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: http://soberlook.com/2012/12/precious-metals-hit-by-evans-rule.html?utm_source=dlvr.it&utm_medium=twitter

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:  http://ssrn.com/abstract=1908650 .

Last year I gave a presentation at the Science Gallery on some properties of gold, which is posted here: http://trueeconomics.blogspot.ie/2011/08/20082011-yielding-to-fear-or-managing.html .

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.

25/02/2012: Some interesting recent points on Gold

GoldCore guys have an excellent visualisation of some core facts about gold as a vehicle for store of value - a short video certainly worth watching.

You know I am a fan of good visualization as a tool to deliver information. And you know my position that gold is a unique diversifier of some core financial risks (based on my academic work available on my ssrn.com page) when held not for speculative or capital gains purposes and accumulated over time allowing for price-peaks averaging.

You can find much more detailed data on gold demand at the World Gold Council site (here), but it's worth posting few charts that illustrate higher frequency data supportive of the aforementioned trends and also trends highlighted in the video link. All are from Q4 2011 World Gold Council report:

First chart to show the relationship between spot price and volatility for gold - while volatility of gold prices is relatively high, it is clearly consistent with changes in fundamentals (news flows and global liquidity shifts, that largely are indicative of future inflation expectations changes):

The 'China' v 'India' effects are strongly pronounced, with the recent economic growth slowdown in India and the talk of hiking import duties on physical gold there clearly leading to slower demand. What is remarkable, in my view, is that both China and India demand appears to have largely converged in Q3-Q4 2011 to the average levels ahead of 2009, but below the peaks. This, in my view, can lead to further moderation in the volatility of the global gold prices, while providing support for gold price levels.

The third chart illustrates the dramatic turnaround in the Central Banks' and Treasuries' propensity to hold gold since Q1 2011. And the dramatic tie-in between the official sector demand for gold and the news flow. They wouldn't tell us this much directly, but it does appear that Governments around the world are hedging against the Euro crisis risks by going into gold.

Lastly, an interesting chart on private sector demand drivers for gold as investment vehicle. Good news ETFs are buying less (though bad news here is that this means more ETFs out in the markets are now synthetic gold holders - see a note here on the dangers of that asset class). Other good news is that OTC gold instruments are on a shallow decline (suggesting no derivatives panic, but some welcome reduction in derivatives risks exposure for gold, with core risk of sudden position reversals).

As a disclosure - I am on GoldCore's Investment Committee as a non-executive member. In this role I do not contribute to public communications by the firm or to the GoldCore's marketing. I receive no compensation for this or any other post on my blog and, as you can see, my blog bears no advertising (although the latter can change at some point in time, the former will not). I am also long gold in long-term, non-speculative stable allocation that remains unchanged over a number of years. I hold no other gold-related assets, ETFs or gold-related stocks. Furthermore, my posting of this link should not be considered as an endorsement of any product or investment vehicle, as per usual.

20/08/2011: Yielding to Fear or Managing Wealth

Here's a copy of my presentation from August 18th in the Science Gallery covering some of my views on gold (announcement here). All disclosures were made in the announcement and at the beginning of my presentation - do not accept this as either an advice to take any investment action - as usual. You can click on individual slides to enlarge.

Economics 24/08/2009: Oil and Gold – an imperfect hedging tango

In the last bout (right before the collapse of the financial markets in Autumn 2008) much of the inflation was driven by the rapidly rising commodities prices. These prices were in turn linked to the price of oil. Thus, one can naturally think of oil as an inflation hedge. In contrast, the traditional inflation risk management instrument – gold – has hardly kept up with oil prices in the short run back in 2008. So there is a natural question that arises in this context – which is a better inflation hedge? Well, for each month in 2008, in year on year (yoy) changes, oil actually beat gold as a counter-inflationary asset. Only this year have gold and crude exchanged places. But this is optics.

First, both gold and oil prices show some serious medium range inter-annual volatility. This volatility is driven by speculative motives, but also by real demand for oil as a storable commodity that is an input into physical economy. So to abstract away from seasonality and active speculative trading, consider both commodities prices in terms of annual averages. Setting 1968 price index for gold and oil to be equal 100, and adjusting for inflation, chart below shows that both commodities are way off their historic highs and that even in 2008 the two commodities were nowhere near their long term maxima when it comes to a cumulative appreciation since 1968.

Pre 1970, average price of gold ranges around $38-39. It peaked in 1980 at $615 and then got stuck in the flat until 2007 when it breached the 1980s high in nominal terms. The average price of gold was $872 in 2008. Similarly, crude peaked at an average price of $91 a barrel last year. But despite nominal appreciation, oil is still way below its inflation-adjusted highs. Ditto for gold. To do this, gold needs to be at nearly $1,610 and oil at $98-100 per barrel. These are steep, but just how steep? Well, for oil this means roughly an 8% appreciation on 2008 annual average. But for gold this implies a whooping 84% appreciation on same benchmark.

Now, in annual terms, average annual inflation since 1968 was 3.6%. Median annual return to gold exceeded CPI by 1%, while oil did the same by 1.7%. So cumulative gain for oil in real terms since 1968 has been around 96.3%, and for gold it was almost a half of that, or 48.9%. Given that oil took a nose dive in 2009 while gold held its ground, long term comparisons suggest that

• Either oil is oversold today and thus has a mean-reverting potential of ca 45% on current prices to ca $105-110 barrel range (chart below shows WTI, $pb)

• Or gold had been under-bought in the historic past and thus has an oil-inflation trend-reverting potential of ca 50-75% on 2008 average annual price (chart below shows gold price in $ per oz, daily close)

I happen to think that both are likely, though in much more moderate terms, with oil heading for $85pb in 2010 and to $95pb over medium term (5 years), while gold heading for $1,050-1,100 range in 2010 and to $1,300 over the medium term. That would imply annualized gains in oil price of roughly 4.8% and in gold price of ca 6.5% before inflation. Thus, assuming a reasonably well-underpinned by the current money creation worldwide inflation averaging ca 3% pa, this would result in oil beating CPI by 1.8% annually, and gold doing the same by ca 3.5% pa. Why?

For two reasons:

1. Oil demand is going to be imperfectly matched to inflation hedging and short term volatility due to supply/demand for physical commodity will be weighing in oil as a hedge instrument in the current environment where investors are relatively jittery about the markets;
2. Gold simply has to catch up with oil over medium term.

One potential downside to this is continued orderly, but nonetheless pronounced disposal of gold holdings by the Central Banks of the more fiscally strained countries and the IMF. Although China and possibly India are likely to start picking up some of the rising supply through ‘private’ or invisible sales from one CB to another, this unwinding of gold reserves will weigh on the markets.

Per short term oil price volatility a recent example is in order. About two weeks ago, the US crude reserves have been reported to have fallen some 8.4mln barrels, prompting a serious spike in oil to $72.5pb. At the same time, gasoline supplies fell by 2.1 million barrels, distillate stocks declined by 700,000 barrels and refinery utilization reached 84% above analysts’ expectations of ca 83% - in a sign of tighter supply.

In medium term (3-5 years horizon) – watch US Oil Fund (USO) for oil.

On gold side, watch the correlation in gold and stocks, with gold tending to max just ahead of stocks lows (note July/August 2008, October 2008, March 2009 and so on in chart above). In my view, we are set for another local maxima to be tested by gold in months before the end of October 2009.