In 2007 and 2008, people were being advised to buy gold. Inflation was rising and the yellow metal is supposedly an infallible hedge against inflation. In 2009, they are being advised to buy gold. Deflation is occurring and the yellow metal is supposedly a hedge against deflation! In 2003 and 2004, when gold prices were at roughly 30-35 per cent of current level, people were not being advised to buy gold.
Yet in hindsight, it was a great investment. This is not paradoxical. Most financial recommendations are made on “momentum”, targeting investments that are showing an uptrend. In 2003, gold prices were down to 25-year lows; they had been ruling at those levels for five years and “everyone” in the financial advisory space had given up on the commodity, though housewives around the world hadn't.
In 2004, only the madly contrarian would have suggested that, given the inevitability of change in the global business cycle, gold would be a good long-term investment. At that time, if you had asked a financial planner for advice, he would have said “allocate about 5 per cent of your assets to gold, no more and perhaps less.” In 2008-09, with gold ruling at 20-year highs, most planners were advising an asset allocation of 10 per cent or more. What is more, investors were being advised to buy into specialty funds that focussed on gold mining stocks.
The paradox that gold is a hedge against both inflation and deflation, is resolved if you accept that gold is a hedge against currency uncertainty. It has a long relationship of being reverse-correlated against the USD as well. Whenever people are uncertain about the future value of money, (up or down), they do move into gold or gold-denominated assets. This has been evident in the past two years when demand for the physical metal has risen and gold ETFs and speciality gold-funds have been sold aggressively and done well.
However, the housewives who bought jewellery in 2004 beat the investment advisers hollow. Those housewives have stopped buying in the past two months. Gold demand across the world and especially in India has dropped to a trickle. In calendar 2008, India imported over 720 tonnes of gold (a slowdown compared to 860 tonnes in 2007). In January 2009, imports were just 20 tonnes and February was worse with imports dropping below 2 tonnes. Sky-high prices have choked demand.
So do you trust the housewives or do you follow the advice of your investment advisor? Here are some factors to consider. In the past 38 years, when the world has seen plenty of severe financial crises, the price of gold has been at the prevailing levels, or higher, for less than 40 months.
Gold is a mean-reverting asset like most assets - prices tend to move down to reasonable levels rather than rise indefinitely. Your chances of losing money in the long-term, if you are buying at these prices, are extremely high.
It's a difficult asset to hold or trade. If you hold the physical asset, storage and resale are both cumbersome. The same bank or jeweller who sold you the gold will only buy it back at a significant discount - it's a market with large spreads. If you hold the ETF, you are slightly better off.
Gold mining stocks are outperformers when the metal is rising. But mining businesses operate at high costs of extraction and the realisations fluctuate with the metal-price, which is demand-driven. Business risks are divided into systematic risks of overall economies (interest rates, government policy) and unsystematic risks of specific businesses. Gold mining has high unsystematic-risk. Specialty funds carry the unsystematic risks of gold-mining, which often outweigh the systematic risks that gold- bugs hedge.
That said, the global crisis has been deep. It doesn't seem to be over. The dollar could drop catastrophically. In that case, gold is a good trade. So are gold-mining stocks and speciality funds. But gold is not a long-term, buy and hold asset worth investment. Not at these prices.
If you buy now, you will have to let it go when the global economy starts a recovery. If you are comfortable trading gold, good luck! Otherwise, buy something else that is at a five-year or 10-year low. There is no dearth of good businesses in that situation.