to this, it is not possible to value gold. The perceptions change, the demand changes and price is set. Even if the price were to fall to say, $800 (a fall of over 50%) it will not be possible to say with confidence that gold is undervalued. Any valuation, however high or low, is good enough valuation for investors.

 

The greater fool

The mechanism for pricing of gold is through perceptions only. If everyone thinks that gold is a store of value, hedge against inflation, asset of last resort, show of wealth and prestige, and symbol of recognition, its demand will go up and so would its price. Typically, it is perceived that when nothing else works, gold does and presto, there is a case for buying gold.

 

What if suddenly these folks think differently, rather more rationally? What if they decided that all this time they had been some sort of fools trying to price up a piece of glittering commodity? What will happen to that stockpile that has been there? That same physical volume of $8 trillion (India: $1 trillion) will go down to some other value. 

 

The only way investors have been able to profit from gold has been trying to be a bit faster and wiser than another. The investor who has bought gold has to sell it at a higher price to earn profit. For that to happen the new buyer has to hope that the price will go up (for some reason or the other) after the purchase so that it can be sold later at a profit. Initially it appears like the wise men buying and selling, but in reality it is fools chasing greater fools. Without this you cannot price this commodity since gold has very limited industrial or production use. Almost everything that has ever been produced has been there either in the form of decorative or in solid forms just like that.
 

Gold is for.....

Where do we stand? If you are convinced that you will be able to find a buyer for your gold at a higher price (than you would for another asset) you are justified in buying gold. However such conviction has to be backed by facts, not hopes. Since it is not possible, investors in gold are not investors; they are actually punters or speculators with high hopes.

 

Gold as a store of value is just a myth as there is no value there. Gold as a hedge against inflation cannot be proved by facts since gold prices and inflation do not move in tandem. Inflation is largely due to higher costs of production and depreciation of currency. Consider this: nominal gold price of $850 in 1980 translates into inflation-adjusted price of over $2000. Where is the hedge? Gold prices are based on hopes. Gold as the last resort can be forfeited easily since that 18000 plus tonnes stockpile which Indian household owns, largely in jewellery, will probably fetch far less than prevailing market price since any sale of gold by the households has typically been during the times of distress with no (bargaining) power. Any portion that is held in solid form could fetch higher though.

 

Where is the value in gold? On the contrary, it could be argued that gold destroys value. All capital invested is stored under lock and key with no production and cash flow, and hence no real profit. At over $50 billion a year in India if you are calling that an investment you are kidding.

 

It is difficult to understand what makes gold a good investment. In the rational world gold is for someone else. However, we are not in the rational world; so there is allowance for some insanity.

 

Alternative investments...the only investments

Capital invested for productive purposes creates value. We have that $1 trillion worth of stockpile stacked up. That's about equal to the total market capitalization of our stock market. This $1 trillion (plus $50 billion each year) could be invested in some selected business corporates which create employment and generate cash flows for reinvestment. Alternatively, that money could also be invested in any other cash flow generating assets, such as, farms or real estate.

That is if you believe in planting trees for tomorrow's generations lasting a long, long period of time. The shades of those trees could be very soothing indeed. Think about it.

One wise man has already talked about investing in productive asset classes rather than gold and another has said that more blatantly. What's your call?

 

Oops, I forgot to mention that gold production pollutes as well, in a very hazardous manner causing long-term repercussions. Is investing in gold hazardous?