Why Most Of What You Believe About Gold May Not Be True

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Includes: GLD, GTU, IAU, OUNZ, PHYS, QGLDX, SGOL
by: Matthew Allbee

Summary

Many theories have been thrown around Wall Street over the years about the gold market. Many of the commonly held beliefs are either false or misleadingly stated to new investors.

In this article, I will be going over some of these ideas and explaining what the actual data has to say about their truthfulness.

After reading, you will be better prepared to understand how to play off actual gold market movers, as well as market psychology, to profit in the gold markets.

Gold: inflation hedge, 2,000 year bubble, fear gauge, paranoia trade. These are some of the popular beliefs I've heard about gold and gold traders over the years. This asset, a popular speculation instrument, is perhaps one of the most misunderstood popular investments today.

This, perhaps not surprisingly, is why so many theories have been flying around Wall Street over the years. People need to understand how things work, and if they can't come up with a reason they'll often assign one to random price movement. This tendency, called apophenia, has caused innumerate problems for traders.

This is especially prevalent with gold, though. In fact, it is so prevalent that many traders don't even realize they are basing decisions on fiction without data to back it up. In fact, it has proven very difficult to find strong correlations with the price of gold at all. In fact, markets seem to move primarily by trader sentiment.

According to the research paper Facts and Fantasies About Gold[1], while gold has tracked expected U.S. inflation, it has not been successful in tracking unexpected inflation. This is an example of gold markets moving according to trader sentiment instead of the actual causes that many believe. If gold were actually a true inflation-tracker, it would move whenever inflation does and not just when investors believe inflation will occur.

Gold has, in fact, seen prolonged periods of declining real value; one example being between 1982 and 1999. Interestingly, over very long periods gold does seem to hold real value surprisingly well, but prices can deviate from inflation for so long that using gold as an inflation seems unreliable for all but the longest of time frames.

While I wasn't able to find any actual research on this, the idea that gold holds real value over very long periods of time can hold significant value to gold investors. For instance, if the nominal price of gold has risen significantly faster than inflation, one may expect it to decline, or at least stagnate, in the future to equalize with inflation. Similarly, a gold price significantly lagging inflation may be considered a good time to buy the asset. Of course, it is important to also keep track of past inflation and gold behavior as a seeming deviation may actually be a correction from an earlier period!

This paper also found that gold prices were negatively correlated with real interest rates (nominal interest rate - inflation rate); although the correlation is not especially strong for common levels of real interest rates such as those between -5% and 5%. The authors also didn't believe this implied causation, instead favoring the common variable of inflation expectations. Again, this goes back to gold prices following expected inflation rates over shorter time frames, but not correcting for unexpected inflation for possibly decades.

Lastly while gold has been shown to be a crisis hedge due to its low level of correlation to equity markets, this characteristic has been becoming less pronounced over the years. This is believed to be the result of gold's increasing popularity as an investment. When markets fall sharply, gold investors may be forced to liquidate some of their gold positions to pay for margin calls or other liquidity problems. While gold still holds as a hedge against market collapse, it is important to keep tabs on how well this holds into the future.

Gold undoubtedly holds special investment characteristics that will improve the investment portfolios of many. With that being said, it is important to understand that much of what you hear about the gold market is not necessarily true, or at least not as much of a sure thing as you may be lead to believe. With that, invest carefully and stay golden.

Couldn't help it.

[1]- mpra.ub.uni-muenchen.de/64590/1/MPRA_pap...

Disclosure: I/we 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.