The Uncertainty Of Gold

Includes: GLD
by: I Know First Research

By Ethan Fried (Harvard College '16)

There has been much speculation about the price of gold (NYSEARCA:GLD) in recent months, especially after April 15th's 9.3% one-day drop. Many people are struggling to decide whether this is the start of a precipitous plummet or just a slight correction in an otherwise healthy investment. Despite the many passionate opinions about gold, the markets have responded with ambivalence, slightly rallying throughout the rest of April and then slowly returning back to its April 15th nadir. Regardless of which direction you believe the price of gold is going, it doesn't seem to be racing either up or down.

Explanations for Gold's Extraordinary Climb

Gold has been experiencing an incredible climb during the 21st century. During this period, the inflation-adjusted price has increased from $379 to $1451, an astounding 383% increase. Experts, such as Kenneth Rogoff, attribute this appreciation to the lack of confidence in fiat currencies, new financial instruments that make it easier to trade in commodities, and the rising demand for precious metals in a stronger and more globalized economy. However, Rogoff emphasizes that gold is a risky investment and suggests that the long-term growth of gold may very well be unsustainable. Many gold bugs, or diehard advocates of gold, invest in gold because they've lost faith in governments' abilities to repay their ever increasing and arguably unsustainable debts; and many believe that governments will begin to print money and devalue their currencies to pay off their debts, which will lead to high inflation.

Explanations for a Possible Crash

There are many reasons why gold may be poised for a significant crash. Kenneth Rogoff suggests that the price of gold could plummet if interest rates were to rise, thereby raising the opportunity costs of holding gold with respect to bonds. With a steadily growing American economy and the Fed's promising outlook, it seems that interest rates may begin to rise in the near future. If Rogoff is correct, this may be an impetus for a large gold correction. In a widely publicized statement on June 3rd, famed economist Nouriel Roubini predicted that the price of gold would fall below $1000. He argued that with the global financial crises winding down, the fear of high inflation rates subsiding, and real interest rates poised to rise, investors will exit gold and invest instead in stocks and bonds with higher dividends. Though Merrill Lynch lowered its gold forecast recently, analysts believe gold's "structural rally is not broken."

Explanations for a Continued Rally

While there are some gold pessimists, there are many passionate optimists. Blanchard, a gold coin vendor, argues that gold will continue to rise in the near future because of structural flaws in the economy such as high government debt, persistent unemployment, and rampant fear that weak Euro-zone countries will default on their debts and cause market chaos. Blanchard explains that central banks have been increasing their demand for gold, especially as many of them having been continuously increasing their monetary supplies and searching for more stable assets to hold in reserve. Lastly, Blanchard argues that the dollar will soon lose its role as the world's reserve currency and will therefore lose value relative to gold.

One analyst from Seeking Alpha argues that America and Europe's macroeconomic troubles and inflation fears should have negligible impacts on the price of gold because in 2013 their combined demand for gold was only 10% compared to 61% between India and China alone; and according to The Wall Street Journal, Singapore, the essential Asian financial hub, is planning to increase its share of the global gold market to over 10%. This analyst emphasizes that these Asian giants' appetites for gold are showing few signs of abating as these countries have strong traditions of buying precious metals and have limited other credible investment venues. Forbes contributor James Gruber believes that gold is likely to continue to increase because the typical commodity bull market lasts 14 to 18 years and the present bull market is only in its 13th year. Barron's contributor Randall Forsyth points to the highly illogical trading that led to the April 15th correction and suggests that the decline was not the result of a fundamental weakness in gold, but rather an irregularity.

Looking at Gold in the Long Term

Gold is an interesting asset because it has been around for millennia. Perhaps because of the importance and ubiquity of gold, I was able to find data tracing its inflation-adjusted price back to 1833. Interestingly, the historical inflation-adjusted average gold price since 1833 is $524. If one considers only the more recent data, the price of gold has increased gradually - the average price since 1900 is $530, $603 since 1950, and $741 since 1990. However, even the most recent averages are far below the current price of about $1400. When one looks at an historical chart of the price of gold two events jump out: the gold bubble of 1980 and the relatively similar trend in recent years. Of course gold's rise may be structural, as it is becoming easier to trade commodities and as emergent globalized economies increase their demand for the precious metal.

Looking at the Gold Bubble of 1980

Before people hastily compare the 21st century's gold rally to that of 1980, they should consider a few key factors: in 1980 gold precipitously rose and precipitously fell soon after, in 1980 there were many geopolitical factors causing global angst, and double-digit inflation plagued most developed and developing countries. The fact that the present gold rally has remained resilient for more than a decade seems to suggest that it is not an ordinary bubble as compared to 1980 when the movements in the commodity were far more drastic. Insofar as geopolitical and macroeconomic governmental policy, one can draw both similarities and differences between today and 1980.

Looking at Gold as a Mean Reverting Asset

Though there have been a few notable blips in the price of gold over the years, it would seem that gold has relatively strong mean reversion. The historical gold chart (Chart 1) clearly exhibits three major spikes in the price of gold:

Historical prices of Gold

Chart 1: Historical Prices of Gold and Silver

during the Great Depression, the bubble of 1980, and the present rally. The first two events resulted in gold returning to its pre-boom price and similar logic would lead one to believe the same about the present trend. Though the inflation-adjusted price of gold had been increasing gradually over time (averaging $435 in the first half of the 20th century, $525 in the second half, and $875 so far in the 21st century), the present growth of gold seems to be outpacing the historical trend line.

Looking at Gold With Respect to the Current Trajectory of the World Economy

Though there are many people who swear that the economy is still stagnating, I believe most indicators point to a resilient recovery. Currently the American inflation rate is incredibly low at 1.1% and the real interest rate only has room to increase. As the general fear of high inflation rates and global economic distress dissipates, more people will take their money out of the gold safe haven and look for more productive investments. Higher interest rates will increase the opportunity cost of holding gold and will accelerate the exodus from the commodity. The government of India, the world's largest gold consumer, is beginning to restrict gold imports thus lowering global demand; and as the Chinese government eases investment restrictions, individuals there will reduce their appetite for gold as well. Generally the world economy seems to be improving and the international demand for inflationary hedges seems to be waning. With gold at an historical peak it seems to me that it is poised for a dramatic downturn.

Looking at Gold Without Human Bias

Though I may believe that gold has reached a peak, there are many others who vehemently disagree with me. For those who are interested in investing in gold, but don't want to have rely on the often conflicting and often unreliable advice of individuals, they should consider developing their own method, of following one of the predictive algorithms. Often the best investment decisions are those made with the least research, as there is always too much data for any one individual to properly analyze; therefore, perhaps it's best to rely on a detached machine.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.