For Investors, Will Gold Gleam More -- or Turn to Lead?


Some of my friends accuse me of being a gold bug, and I readily confess to seeing one major advantage of the metal over "blue-chip" investments like Enron and Lehman Brothers: Gold won't go to zero.

Few investments are more emotional than gold. Conspiracy theories featuring central banks dead-set on thwarting the yellow metal's rise are a staple topic, as are calls for a rise to $3,000 an ounce within five years and warnings that gold has entered the mania stage.

What's undeniable is that gold has risen from the sub-$300-per-ounce level to around $1,200 in the last decade. Is gold in bubble territory, set for a dramatic decline, or is it ready to break out to new highs?

Store of Value

Let's start our investigation by noting that gold is a relatively small player on the global investment scene. The total value of tradable gold is estimated at $5 trillion. Compare that with a global GDP of $58 trillion and a market value of publicly traded shares of around $60 trillion.

Unlike stocks and bonds, which can be issued in nearly unlimited volumes, gold is intrinsically limited in quantity. It also has industrial or dental uses and is considered a traditional store of value in the world's two most populous nations, India and China.

In investment circles, gold is widely viewed as a safe haven in times of volatility and as a hedge against inflation. Despite this, gold has suffered sharp price swings in the past two years, fluctuations that defy simple explanations.

Many in the gold camp view any price drop with suspicion, as if all declines are the result of central-bank manipulation. Central-bank intervention in foreign exchange markets is a well-documented phenomenon, so their actions in other markets is not far-fetched. After all, central banks hold about 20% of all gold as bank-reserve assets.

Source of Quick Cash

Rather than speculate about central-bank intervention, an examination of the four market forces present in the gold market may help make sense of recent price action. Gold acts as:

  1. A safe haven -- "flight to safety" in volatile, risk-averse times

  2. A store of value and hedge against inflation

  3. An asset to be sold to raise cash and pay down debt

  4. An asset that becomes less attractive in deflationary eras

That gold tends to hold its value ironically makes it an attractive asset to be sold in times of need. Consider India, where gold and silver are traditionally favored as hedges against inflation. With food inflation running at 16% now in India, families hard hit by sharply rising food costs may not be able to afford to hold a gold hedge permanently.

The same phenomenon may also be at work in financial circles. When stocks plummet and margin calls must be met, asset managers might be tempted to sell the assets that have held up the best -- in some cases, gold -- to quickly raise cash to either make interest payments or reduce debt.

I've marked this chart to illustrate how these four market forces may have acted on gold's relative valuation.

When the global credit crisis began building in 2007, gold rocketed as investors fled risky assets for the safe haven of gold. Then, as fears of a contagion receded, so did gold's price from above $1,000 per ounce down to $750 in early September, 2008.

A few weeks later, Lehman Brothers collapsed, and the flight to safety drove gold almost $200 an ounce higher in a matter of days. But by October, gold had crashed to the $680-per-ounce level, a 35% decline from its peak in March.

What happened to the flight to safety? While speculation of central-bank manipulation is ever present in gold markets, investors desperate to raise cash to meet margin account and other debt requirements may have sold gold precisely because it had retained its value in the global meltdown of financial and real estate assets.

Anticipation of deflation was another factor. Gold's value as a hedge declines somewhat in deflationary periods. U.S. Treasuries or high-quality corporate bonds paying some yield become more attractive when deflation is present.

Fear Boosts Gold

After this orgy of selling, the fear trade returned as global stock markets resumed their slide. By the time the U.S. stock market hit its lows in early March, 2009, gold had regained the $1,000-per-ounce level.

As global growth resumed in spring, 2009, the flight to safety trend gave way to the hedge against inflation trade, as investors anticipated resumed global growth and heavy government stimulus might stoke the fires of inflation. As confidence on global growth strengthened, gold gained about 20% from its previous high in March, 2008.

When global stock markets dipped in November, 2009, gold responded in see-saw fashion by spiking up. Amidst the recent stock market turmoil, the metal's price hit a new high, perhaps as the re-emergence of the flight to safety trade.

So is gold setting up for a drop, or is it likely to continue its advance? If we look at this chart of gold's exchange-traded fund proxy, the SPDR Gold Trust (GLD), we see that gold's recent uptrend is climbing even more steeply than its previous advance from 2005 to 2007.

But gold suffered its sharpest decline right when the global financial meltdown peaked in late 2008, falling about 35% from its peak.

Depends on Growth

That suggests that gold's future action will depend on the global financial situation. If deflation is once again expected and cash must be raised quickly to pay down debt or make interest payments, then recent history suggests gold could swoon as it did in late 2008.

If global economic growth resumes, then gold's long history as a hedge against inflation suggests the current uptrend could continue unbroken until the next global financial panic occurs.

Originally published