Financial market conditions during the past year should have suited gold related investments. If anything, the gold price reaction and the response of related equities have been disappointingly weak.
The aim of this note is to discuss:
-
the continuing potential of gold as a hedge against financial crisis; and,
-
the nature of the connection between gold prices and the stock prices of gold producers.
The Background
Gold has long been accorded special status as an
investment asset class. This role is rooted in a
long history of people trying to secure their wealth
against the ravages of inflation or as a defence
against unscrupulous rulers bent on bilking their
citizens.
But for the occasional gold rush or bullion shipment from distant lands, supplies of gold were historically limited permitting the wealthy whose assets were in gold to keep their stranglehold on their local economies. This gained gold considerable support. It also allowed the rich and powerful to keep their wealth stored neatly and discreetly. Convenience has been a strong factor in the universal acceptance of gold as a store of value and medium of exchange.
Today, the analytical basis for this is less strong. Why gold and not plywood, for example, as an investment asset in an era of advanced technology, market regulation and product innovation? Over the nearly 30 years between 1980 and 2007, plywood prices rose at a 1.98% average annual rate compared to a 0.62% rise for gold. The average yield on three month U.S. treasury notes over this same period of time was 5.79% per annum . There is little in the history of relative returns to convince an entirely objective investor of the merits of gold.
Nonetheless, its widespread acceptance has ensured its continuing use. And, not to be disregarded, politically conservative business people sceptical about the honesty and financial integrity of governments have kept interest alive. As they have maintained the faith, they have added to the flow of funds that have continued to support gold prices in virtually all circumstances.
They have also prodded national governments into retaining at least some part of their reserves in the form of gold, lobbying against attempts by central banks to discard their gold holdings in favour of more diversified portfolios of financial assets. According to data from the International Monetary Fund and the World Gold Council, official gold holdings amount to 29,800 tonnes or approximately 12 times current annual mine production.
An Alternative Currency
In the midst of man-made financial disasters when
national currencies are at risk, gold is supposed to
offer a path to financial security. However, the
value of gold is very much in the eye of the
beholder. It has little intrinsic value.
If, for the sake of argument, all the world’s gold supplies were to suddenly disappear, beyond a few surprised central bankers, there would be little detrimental effect on the world economy. The same could not be said of oil or bauxite or even unfashionable lead. If they similarly disappeared, parts of the global economy would quickly grind to a halt as industries could no longer function without their critical raw material inputs. In this respect, gold has the characteristics of the fiat currencies it is supposed to supplant. It only has value as long as a buyer and a seller agree to place a price on it. That price could be $1 or $1000. The price is entirely discretionary because virtually all the gold ever produced is still available in stockpiles today. Consequently, the marginal cost of obtaining physical gold, since it is never permanently consumed, is very low and largely unrelated to the cost of mining.
Gold prices are formed in a different way to the prices of other commodities . There is relatively little coal or iron ore or copper, for example, stockpiled and available for use at any time. There might be as little as 4-6 weeks of consumption. There would not have to be much of an uplift in usage to require new product to be mined. Consequently, prices of these commodities tend to hover closer to primary production costs.
Gold miners often point to their costs as a guide to the minimum likely price for gold but prices could remain below this level for prolonged periods if all the gold that people wanted was readily available from stockpiles of previously mined metal. Equally, the price could remain high oblivious to mining costs under the right macroeconomic conditions.
Losing Its Allure
The gold market is much smaller than other financial
markets so that even modest capital flows from
global equity or foreign exchange markets, for
example, could swamp the gold price.
The subdued reaction to the macroeconomic
convulsions of the past two years when safe havens
for financial assets have been in desperately short
supply signals that gold could have lost a good deal
of its investment allure. If meaningful amounts had
been drawn from other financial assets into gold,
its price should have been some multiple of the
levels actually reached.
There are several reasons why gold might be losing its appeal. One is the elimination of international capital market constraints. Capital is now relatively free to roam across national borders in pursuit of any number of different financial instruments. Not so long ago, local residents in China or the Soviet Union, for example, were severely constrained in their choices when deciding how to safeguard their wealth as they searched for alternatives to their domestic currencies.
For them and many others, gold used to play an essential role which is no longer so urgently needed as long as they have access to a widening array of investments.
Influences on Demand
The demand for gold as an investment should be
affected by three influences: its own price,
relative prices and changes in wealth.
Rising wealth creates demand for more financial assets to act as stores of value. Some of this demand flows to gold even if gold represents a diminishing proportion of the total asset base.
For any level of wealth, the lower the price of gold, the more investors should want. However, low prices are sometimes a deterrent to an investor if they reflect a poor financial return over a prolonged period and other asset returns have been more attractive.
Sometimes, investors monitor other price benchmarks
to gauge whether gold is cheap or expensive. Some
people look to the oil price as a guidepost for what
might happen to gold prices because both are often
associated with inflation outcomes.
The chart shows how much oil an ounce of gold has been able to purchase on average each month since 1964. There is a fairly well-defined range to this series characterized by a firm lower end and an apparently declining upper end.
When gold reaches the relative price
it reached in each of 1979, 2000 and 2005, for
example, it tends to rebound. On this basis,
unsurprisingly, the gold price was on the rise
throughout 2007 and most of 2008 while oil prices
were going up. Indeed, some market speculators would
have been buying gold simply on the assumption that
this relationship would remain intact and that gold
prices would have to approach $1,000 an ounce as
long as oil prices were above $130 a barrel.
Uncorrelated Returns
One of the remaining attractions of gold as an
investment, combined with its long history as a
monetary asset, is the low correlation between its
investment returns and the returns from other
assets.
A correlation of +1.0 between the returns from two assets will mean that the return from a portfolio will be no different whether or not a second asset is included. In the other extreme, a correlation of -1.0 will mean that the returns from the two assets will exactly negate one another if equally weighted in a portfolio.
The lower the correlation in returns between two assets, the greater the opportunity for an asset manager to modify overall portfolio returns by adjusting the allocation of funds between the two assets.
The table shows the correlation in monthly returns among Australian industrial companies , resources companies and gold bullion since 1980. Within this three asset class world, average monthly returns from gold were lowest (+0.28%). Resources sector returns (+0.87%) were higher than industrial sector returns (+0.79%) but the higher returns from resources came with greater volatility, measured by the standard deviation in monthly returns.
The volatility of gold returns was lower than for resource sector equities but higher than returns from industrial sector investments.
The correlation between gold and industrial companies was just +0.04 or little different from zero. As one would expect, the correlation in returns between gold and the resources sector was higher but still only +0.23. There was a relatively high +0.64 correlation between the two equity classes.
Industrial equities had the highest risk adjusted returns and could be expected to form the cornerstone of any portfolio based on these historical data.
Since industrial equities had a relatively high correlation with resources sector equities, the potential role of resources stocks in the portfolio would be limited. Their place would depend on the extent to which an investor was seeking to maximize returns and was unconcerned about volatility.
The essentially uncorrelated gold could be used to modify the volatility characteristics of a portfolio in which industrial stocks were given the higher weighting.
