Gold rose 58 times from $19 in 1900 to touch $1,110 in 2010, while the Dow Jones Industrial Average jumped 172 times from $61 in 1900 to $10,500 in 2010.
Today, gold and real estate have become essentials in every investor’s asset creation. But is there a danger that these two asset classes could turn out to be the biggest bubbles in the long run? We all presume that we will be the smart fellow and will bail out before the others. However, mass following, inflation and the action of governments such as constant bail outs and subsidies ensures that these assets keep inflating in value. It is likely that lack of faith in the sovereign as well as inflationary pressures and crowd behaviour could keep these assets on the high for times to come.
Gold is a metal, which has no intrinsic use or value, but it has become a synonym for wealth due to purely emotional or sentimental reasons. In the frenzy of speculative hoarding, it has virtually become a self fulfilling prophecy. If we take the pure extraction cost, it is well under $400 per ounce. However, it has become a store of value and is driven by factors such as the strength of the dollar, the degree of likelihood of an alternative to the dollar as a “safe haven”, the fetish of Indian and Chinese households for the yellow metal and the speculative forces of hedge funds and commodity funds.
The one thing to note is that gold does not follow any predictive valuation model. It is perception and a function of demand, supply, fear, greed and hype. In dollar terms, gold gave negative returns from 1980 to 2006! The quantum leap has come only post 2006.
For Indians, there were some positive returns as the rupee consistently weakened during the entire period. Gold was used primarily as jewellery and as a store of unaccounted money.
A year ago, gold was trading at under $1,300 an ounce. Now it is around $1,700, after breaching $1,800 per ounce and it is now looking volatile. Can it fall further? The key to that lies in whether the global money managers believe in what the US is doing. If faith flows back to the dollar, gold will get sold off or vice versa.
Faith in the US government is perhaps the most important factor that will influence future gold prices. Most governments that have huge trade balances have invested bulk of their surplus money in bonds issued by the US government. The day this faith cracks, there will be a dumping of these bonds, a run on the dollar and a mad rush to gold. Perhaps, there is not enough physical gold in the world to accommodate all the surplus money and hence the governments may not dump the dollar for gold in one go.
For Indians, gold prices are also determined by the exchange rate of the Indian rupee. If global prices of gold fall by five per cent and the Indian rupee depreciate by five per cent, the rupee price of gold will not show any change. So the price of gold in the Indian markets is also a function of the Indian rupee!
Indian demand for gold is a significant price driver for gold. Today, India and China account for nearly 60 per cent of gold demand! An important factor to note is that in spite of the rapid price rise in the last 12 months, the Indian hunger for gold has not declined. In fact, demand for physical gold has also increased due to investment buying through the ETF route.
To sum up, gold has become an important alternative investment thanks to the recklessness of governments. Lack of trust in third parties, perhaps makes gold a good friend. The higher is the mistrust in governments, the higher the payoff in gold and vice versa. Should you continue investing in it? That is your call, depending on how you assess the economic situation and your own investment strategy.
(The writer is an independent analyst)