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The Future Price of Gold – The Golden Dilemma

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A recent research paper by Erb & Harvey, Duke University – Fuqua School of Business; National Bureau of Economic Research (NBER), revised August 3, 2012 is titled The Golden Dilemma

In this paper, many of the ‘street’s’ beliefs in gold are examined in a detailed and historical context. The paper is too lengthy for this blog and I urge readers to download it themselves. I will quote and comment on some key aspects here. Quotes are in italics.

Will Gold Rise in Value – The Inflation Hedge
Gold has often been described as an inflation hedge. If gold is an inflation hedge then on average its real return should be zero. Yet over 1, 5, 10, 15 and 20 year investment horizons the variation in the nominal and real returns of gold has not been driven by realized inflation. The real price of gold is currently high compared to history. In the past, when the real price of gold was above average, subsequent real gold returns have been below average. As a result investors in gold face a daunting dilemma: 1) seek inflation protection by paying a high real gold price that almost guarantees a decline in future purchasing power or 2) avoid gold and run the risk of a decline in future purchasing power if inflation surges. Given this situation is it time to explore the rationalizations that “this time is different, because this time gold will continue to rise”?

If Not Now, then When?
It seems that all factors and prompts are in place for gold to rise, yet gold has actually fallen a bit since 2011. The rationale for an increased price of gold is obvious. As we print more money, currencies lose value and investors must buy gold to offset losses in currency value. That is motherhood to gold believers.

Gold is currently trading at an historical high, yet in spite of the beliefs of so many, gold refuses to break above its recent highs. As the amount of money printed to date is staggering, and as the debts of nations are at historical highs, one would think that gold should now be exploding in value. Although gold’s value remains high, it is below both inflation adjusted previous highs of the 1980′s and is also below recent highs of 2011.

Yet, it is essential to have some sense of gold’s expected return for asset allocation. Current views are sharply divergent. On one side is (Warren) Buffett (2012) who compares the current value of gold to three famous bubbles: Tulips, dotcom, and the recent housing bust. Buffett writes:
What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As “bandwagon” investors join any party, they create their own truth – for a while.”

The Alternate View – Gold is Poised to Rise in Value
An alternate view is well respected technical analyst Louise Yamada who was interviewed on CNBC September 18, 2012. She reiterates her forecast that gold will move pass $1,800 and move to $2,000.

Quite a divergence of opinion given the thought that went into both positions. Looking at supply and demand might shed more light.

Who Has the Gold?
A recent Gallup poll found that about 30% of respondents considered gold to be the best long term investment, making gold a more popular investment than real estate, stocks, and bonds. The physical gold holdings of the world’s largest gold exchange traded fund, the SPDR Gold Trust (launched 2004) have grown from nothing to over 1,000 metric tons. Its holdings of physical gold are stored in vaults in London. GLD currently holds a little less than 1% of the world’s known supply of above ground gold. GLD’s purchases of gold represent about 15% of the total investment demand for gold since 2004. This ETF has more gold that the official holdings of China.

Demand and Supply – Demand
The World Gold Council tracks annual demand for gold from the jewelry, investment (central bank and private investment) and technology (fabrication) sectors. As the price of gold per ounce rose from $279 in 2001 to $1,567 in 2011, the annual demand from the jewelry sector declined from 3,009 metric tons in 2001 to 1,963 metric tons in 2011, annual demand from the investment sector rose from 357 metric tons to 1,641 metric tons and annual demand from the technology sector barely changed going from 363 metric tons.

Interestingly, the investment demand for gold has increased dramatically as the price of gold has gone up. A single exchange traded fund, GLD, holds more gold than the official reserves of China. Our paper asks the question of what happens if key emerging market countries boost their per capita and per GDP gold holdings to levels that more closely reflect the experience of more developed markets? Our calculations suggest that such a move would exert substantial upward pressure on the price of gold.

Demand and Supply – Supply
On average gold mine production was about 2,500 metric tons per year. The difference between production and demand was made up from scrap, sourced primarily from the jewelry and technology sectors.

Have the Chinese been buying gold? World Gold Council estimates of the central bank gold holdings for Brazil, Russia, India and China, the BRIC countries. China’s estimated central bank gold holdings are currently over 1,000 metric tons, although there is no reason to believe that Chinese central bank gold holdings are more accurately reported than any other Chinese government statistic. Even though China’s gold holdings have risen sharply over the last few years, China holds less gold than the SPDR ETF. China’s gold holdings may still be rising.

Inflation v the Price of Gold
The price of gold swings widely around the CPI. The inflation derived price of gold and the actual price of gold have rarely been equal. Given the most recent value for the CPI index, this version of the “gold as an inflation hedge” argument suggests that the price of gold should currently be around $780 an ounce.

From the 1970s until today the real gold price has fluctuated wildly. The real price of gold is currently very high relative to the 1791-2011 average. The message is that the real price of gold fluctuates and that it seems to have been more volatile recently than during the previous, roughly, 200 years. The absence of a pronounced upward or downward trend in the real price of gold supports, but does not prove, the idea that gold’s real rate of return might be on average close to zero.

It is a fact that the real price of gold is very high compared to historical standards. A number of reasons have been advanced to explain the price – some of these stories argue the price of gold is too high and others suggest the price could go even higher. The goal of this paper is to analyze these reasons. We find little evidence that gold has been an effective hedge against unexpected inflation whether measured in the short term or the long term. The gold as a currency hedge argument does not seem to be supported by the data. The fluctuations in the real price of gold are much greater than FX changes.


For a particular currency pair, even if gold hedges one country’s currency, it cannot hedge the another’s. We suggest that the argument that gold is attractive when real returns on other assets are low is spurious.

Finally, we examine the asset allocation problem of the average investor. Gold is about 9% of today’s capitalization of world stock and bond markets. If we look at investible gold, the share is about 2%. It is also a fact that very few investors hold 2% of their portfolio in gold. A widespread move to increase gold in diversified portfolios would lead to upward pressure on the real and nominal price of gold.

A Summation of Whether Gold Will Go Up
A lot of interesting observations from this paper. A key poins seem to be that gold is at an historical high. Remember the old adage – “Buy Low, Sell High“.

Another overlooked comparison is how much gold is held in the GLD ETF. Apparently more than is in the vaults of China. So the point is made that if everyone bought just a little more gold for their investment portfolio, the increased demand would send the price of gold dramatically higher. An alternative view might be that during the last decade, gold has become a darling investment of many fearful people, as proven by the size of the GLD ETF. Consider what would happen if this fear abated as the economy improved. There would be a liquidation of the gold holdings. Remember, what goes up, comes down much quicker and more dramatically.

So the bottom line, is that buying gold at these prices is one massive crap shoot. If you like gambling, go to the casino.

The views expressed in this blog are opinions only and are not investment advice. Persons investing should seek the advice of a licensed professional to guide them and should not rely on the opinions expressed herein. This blog is not a solicitation for investment and we do not accept unsolicited investment funds.

China • Deficit, Gold, Silver, Investing, Buy low sell high, GLD, inflation, NBER, The Golden Dilemma, Warren Buffet, World Gold Council 



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