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Introduction

Gold is an investor's paradise. It is considered to be a safe haven for investors, despite losing 9% in a day this month. There are various reasons for this, not the least of which is public perception.

For years now, with the downsizing of the global economy and rising inflation, unemployment reaching its peak and unpredictable behavior of stock markets, gold appeared to be the "The Silver Lining" to millions of investors around the world, be it in the form of bullion, gold certificates, derivatives, ETFs, mining-shares and jewelry.

In this article, I am going to give you a brief history of gold and its price movement, factors determining its price, why it makes sense to invest in this yellow metal, its downsides, and then finally conclude by providing a future outlook.

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Price trends of gold

Let me first begin with a fun fact. If you have invested $10,000 in January 2001, your 37.81 ounces of the precious metal would have been worth more than $69,000 by September 1, 2011.

Gold prices have risen by around 600% in thirteen years. If we consider the last two years only, except the recent fall, the yellow metal provided a return of more than 100%. Gold has been following a normal upward trend in the past decade. Gold Prices were in the $350 per ounce range about 10 years. From 2009 until the end of 2011, Gold Prices rose steadily, from the $900 range to well over $1,800 per ounce. Further, in the first half of 2012, gold faced a price retreat. During 2012, gold prices have bounced around between $1,600-1,750 per ounce. Recently gold prices registered a drop of 9% on April 15, the biggest fall since 1983, signifying a steep downward trend. The chart above provides the gold price trend over the last 10 years. As an investor, what should we make out of this frequent price fluctuation of gold? What factors actually determine the gold prices? Before discussing these, let me give you a brief history of gold as an investment.

History of Gold

Gold has served as one of the most essential monetary standards throughout history. Its metric is troy ounces, and the price of gold is typically stated in terms of the cost of one troy ounce. One ounce of gold is equivalent to 31.1 grams or 0.07 pounds. The United States usually determines the historical price of gold. One ounce of gold was fixed at an estimated $20.67 for many decades. Then came a major change in the pricing of gold and its price was kept floating, which increased the liquidity of the yellow metal.

Gold history can be briefly categorized in 4 major phases:

  • Bretton Woods Conference (1944 -1971): In the Bretton Woods conference in a New Hampshire hotel after World War II, a monetary order was established promoting the US dollar to the reserve currency and other currencies tied to it. Gold price was fixed at $35 per ounce of gold. The aim of the Bretton Woods conference was to break the barriers of trade between countries based on fixed exchange rates. However, this was not sustainable, as the US was not able to fulfill their contractual obligations, since other countries had more US dollar reserves and tried to redeem them in exchange for gold. This ultimately brought the collapse of Bretton Woods and fixed gold prices ceased to exist since then.
  • Bull Phase (1971 - 1980): After the abolishment of Bretton Woods, gold prices jumped to $50 per ounce on May 1, 1972. On November 14, 1973, possession of gold by US citizens was legalized. This decade was marked by the oil crisis, high uncertainties in the financial world, increase in money supply and high US national debt. Industrial countries experienced stagflation and hence people were playing safe and buying gold which increased its price fifteen-fold. On Dec 27, 1979, gold prices reached a new high of $500 per ounce and $873 per ounce in 1980.
  • Bear Phase (1980 - 2001): To end the stagflation, the US treasury limited the money supply increase in the economy. Interestingly, this was a phase when gold did not go up with the inflation, which was high (gold went down 70%). The reason was, again, the stagflation. This implied high inflation coupled with low growth - the low growth resulted in gold's downward plunge. This led to a higher unemployment rate and recession temporarily, but in the longer term, helped to curb inflation. So the gold prices declined steadily and reached an all-time low (adjusted for inflation) of $252 per ounce in 1999.
  • Bull Phase Again (2001 - 2011): The establishment of the Shanghai Gold Exchange in 2002 increased the trade flow of gold and the demand for this precious metal. China became the second biggest gold buyer after India. Higher demand coupled with depreciation of the US dollar led to higher gold prices. It reached the mark of $500 per ounce for the first time since 1987. Then came the financial crisis and recession of 2008 which further increased the demand for gold and exchange traded funds. More demand came in late 2010 from the higher reserves of gold by various national banks owing to global uncertainties like the Euro Zone crisis, growing national debt, inflation, low interest rates, and risk of downgrade due to default of sovereign bonds. Gold prices crossed the $1900 per ounce mark in August 2011, thanks to the fear of a new recession.

Factors determining gold prices

Gold prices are governed by several variables like US exchange rates, oil prices, dollar index, Dow Jones Industrial Production Index, USA real interest and inflation rates. Some of them are described below:

1. US exchange rates: Empirical evidences show that gold prices have a negative co-relation with the US currency. In other words, gold price increases when the US dollar depreciates. This happens because central banks of countries holding dollar reserves diversify their risks by investing in assets like gold, which pushes up the yellow metal's price.

2. US inflation rates: Gold is an asset which rises with inflation. Prices of several goods and commodities rise with inflation which reduces the purchasing power of people. During these times, people hedge the price increase by investing in gold which is a safe asset and will give steady returns in future - at least, people hope so. The inflation adjusted gold price chart is given below.

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3. Demand and Supply: Economic forces of demand and supply always govern the price of any commodity in the market. Gold is no exception to this. Prices of gold will go up if the demand for gold is higher than its supply.

Gold demand mainly comes from the following sectors:

  1. Jewelry sector: This sector consumes around 68% of the total gold supply. Usage of gold is highest in countries in the Middle East and Asia. Seasonal demand, in case of festivals like Chinese New Year and Indian Diwali and wedding season, also affects gold prices.
  2. Manufacturing and Medical sector: This sector constitutes around 14% of the global demand. Gold is used in new technologies like chemical process, nanotechnology and electrical devices.
  3. Investment sector: In countries experiencing rapid economic growth like China and India, governments use their reserve funds to buy gold to reduce their exposure towards US bonds. This also acts as a demand driver of gold.

Gold supply comes from the following sectors:

  1. Production in mines: Mines produce around 60% of the total gold produced each year. South Africa is the world's largest gold producer at 14% followed by the US, Australia, Latin America etc. Supply from mines is crucial to the price determination of gold as lower supply will cause an immediate price rise. Recently companies like Barrick Gold (NYSE: ABX) have faced issues in their Pascua Lama mine which decreases their future estimate of gold production. Limited supply will put an upward pressure on the gold prices.
  2. Recycled gold: When gold prices rise, supply of recycled gold increases and the amount of this gold can affect the limit of price rise.
  3. International Organizations: Organization such as the International Monetary Fund (IMF) hold around 25% of the total gold reserves. Central banks in North America and Europe also hold some of the reserves. If these institutions release gold in the market, automatically that will distort the demand-supply equilibrium triggering a price correction.

4. Interest rates: If the short-term interest rate rises, gold prices will fall. Gold is a non-interest bearing asset and does not earn interest in case the interest rate rises in that country. People will then tend to keep money more in deposits which will give them better returns than gold. This phenomenon will create pressure on gold causing a decline in its prices due to lower demand.

5. Global economic situation: Gold prices increase during times of international political tension and natural catastrophes like tsunami and earthquake. During these periods, asset prices usually go down and people sell them and buy gold. Gold, being a fixed asset, will provide a more stable return than any other asset.

6. Oil prices: It is found empirically that oil prices have a direct co-relation with gold. As oil prices increase, gold prices move up and vice versa. This can be visible from the following graph.

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Exceptions do exist

However, there are some exceptions to the drivers affecting gold prices just mentioned. One of them is the case in Indonesia. What happened in 1998, as the Indonesian currency Rupiah fell sharply against the U.S. dollar currency, is that the government of Indonesia increased the interest rates significantly with a hope to put a halt to the rising U.S. dollar exchange rate. Hence, in spite of the rising interest rate, gold prices also rose where it should have fallen in the ideal case. We need to keep in mind that the above factors are a comprehensive list driving gold prices, but market conditions are not always stable.

Benefits and risks of holding gold

  1. Gold helps in diversifying an investor's portfolio as it usually tends to progress opposite the stock market. Traditional options, such as bonds, property and hedge funds often fail to handle the market panic, and may sell off with equities in times of uncertainty. Portfolios consisting of gold may leverage this uncertainty and would be able to withstand catastrophic economic situations.
  2. Gold enjoys a tax-free life in countries such as UK, where gold coins like Sovereigns and Britannias are viewed as currency and hence exempted from VAT. Additionally, since the increase in value of gold is not an income, it is not subjected to income tax. Silver and other metals do not enjoy the same luxury.
  3. During a financial crisis and depression, gold is perceived as the "World's Frightened Bunny." For example, when Lehman Brothers declared bankruptcy in September 2008, the gold prices rose by 27% from $728 per ounce to $922 in just 3 days.
  4. Gold is used as a protection from inflation by controlling the country's currency against fluctuating dollar. Many currency traders treat gold as the fourth global currency, after Dollar, Yen and Euro.

On the other hand, when gold or any other investment becomes too popular, it increases the risk of a bubble. The consistent high prices might prove to be unsustainable which could suddenly plummet, losing investors a lot of money quickly. Apart from the several benefits of gold, it possess some risks described below.

  1. Physical risk of gold: Physical gold is prone to the risk of loss and theft. It becomes an illiquid investment and people do not wish to sell them quickly. Huge costs are involved to mitigate the risk in the form of transportation and storage.
  2. Gold volatility: Gold prices can fluctuate fundamentally and this volatility should be of concern to both short and long term investors. As is visible from the below chart, gold prices swung between $1320 per ounce and $1470 per ounce within just a period of 6 months from November 2010 to April 2011. Even in between this period, it fluctuated several times.

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3. Political risks: Socio-economic and political risks are prevalent in every country. Gold prices might be affected by government intervention like nationalization of the gold mines in the country, prohibition of gold possession to a certain extent and limitation of gold trading by determining a fixed price. For example, Vietnam once restricted the free trade of gold in 2011.

4. Market manipulation: In early 2007, there was severe short-selling among stocks of smaller mining companies which forced the prices of gold to drop by a huge margin. Scams like this are bound to affect the price of the yellow metal and pose a huge risk to investors.

Present situation

On April 15, 2013 spot gold prices fell by 9% which marked the biggest one day decline since February, 1983. Not only gold, other commodity prices such as silver, platinum and palladium declined by a bigger margin of 10%. Even energy and agricultural commodities are down significantly. The recent significant downward trend in gold prices can be attributed to the following reasons:

  1. Reports of Cyprus selling 400 million euros of gold reserves to finance its own fiscal position triggered fear in the minds of many. Some of the European countries have also followed suit. This will lead to a disproportionate increase in supply of gold in comparison to demand as a result of which gold prices have started to fall.
  2. Improvement in macro-economic situation and political stability influenced people to buy more risky asset classes like real estate and equities. The Fed also helped in the cause by its quantitative easing (QE) approach and reduction of interest rates which in turn increased the money supply in the economy.
  3. Analysts were predicting a price correction of gold as they felt the yellow metal may have risen too much too soon and is due for a pullback. So the recent events may cause some investors to exit the metal altogether and book profits.
  4. The GDP growth in China for the first quarter of 2013 was below estimates at 7.7%. Such growth levels dampened the sentiments of investors, spreading concerns that the US and the other markets, which are dependent on the Chinese economy, cannot improve their own economies.

Future Outlook

Coming to the way ahead, the drivers of the gold price will be governed by the development of the financial crisis in various key countries. The levels of debt in Japan are certainly not sustainable in the long run. Gary J. Goldberg, the CEO of the largest US gold mining company Newmont Mining (NYSE:NEM) estimates the price of gold to reach $2,550 per ounce this year. I, however, don't think gold prices can go up to this level. Gold prices might be in for a correction within the next few months but the financial crisis has not been sorted out yet, so that correction won't reach such optimistic highs. The yen, which is highly sought in cases of financial uncertainty, rose earlier this week after gold prices kept falling. On April 17, spot gold found some ground and stabilized its position. The financial crisis is not yet sorted out and gold prices might be in for a correction within the next few months. It will be interesting to see what happens next.

Source: What Determines Gold's Price?