Gold Ahoy!

I have to admit. It’s not my forte. And that’s why I decided to put some research into it. With the gold prices going sky high and some well known investors like Jim Rogers and David Einhorn recommending that some part of the portfolio be dedicated towards gold, it certainly deserved serious attention from an investor.

A bit of background

Gold has been valued from the early Bronze Age. The first known gold objects, dating possibly as far back as 5000 BC were Egyptian ornaments, ritual vessels, and personal jewellery. Gold’s high melting point and resistance to corrosion made it indestructible and very useful indeed.

Goldsmiths in the 17th century issued certificates representing gold on deposit, which were among the earliest forms of gold backed paper notes. When the Bank of England was created in 1694, it mainly financed government debt by issuing these notes.

Safe Haven

“Europe collapsed and North America collapsed!”, said the Indian finance minister, Pranab Mukherjee as he announced India’s purchase of 200 tonnes of gold from the IMF. This purchase was the single largest central bank purchase in 30 years over as short a period as a fortnight.

This must have been a BIG decision by the country’s think tank considering that this constitutes over a 50% addition in its gold reserves. After the purchase India now has close to 560 tonnes of gold (about 6% of the reserves in value), that’s the ninth largest gold holdings amongst central banks. China on the other hand has grown its gold reserves by 75% vs. last year (as of now China has around 1000 tonnes of gold, constituting around 2% of its reserves). Compared to some of the other nations like Germany (69%), Italy (66%), France (70%) – this is still a miniscule percentage.

And therein lies the logic of the gold purchase by India and China – diversification of risk to assets other than USD. At a governmental level, it pays more to safeguard the country's assets than to look for returns.

Gold and Dollar are considered the world’s primary safe haven investments. If the confidence in Dollar collapses, gold then takes over as the world’s sole safe haven investment. In that sense, gold has historically provided a low and even negative correlation with most other asset classes and has been used as a portfolio diversifier whenever there has been a perceived high level of risk.

As the following chart shows, gold rose from USD 100 per ounce in the period ‘75-’78 to a high of USD 750 per ounce around the early ‘80s. This was a period marked by high credit (average annual credit grew by 11%) and at times higher inflation (average inflation rate of 12% in 1974 and again in 1979-1980). Investors flocked to buy gold as confidence level in the world economies fell.



Just immediately after this, gold’s price fell massively (in 2000 it was back to around USD 250 per ounce) as monetary order was restored and the economy and stocks soared.

Moving back to the present times, with the US Congress spending billions of dollars in stimulus funds to jump-start the economy funded almost entirely with debt, the dollar has become weak since currency investors tend to shy away from high-debt countries - just like in equities where (all other things being equal) we would not prefer to invest in a company that is highly levered.

In the case of a country, a high level of debt also causes higher inflation, another reason for investors to stay away from USD and hence moving into the only other known safe haven – gold.

Resultantly, the yellow metal now rules over USD 1100 per ounce. This means a return of over 50% over last year.

Crystal Ball gazing

So with gold now at the USD 1,100 per ounce levels, bets are being placed on what could be the next probable price target. Wild guesswork is at work, as is usual. And some say that even US$ 1,500 by the end of 2010 does not look like a very tall order.

It was reported that Barrick Gold, the world's largest producer of gold is moving to completely close its hedging operations as it does not believe that gold prices could fall a great deal from here. The company feels that global output has been falling by roughly 1 m ounces a year (approx 33 tonnes) since the start of the decade and hence, there is a strong case to be made that we are already at 'peak' gold.

And with central banks around the world also turning into net buyers of gold in recent times, supply crunch is likely to worsen a great deal more, taking gold prices even higher.

Barrick is not the only one betting on higher gold prices in the future. Marc Faber, one of the world's pre-eminent investors has also jumped on to the bandwagon. "We will not see less than the US$ 1,000 level again", he is believed to have said at a conference today in London. "Central banks are all the same. They are printers. Gold is maybe cheaper today than in 2001, given the interest rates. You have to own physical gold", he is reported to have said.

Even the best can’t be right all the time

The average investor is blindly following these noteworthy men.

But as the earlier chart depicting the gold price showed, gold as an investment suffers from the same malaise as any other investment. Buy at a high and the probability increases that you will lose.

Notwithstanding what Barrick believes, the Fortune magazine has reported that gold miners invested more than $40 billion into new projects since 2001, and they "are now bearing fruit." Bullion dealer Kitco "predicts that these new mining projects will add 450 tons annually -- or 5% -- "to the gold supply through 2014, enough to move prices lower." The demand also brings out sellers of scrap gold, which adds even more to the supply.

All this while world demand for gold (as in the demand from the ordinary consumers) has dropped 20% in the past year. In fact according to the World Gold Council, India's gold demand dropped 38% in the second quarter, with jewellery purchases down 31% from a year earlier. For India! This is where everyone loves gold!

By the above logic, if the supply is going to move up and the consumer demand is down, the only reason that the gold will continue to rise in the future is if the investors continue to buy more gold.

Don’t know if it is the right comparison, but this sounds like a giant Ponzi scheme. As long as there is fresh demand from investors, the prices will rise. And we know these don’t last forever. Remember oil DID NOT reach USD 200 per barrel from the USD 130 levels or so, despite a lot of the so called experts preaching that it might.

What can turn the tide?

Very clearly the return of the US economy back on track.

As mentioned earlier, all things considered, gold is essentially a bet on the collapse of the current monetary arrangement based on paper currencies. And although the US dollar might look like it is overvalued and prone to collapse, what if the US economy does not collapse and actually recovers and the Fed starts raising interest rates?

Mr. Buffett is already betting on it.

“It’s an all-in wager on the economic future of the US. I love these bets... America’s best years lie ahead, no question about it” so said the sage of Omaha, Warren Buffett as he announced the acquisition of Burlington, a US railroad company at a total price of USD 44bn, his company's highest investment thus far. Ever.

As for gold, he had the following to say:

“It gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”

(Fittingly one commentator used the above to say this about printed money: “It comes in abundance from trees with little to no efforts, we print as many as we want and assign whatever value to it, but we make certain it contains official looking faces and logos so that we can pay people with it to stand around guarding it!)

So there. After all the research, I have to admit that I still don’t know how to value gold like I would value a company. Which means that if I can’t invest in (Indian) equity, which at this point in time seems the case, then gold doesn’t look the right choice of investment either. Back to square one.

Umm, and Indian equities?

Well just because the US economy is looking to come out of the doldrums and Mr Buffett is betting big time on it, I am afraid it does NOT mean that the Indian equities will follow suit. This could well mean a flight of capital from emerging markets like India and back to US (I referred to this in my last blog entry too), with obvious effects on the market levels.

Meanwhile, the best strategy in my view is to keep smiling that golden smile and hold on to the cash. The time to invest will come.