In my last article on gold, which generated quite a bit of controversy, I said that gold (GLD) doesn't do a good job of protecting investors from inflation. Specifically, I outlined how and why the correlation between gold's price and inflation was fairly weak over time. This suggested that gold is not a particularly good hedge against inflation, or at least that it is no better a hedge than many other assets. This is significant because many investors view gold's primary purpose as an investment to be protection from inflation. (For more on this issue see my blog here.)
In this article, I review a couple more possible functions of gold as an investment: (1) gold's use as a stable currency, and gold's value as a safe haven asset. The price of gold over time is partially driven by demand, and per capita income, but like any investment, gold can become undervalued or overvalued periodically. The chart below compares the per capita income in the US in USD with the per capita income in ounces of gold. Basically, what this is showing is that the price of gold has far outstripped per capita income growth in the last decade or so, which in turn suggests that gold is currently overly expensive in real terms.
Further, while many investors look at gold as a stable currency, there is very little evidence that the metal serves as an effective hedge against currency risk. If gold were an effective currency hedge, then we would expect that changes in the value of the currency would not translate into changes in the amount of gold that currency could buy. Essentially, if you have $100 Billion in currency in the US economy, and you print another $200 Billion, you should be able to buy the same amount of gold before and after the additional currency is printed. Yet when we look at the data, this doesn't hold up as the chart below shows.
To that end, gold may be the best of a set of bad investment choices of hedging various unorthodox risks like inflation, and currency risks. The chart below provides evidence on this point by showing that investors have become an increasingly important purchaser of gold in recent years. To that end then, gold is only likely to maintain its value as an investment as long as other investors continue to view it as the best (or perhaps least bad) choice to hedge a variety of investment risks.
Unfortunately, the continued viability of real world companies like Goldcorp (GG), Barrick (ABX), Newmont (NEM), Yamana (AUY), and to a limited degree even Freeport McMoRan (FCX), increasingly depends on the continued attractiveness of gold as an alternative investment, and this puts many investors in these equities at risk if other assets start to usurp gold's place.
So gold's price is not driven by the metal's function as a currency hedge… but is the price of gold driven by demand for the asset during times of crisis? If this is the case, and gold is acting as a safe haven asset, then gold's value should be inversely related to that of the stock market. More specifically, when stock prices fall, gold's price should rise, or at least not fall. To that end, let's look at a plot of monthly returns of gold vs. the monthly returns of the S&P 500 over time.
If gold is a safe haven asset, then the bulk of its returns ought to be in quadrants 2 and 4 - that is,, investors should be investing in gold when the S&P is doing badly leading to positive gold returns (quadrant 2), and they should be selling gold when the S&P is doing well leading to negative gold returns (quadrant 4). Any observations that fall into quadrant 3 in particular are especially troubling because they indicate that gold's price is falling when the S&P 500 is also falling. The graph above shows that the returns are essentially evenly divided among the 4 quadrants which does not suggest that gold play's a particularly strong role as a safe haven asset.
So if gold isn't acting as a hedge against currency risk, inflation risk, or asset risk (safe haven asset), then could gold's price simply be driven by the perception that it is a good hedge? Or perhaps that it is the best hedge among a set of poor alternatives? This is a possibility.
In fact, gold's price increase over the last decade may well have been driven by its increasing attractiveness as an investment to protect against various risks even if the metal is not all that good at protecting against these risks. Put differently, gold may be a poor hedge against inflation, but it could be the best choice an investor has available. Brazil between 1980 and 2000 provides an example.
Brazil essentially had hyperinflation of about 250% annually from 1980-2000. Thus if an investor stuck 1000 Cruzeiros (Brazil's currency at the time) in his mattress in 1980, they were essentially worthless in 2000. If the investor stock a gold coin in the mattress, the value of that gold coin in real terms declined by 70% between 1980 and 2000 as the chart below shows, but that 30% of value which was preserved is far better than the essentially 0% of value preserved by the currency itself.
As the graph shows, the price of gold in local currency is not at all stable for any of the world's major currencies. Gold does not act as a hedge for the value of currencies (a fall in currency value can't be avoided by holding gold instead), nor do changes in currency values help explain the real (rather than nominal) price of gold.