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Should You Buy Gold Now?

Price of gold ran up hugely over the recent months. Check out its scope

This is an article that appeared in the 15 December, 2009  - 14 January, 2010 issue of Mutual Fund Insight magazine that looks at the reasons behind the huge movement in the commodity and charts a path for investors

Legendary commodities investor Jim Rogers has forecasted that gold is set for a historic $2,000 mark in the next decade that begins in 2010. Conversely, noted economist Nouriel Roubini has rubbished that prediction. “Maybe it will reach $1,100 or so, but $1,500 or $2,000 is nonsense,” he said at a conference in New York, which was reported by Bloomberg. That was in November 2009. 

Rogers successfully predicted a rally in commodities in 1999. Roubini predicted the collapse of the housing market and financial meltdown in 2006. Now, the two personalities are pitched against each other in predictions concerning the price of gold. And, frankly, there’s no telling who is going to win this round.

What’s pushing up the price of gold?

The rally in gold prices has resulted in frenzied forecasts and frantic buying. In December 2009, the price of gold crossed $1,200/ounce. According to a report by Commodity Online.com, bullion has risen by 37 per cent this year as the dollar has dropped 8.5 per cent against a basket of six major currencies. 

Gold prices are being pumped up due to a variety of reasons. The weakening dollar, shrinking gold supply, increased demand and rising cost of mining gold from the earth are all making gold a much-sought after asset. It provides the lowest risk of all the precious metals options available to investors. Pension funds and individuals have bought gold as a hedge against potential currency debasement and inflation. Holdings in the SPDR Gold Trust, the biggest exchange- traded fund backed by bullion, increased 0.61 ton to 1,130.60 tons (December 1, 2009). 

More recently, the biggest gold buyers have been central banks. In 2005, Russia, Argentina and South Africa decided to increase their gold reserves. It is a pity that India did not act then. When the Reserve Bank of India’s (RBI) forex reserves fell to a critical level in 1991, the gold proportion of the reserves was high. Since then, we have seen a rise in the forex reserves while the proportion of gold to them has simultaneously fallen. In recent times, the proportion of gold to forex reserves was around 3 per cent. Now the instability of the major reserve currency has led the central bank to purchase more gold. During the end of October 2009, India purchased 200 tonnes of gold from the International Monetary Fund (IMF). If India can be criticized for buying too late, the UK can be faulted for selling too early.

The UK’s sale of 395 tonnes of gold in 17 auctions between July 1999 and March 2002 turned out to be one of the least well-timed investment decisions in recent history. The average price achieved in those disposals was around $275/ounce. Gordon Brown as chancellor, along with his advisors, disliked the intrinsic laziness of gold which simply sat in the vaults gleaming, but earning no interest. The revenue raised was invested in interest-bearing assets denominated in dollars (40%), euros (40%) and yen (20%). The Swiss, the Belgians and the Dutch gave the British company. None contemplated the price of gold shooting through the roof.   

Will gold continue to rise?

More pertinent now is whether the price of gold will continue to rise. Will Jim Rogers be right or proved wrong? The December 2009 Goldman Sachs’ report “2010 Outlook: Resource Realignment” has stated its gold price forecast as $1,350/ounce (12-month), $1,265 (average in 2010) and $1,425 (average in 2011). In discussing its bullish outlook for gold, the report noted that “in the interim, the balance between investor buying and central bank sales suggests that the balance of the gold price risk remains skewed to the upside.” This view is echoed by many who feel that the fundamental reasons for driving up the price of gold have not changed. 

The weakening dollar is pushing investors towards gold. Countries like China and Turkey are showing an increased demand for gold jewellery. Central banks have turned out to be net buyers of gold. China holds $2 trillion in forex reserves and a meager portion, only 2 per cent, is in gold. China would probably make the logical move to increase its gold reserves. Demand of gold for industrial applications still exists. While demand on all fronts shows no sign of letting up, the supply of gold is relatively inelastic. The surface level of gold has all been discovered and supply is falling behind demand as the diminishing number of new reserves fails to compensate for dying mines. Reserves are depleting faster than they can be discovered and once discovered, it would take 4-5 years for a gold mine company to start producing gold. 

The demand and supply economics favour gold. But does that justify buying gold at current prices? Probably not. If one wanted to make a killing in gold, the right time to have bought would have been in 2006. You could buy at the next correction. Rogers himself said that there may be a gold correction because “there’s so many bulls on gold.” But there’s no telling when that will take place and by how much it would correct. 

Gold in your portfolio

Over the past few years, gold has emerged as an asset class, not just in theory but actual practice. But does that necessarily translate into a great investment? Not really. A look at the data in the table (Gold v/s Equity) suggests that one can make more money in equity. If an investor had invested in the Sensex in 1992 and sold at the peak of the bubble, the Sensex would have given an absolute return of 939 per cent. This is not taking into account dividends or bonus shares. On the other hand, gold would have delivered 141 per cent. 

Even if one sold when the market plummeted, or when the price of gold was at an historical all-time high, the return from equity would still have been ahead than what one would have got from gold. 

Another flaw of gold as an investment is that it does not generate income by way of dividends (equity, mutual funds), rent (real estate) or interest (fixed income). On the flip side, its saving grace is that it’s the only financial asset that is not simultaneously someone else’s liability. It is also the most liquid investment, no matter what the prevalent economic or financial conditions.

As a form of ownership, it has become much more accessible and liquid over the years. The result is that it has excellent speculative potential. So for gold to find a place in your portfolio, it should not be viewed as a hedge against inflation or a store of value. Consider gold as a valuable tactical asset. If you are buying gold now, keep a price target in mind to book profits and exit. 

If you want to stay in for the long haul because you do believe in holding gold in your portfolio, then divide your gold allocation between actual gold and gold stocks. If you don’t want to buy physical gold (bullion), you could alternatively consider units of a gold exchange traded fund (Gold ETF). It’s safe to say that gold mining stocks and bullion are entirely different asset classes. Unlike mining stocks, bullion is not subject to changes in production costs, management skills, availability of financing or exploration success. On the other hand, these stocks could deliver handsomely not only because of the metal they mine but because they embody a neat trait called leverage. So when the price of gold rises, they rise by much more. While the positive leverage could be as low as 2 to 1, it could go up to 4.5 to 1. What this means is that for every 1 per cent rise in gold, there is a 4.5 per cent rise in the gold stock. But the reverse takes place in market downturns. 

While gold mining stocks will track the price of bullion, they are still stocks. So in market downturns, they become correlated to the broad equity market. During a bull run, gold stocks typically rise high enough to outperform bullion. When economic or market conditions deteriorate, investors inevitably seek a safe haven, as opposed to speculative investments. At such points in time, bullion outperforms gold stocks. 

So gold mining companies are a leveraged, but more risky, bet on rising gold prices. Buy gold for safety and gold stocks as a more lucrative bet.