Let me start by saying that I am not a Gold Bug. I don't think the Fed is part of an evil conspiracy to steal wealth from Americans, nor do I think that we are about to have hyper inflation any day now. That said, I do think that gold is a major investment for a lot of individual and institutional investors, and that everyone should be paying attention to gold right now because its price volatility can teach us all something about how fast markets can fall apart.
I intend to write several articles about this topic because I think gold's (GLD) price is too complex to be explained by just one article. This first article is all about the relationship (or lack thereof) between inflation and gold.
The combined market value of all stocks and bonds around the world is about $90 trillion whereas the mined value of all gold has a value of roughly $8 trillion. Of the $8 trillion however, only about $2 trillion is owned by investors (both institutional and retail). Given this, and given that the supply of gold (rate at which it is mined) is mostly unresponsive to the spot price (see my blog here for more details), it's hard to say that the price of gold is being decimated by an excess supply (vs. historical levels of supply).
Investor perceptions about the value of gold differ sharply though. For example, Warren Buffett famously believes that the recent run up in gold prices is comparable to the Dutch Tulip Bubble, the Dotcom Bubble, and the Housing Bubble. As he explained in a recent letter to Berkshire Hathaway (BRK.B) shareholders:
What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As "bandwagon" investors join any party, they create their own truth - for a while." Berkshire Hathaway 2011 Shareholder Letter, p. 18.
On the other side (at least as of 2011 and a Barron's interview at the time), you have Ray Dalio the founder of the world's largest hedge fund.
Gold is a very under-owned asset, even though gold has become much more popular. If you ask any central bank, any sovereign wealth fund, any individual what percentage of their portfolio is in gold in relationship to financial assets, you'll find it to be a very small percentage. It's an imprudently small percentage, particularly at a time when we're losing a currency regime. - Interview with Barron's, 2011
Gold has been seen as a viable alternative to stocks for more than a decade now, in part because for at least 20 years, gold has basically kept up with the stock market in terms of price appreciation. The fact that a gold bar is a non-productive asset, and that firms are supposed to grow in size and profitability, lead the comparability of returns between the two groups to be as much an indictment of stocks as an endorsement of gold. For example, from December 1999 to mid-2012, gold returned an average of 15.4% annually vs. 1.5% for stocks and 6.4% for US bonds.
Given the stellar performance by gold over the last two decades up until a couple of months ago, it is worth asking if these last two decades have been an aberration for gold, or if they are the norm. That is - will gold's price come back? Now of course, history is no guarantee of the future, but it is the most reliable guide we have.
Gold is often cited as a hedge against inflation, but in truth, its price seems to reflect much more than just that. For example, the following chart shows the ratio of the price of gold to the Consumer Price Index [CPI] for the US over time. If gold's price were truly just a function of inflation, then this ratio should be roughly constant on average overtime. As the graph below shows, it's not.
This hypothesis of gold's price being essentially a demand driven story is backed up by the final graph below which shows that gold output has not changed much since early 2000, even while the price of gold has skyrocketed.
Overall the conclusion from this evidence is that gold's price does not appear to be a reflection of inflation. Thus, while it is likely that eventually inflation will increase in the future, this may not actually help the price of gold much. This makes lowering, or at least restraining growth in, mining costs for companies like Barrick (ABX), Yamana (AUY), Newmont (NEM), and Goldcorp (GC) all the more important to the future of these companies. This does not necessarily mean that gold is a bad investment, or that these companies are a bad investment, however, as I will explain in my next article.
Finally, it's not at all clear that gold's price volatility is a product of inflation, fiat currency, or any recent phenomenon. Instead, as the graphs show, gold's price has simply started to rise very quickly in the last 80 years as Americans have become richer and had more money to invest. Essentially, it appears that the price of gold could be a demand-driven story.
Similarly, if we look simply at the real return on gold, the nominal return on gold, and the CPI, we see the same thing - gold's price is NOT driven by inflation or even actual future inflation or recent past inflation.