Why gold hasn't met expectations during turmoil

By Neil Behrmann

June, 09:- Gold is a safe haven investment that retains its purchasing power over the long term. The provisor, however, is that the metal must be bought at cheap prices.

This simple, basic fact is illustrated in “The Golden Constant”, a book that has just been published by the World Gold Council (WGC), which promotes gold on behalf of its producer members.

Huge Investor and speculator gold stocks bearish

Before delving into the book's historical data, the natural question of investors is whether they should follow precious metals salespeople and buy gold now. The sales points are global economic and geopolitical uncertainty, potential inflation following considerable monetary ease and China and other central bank and sovereign wealth fund diversification from the US dollar and general greenback weakness.

Indeed a huge crowd of investors have already placed money in gold. Ironically for them their large holdings of gold is a bear factor that could precipitate a sharp downturn in prices. The investment and speculative crowd could sell if the price becomes rocky and breaks down from its recent trading range of $927 to $960 an ounce. Their exposure is massive. Investment in gold exchange traded funds has soared from around 15 million ounces in 2006 to more than 45 million ounces. Hedge funds and managed futures funds held 20 million ounces of net bull futures and options positions on COMEX, the New York Exchange, on June 9, while the small speculators held 37 million ounces. These investment and speculative holdings amount to around 100 million ounces or around 90 percent of annual supplies. Over and above these positions are large gold holdings in commodity mutual funds, pension and sovereign wealth funds and coins and gold bars held with London, Swiss and other bullion banks. In short there is a glacial overhang of bullion inventories, some in strong hands, others weak.

Jewellery demand slumps and gold scrap exceeds mine output

While investors and speculators have bought, precious metal and diamond jewellery  demand, normally the biggest component of physical consumption, has slid during the recession. Indeed high prices and tough economic conditions have encouraged people to either sell or pawn their jewellery. Production of recycled gold scrap has soared to such an extent that it matched mine output in the first quarter of this year, according to the WGC. This illustrates the extent that the market has become dependent on investors and fickle speculators.

The Golden Constant - How gold performed in the long term

Over the very long term, how has gold performed during the past few hundred years? “The Golden Constant”, originally written by former University of California professor Roy Jastram and published in the mid seventies, has been updated by Jill Leyland, an economic consultant of the World Gold Council. It covers gold prices and the cost of living from as far back as 1560 to 2007. The book shows that gold prices, in real inflation adjusted terms, unsurprisingly tended to increase its purchasing power during inflationary times. Its purchasing power tended to sag during depressions and deflation. There have been exceptions. Gold rose by 43 percent in purchasing power in the first four years of the Great Depression between 1930 and 1933 and then shot up when President Franklin D. Roosevelt devalued the US dollar and increased the gold price to US$35 an ounce. From the end of the Second World War, when consumer prices stabilised and fell back slightly gold’s buying power dropped slightly. These were the times when the gold price was fixed at $35 an ounce.

Gold's volatility after it began to float freely with currencies

When gold, the US dollar, European currencies and the yen began to float freely from the 1970’s onwards, gold’s nominal and real value began to fluctuate with increasing volatility. From 1970 to 1980 when global inflation surged and there was a precious metal boom, gold's purchasing power soared by a whopping 700 percent in US dollars, an annual real compound rate of around 22 percent! But from 1980 to the end of 1999, gold’s purchasing power shrank by 78 percent, a truly ghastly period for miners and gold bugs, although there were brief rallies in the interim. From 2001, when the nominal price bottomed at $251 an ounce before September 11 to the end of 2007, gold’s buying power rose by 119 percent, an annual compound rate of 12 percent. From the end of 2007, when the book’s statistics end, gold in nominal terms has mainly traded within a range of $800 to $1000 with a brief peak of $1031 early 2008.  Inflation has been minimal, so its real price has also fluctuated in a 25 percent range.

                  Purchasing Power of Gold                             

            Source: The Golden Constant  (Edgar Elgar Publishing)

Japan a case study for gold's performance during deflation

Since gold began to float in a free market it has generally been a good hedge against inflation and more recently a safe haven against banking collapse. But such has been the volatility in currency and precious metals markets that investment within the present historically high range has been a guessing game.

Japan has been the only recent test for gold’s purchasing power during times of deflation. During the seventies gold’s purchasing power soared in Yen. But a Japanese investor who bought gold in 1980 would have experienced purchasing power shrinkage of 84 percent in the subsequent decades. Despite a strong gold market in recent years, the Japanese investor’s gold purchasing power would still be down by 55 percent. Granted, 1980 was a time when gold then hit an all time high of US$850 an ounce, but even if a Japanese investor had bought gold when the market was weak in the mid eighties and nineties, real prices remained depressed until takeoff in 2006.

Real price trends indicate that gold is not good value

Is gold good value now? Historical real prices indicate that it has become pricey (see chart above) . The purchasing power price index rose to 290 in 2007 and has traded around 300 currently.  This is the level seen during the boom years of 1979 to 1981, although the 1980 average bubble peak was 492. The average peak range from 1800 was around 200 and from the early 1970's about 220.  This would indicate a fair value peak of $650 to $700 an ounce and an average level of around $500. This is a warning that gold is for trading and is not good value at present prices.


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