Since the start of the new millennium, the price of gold has moved from roughly $255 per ounce to a peak of $1900 per ounce in 2011, representing a six fold increase in the price of the metal. Along the way, there have been those that have called for a much higher gold price, suggesting that mismanaged fiscal policies on a global scale will lead to higher inflation and a weaker U.S. dollar, each point justifying a higher price for gold. Early projections for $1000 per ounce were scoffed at and projections that ranged from $1500 to as high as $10,000 per ounce were ridiculed as pie in the sky. Alternatively, the bears have argued since the early days of the metals advance that it is in a bubble and is sure to collapse. Professional money manager are divided on gold, some arguing that since gold is difficult to value, it should be avoided as an investment. Many have argued that with no use for gold other than jewelry, that if India is not a big buyer, prices are sure to collapse.
The following chart illustrates the closing price of gold and the yearly high price from 2000 to 2011. As can be seen, gold has closed at a higher price each and every year but also of significance is the fact that in each year, the price of gold has also made a new high. With the close of 2012 fast upon us, it would appear that the price of gold is within reach of making another new closing high in 2012.
Data from Bloomberg
It is amazing to hear investment professionals scoff at an investment that has achieved higher prices each year and has outpaced most major indices. Claims that it is historically a bad investment and it’s a bubble waiting to burst are arguments liberally floated. Yet these tend to be the same professionals that could not identify the tech bubble or the housing bubble, both of which garnered the attention and adoration of the investing community. The reality is gold is not a widely held investment and is actually missing from most portfolios, a condition that is not generally associated with bubbles. It may be difficult to draw a conclusion supporting an investment in any security or commodity but as professionals, we must make an effort to analyze the data to determine which arguments may be valid and which ones do not hold water.
The usual arguments against gold includes, gold is not consumed, it does not pay you anything and it’s a bad store of value as it has been an ineffective hedge against inflation. It is correct that gold is not consumed. Other than jewelry, the metal is really too expensive to have many industrial applications, unlike silver. It is also correct that gold does not pay anything, meaning no dividend but instead, one will have to pay a storage fee and possibly insurance fees if you are holding vast quantities of the metal.
To understand the reasons for the price action in gold, it may be wise to examine the reasons that investors have been lured to the metal. The fact that gold has limited industrial use and holders of the metal itself may be subject to storage and insurance fees has not been enough to deter investors. Gold has generally been considered as money and a good store of value. It has been referred to as no ones obligation and has historically been accepted as a good medium of exchange. Currencies or bonds are obligations or promises to pay and whose value is accepted as long as all parties have faith that the obligation will be repaid, think Greece or Argentina. Gold is an asset whose value is reflective in and of itself, it has no claims on it and if you own an ounce of gold, the price is easily determined. It is interesting that gold has historically been used to back many currencies of the world, including the US dollar which was partially backed by gold up until 1971. The reasons gold was a good backing for currencies was because the quantity of gold could not be readily expanded to suit the wishes of politicians or central bankers who have always been able to expand the money supply when fiat money is used.
Some reasons why investors hold gold is for its portability and as protection against inflation. Interestingly, it is this same argument that many professionals have argued that gold has been an ineffective hedge against inflation. The following chart illustrates how the price of gold has performed from various points in time going back to 1920. All figures in US dollars.
|Performance of Gold Since 1920|
|1920||$ 20.68||$ 1,564.91||4.87%|
|1935||$ 34.84||$ 1,564.91||5.13%|
|1950||$ 34.69||$ 1,564.91||6.44%|
|1960||$ 35.27||$ 1,564.91||7.72%|
|1970||$ 35.17||$ 1,564.91||9.70%|
|1980||$ 850.00||$ 1,564.91||1.99%|
|1990||$ 401.25||$ 1,564.91||6.70%|
|2000||$ 288.00||$ 1,564.91||16.63%|
Data from Bloomberg
It is only for the period from 1980, where we cheated a bit and took the all time high price achieved on January 21, 1980 and not the opening price but even then, the return to the end of 2011 is still 1.99%, which is not far off from official CPI figures. Other than the 31 years period from 1980, it would appear that the price action of gold has kept up with long term inflation figures.
Chart 3 shows the price of gold in comparison to US CPI figures. It is obvious that there have been times when the price of gold has lagged the CPI but over long periods of time, it seems to catch up to the CPI Index like it did in the early 1980’s and now in 2012. We need to keep in mind that the price of gold was set at $35 per ounce in the 30’s and stayed there until President Nixon severed the link between the dollar and gold in 1971.
Chart 4 shows the price action of gold to world CPI figures. Once again, we see that gold has gone through periods where it trails official inflation figures, but over the long term, they converge. It appears that investor optimism tends to take gold to such heights that it overshoots the mark, leaving itself vulnerable to long consolidation periods, similar to many other investments. So while gold is vulnerable to wild price swings, over the long haul, it has offered relatively good protection against inflation.
To argue that gold has been a poor hedge against inflation would be correct if taken from specific timeframes. Certainly there may come a point in the future when gold will lag official inflation figures again, but it would appear that over long time frames, gold does hold its value and does a good job of protecting the purchasing power of capital.
A $1,000,000 investment in gold bullion at its peak in 1980 would have resulted in the purchase of 1,176 ounces of gold. In 1990, that same $1,000,000 purchased 2,492 ounces of gold and in the year 2000, it resulted in the purchase of 3,472 ounces. At the closing price in 2011, the 1980 purchase was worth $1,840,334, the 1990 purchase had grown to $3,899,756 and the purchase made in 2000 was now worth $5,433,367.
If the main reason’s for holding gold has been to protect capital and its purchasing power, then we should conclude that gold has done its job. In volatile markets and when geo-political concerns are on the rise, gold is generally seen as a safe haven for the protection of capital. To help shed some light on why gold has risen in value, we need to investigate which factors appear to contribute to a higher gold price.
At T.E. Investment Counsel we take a long term view when constructing client portfolios. Most of our clients will have diversified portfolios which will likely have exposure to gold stocks. This article is meant to be for information purposes only and not a recommendation to purchase or trade in gold or gold stocks.
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