What Does the Future Hold for Gold? 3 Determinants

The best way to think of gold is as a non-yielding currency with a special trait: The only way to “print” it is to pull it out of the earth at great cost. As a currency with no yield and limited practical use…gold’s investment case largely rests on its ability to insure against currency depreciation. Few people expect to make money by taking out insurance policies. I don’t recommend allocating any more than 10% of a portfolio to gold. Words: 610

So writes Samuel Lee (www.morningstar.com) in edited excerpts from his original article* as posted on Seeking Alpha entitled Gold’s Dull Future.

The post by is presented compliments of www.FinancialArticleSummariesToday.com (A site for sore eyes and inquisitive minds), www.munKNEE.com (Your Key to Making Money!) and the Intelligence Report newsletter (It’s free – sign up here) and may have been edited ([ ]), abridged (…) and/or reformatted (some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. Please note that this paragraph must be included in any article re-posting to avoid copyright infringement.

Lee goes on to say in further edited excerpts:

There are many ways to own gold. Because the metal is a bet on disaster, some gold owners prefer physical possession, preferably beyond the knowledge of the tax man. They fret the government could criminalize the private ownership of gold…so if you’re truly worried about such a scenario, no exchange-traded fund is worth consideration. In fact, no mode of ownership that relies on the rule of law–gold accounts, structured notes, certificates, futures, warrants, and so on–will shield you from the government should the unthinkable occur.

For investors who aren’t worried about confiscation or a Mad Max scenario, exchange-traded funds are likely the most efficient way to own gold. SPDR Gold Shares (GLD) is synonymous with gold investing, owing to its massive size and liquidity. GLD has at times held more assets than any other ETF…

Fundamental View: Even though gold’s long-run return is almost certainly abysmal, I’m reminded that a great economist once said, “In the long run we are all dead.” Gold, as a currency, can do well for all the reasons currencies do well. It can:

We’ll treat each factor in turn.

1. Yield: The biggest determinant of gold’s price is its relative yield, not inflation, as many believe. The gold run got its legs when short-term interest rates hit zero in 2008 and the Federal Reserve began its first round of “quantitative easing,” reducing fears of deflation. When short-term interest rates went negative, the opportunity cost of holding gold as opposed to cash became positive. Should real rates rise, gold investors will be slaughtered. Therefore, gold is a bet that real interest rates will remain low for a long time.

(click to enlarge)

2. Safety: Another big determinant of gold’s price is market’s perception of the dollar’s safety. Since 2008, emerging-markets central banks have bought gold to diversify their foreign exchange reserves away from the currencies of the big debtor nations. Prominent investors, such as Bridgewater Associates, have advocated for gold as a strategic holding. John Paulson, who famously made a fortune betting against subprime mortgages, is GLD’s biggest shareholder. There’s a lot of fear baked into gold’s elevated price, so investors will have to get a lot more fearful than they are today for this factor to come into play.

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3. Real Exchange Rate: Gold has a real exchange rate, just like any other currency. Exchange rates tend to converge on the point where purchasing power is equalized. Gold’s purchasing power of real goods is at an all-time high: Since 1975, the gold price/CPI ratio averaged 3.5, but now is higher than 7, suggesting gold is overvalued by 100% in real purchasing power against its history. However, unlike with normal currency pairs, there’s no mechanism for arbitragers to buy goods in the cheap currency and sell them in the expensive one, so gold can remain expensive for a long time.

(click to enlarge) – source: Morningstar Analysts

Additional Determinants: Aside from the currency factors, there is also a wild card in Chinese and Indian investment demand. As emerging markets become richer, gold demand may continue to rise. In this regard, gold is an implicit bet on emerging-markets growth.

Editor’s Note: The author’s views and conclusions in the above article are unaltered and no personal comments have been included to maintain the integrity of the original post. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor.

*http://seekingalpha.com/article/1309031-gold-s-dull-future (© 2013 Seeking Alpha)

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