Thursday, December 13, 2012

13/12/2012: Some thoughts on gold

Tonight's Prime Time program covering gold is undoubtedly one of the rare occurrences that this asset class got some hearing in the Irish mainstream media. Which is the good news.

Not to dispute the issues as raised in the program, here are some of my own thoughts on the question of whether or not gold prices today represent a bubble.

A simple answer to this question, in my opinion, is that we do not know.

Short-term and even medium-term pricing of gold (in any currency) is driven by a number of factors (fundamentals), all of which are hard to capture, model and value.

For example, currency valuations forward suggest that gold is unlikely to experience a sharp and protracted correction in the US dollar terms, if you believe the Fed QE4 is likely to persist over time. In euro terms, potential for devaluation of the euro implies pressure to the upside to the gold price. Yen price is also likely to play longer-term continued devaluation scenario. Things are less certain when it comes to Pound Sterling price… and so on. Here's just one discussion on one of the above effects:

Another example: drivers for prices on demand side that include rather volatile regulatory conditions in the major gold demand growth markets, such as China and India.

In short, things are much more brutally complex than the PrimeTime programme allowed for.

The reason for this complexity is that gold acts simultaneously (as an asset) in several structural ways:
1) as a simple bi-lateral long term hedge for inflation, equities and currency valuations
2) as a medium term (albeit not entirely persistent) hedge for some asset classes (e.g. equities)
3) as a short term speculative instrument to some investors
4) as a backing for numerous and large volume ETFs
5) as a benchmark backing for numerous and relatively large volume synthetic ETFs
6) as a store of value
7) as a risk management tool for complex structured portfolios
8) as a bilateral safe haven against equities and bonds, political and economic risks, systemic financial markets risks, etc.

These relationships can be unstable over time, can require long time horizon for materialization and are 'paid for' by assuming higher short term volatility in the price of gold. That's right - while PrimeTime contributors spoke about gold price 'correcting' or 'bubble bursting' none seemed to be aware of the fact that if you want to get something you want (hedging and safe have properties being desirable to investors), you should be prepared to pay for it (price volatility seems to be a good candidate for such cost of purchase).

No matter what happens in the short- to medium- term, gold is likely to remain the sole vehicle for the store of value and risk hedging over the long-term. It did so over the last 5,000 years or so and it will most likely continue doing so in years ahead. This property of gold is well established in the literature and is hardly controversial.

There is one caveat to it - due to instrumentation via ETFs, there are some early (and for now econometrically fragile) signs emerging that some of gold's hedging properties might be changing. More research on this is needed, however and only time will tell, so in line with PrimeTime, let's stay on the RTE side of Complexity Avoidance Bias on that one.

There is an excellent summary on what we know and what we don't know about gold by Brian M. Lucey available here: .

Last year I gave a presentation at the Science Gallery on some properties of gold, which is posted here: .

Not to make this post a lengthy one, let me summarize my own view of gold as an asset class:

  1. In my view, gold can be a long-term asset protection from the risk of expropriation, inflation, devaluations, and tail risks on political and economic newsflow side etc.
  2. To me, gold is not a speculative (capital gains) instrument for the short-term and it should not be acquired in a concentrated fashion - buying in one go large allocations. Gold should be bought over longer period to allow for price-averaging to reduce exposure to gold price volatility.
  3. Gold allocation should be relatively stable as a proportion of invested wealth - different rules apply, but 5-10% is a reasonable one in my view.
  4. Of course, any investment portfolio (with or without gold) should strive to deliver maximum diversification across asset classes, assets geographies etc.

Disclosure: I have no financial interest in or any commercial engagement with any organization engaged in selling gold. Until December 1, 2012 I used to be a non-executive member of the investment committee of GoldCore Ltd and was never engaged on their behalf in any marketing or provision of advice to any of their current or potential clients.


Kieran Magennis said...

I only wish gold (physical possession) was overvalued or a bubble, because that would mean that:

The euro, sterling, usd and other currencies will not remain volatile.

Governments could not burgle other savings/pensions etc.

Financial institutions could not sink with your savings on board.

Paper investments (e.g. bonds, mine certificates, ETFs etc.) cannot be destroyed by a run on them.

Unfortunately this does not seem to be the case.

If that is true, an allocation of 5-10% to gold seems overly cautious.

Brian O' Hanlon said...


I have developed a thesis over a lengthy number of years, which I might label, the bad apples in a basket theory.

It states, that when one influential member (by natural disposition), of a group decides upon a strategy of hopelessness, their natural aggressive or leadership instincts become targeted at those of the group who may intentionally or un-intentionally dare to contradict the impulse towards the hopelessness strategy.

This thesis also operates in reverse. I.e. Where the influence member of a group decides on a euphoric strategy, similarly, members of the group who intentionally or unintentionally dare to contradict the instinctive impulse also become singled out as targets for consistent and relentless attack.

In other words, it works either in the upward or downward part of natural cycles. The individuals who hold these tendencies in a marked way, and pursue their behavioural norms no matter what the cycle does. It lends great stability to their lives, and allows them a luxury of making some 'meaning' from the cycles.

Gold, is the flip side of the boom cycle, which enables people to express a belief in a strategy as strongly, as they would do when buying beyond their means in a rising part of the cycle.

I am unsure of an established theories in this regard, which may combine aspects of economics cycles and psychology. I was wondering if you had any further thoughts on this, which you would care to publish in a later blog entry.