Seeking Alpha

Rupert Hargreaves'  Instablog

Rupert Hargreaves
Send Message
Private Investor - Ex FX trader - Freelance investment writer - Part-time blogger. Background in investing in small caps and day trading stocks. Now focused in longer term investing and detailed company analysis.
My blog:
A Pauper in the Midst of Wealth
View Rupert Hargreaves' Instablogs on:
  • Why I Will Not Invest In Gold

    I will not make an investment in gold because I believe the price of the metal is too unpredictable.

    Unlike equities, which are priced more on fundamentals. Commodities are priced on a supply and demand mechanism; however with so many people having the ability to trade these assets there is now a large amount of speculation involved in the pricing.

    I believe this leads to inefficient pricing and fashion investing, with people will only buying the asset because everyone else is producing a sheep effect.

    This kind of fashionable investing and speculative investment makes gold impossible to value correctly in my opinion. There is also a lack of data available, to calculate the true supply and demand gold and to price accordingly.

    There are two main examples for this lack of efficient and predictable pricing; firstly the price of in gold in relation to Inflation over the past 10 years.

    Gold prices have only started rising above the rate of inflation since 2002. Previously gold prices were completely uncorrelated making the price of gold cheaper in real terms.

    Only after 2002 the price of gold has consistently risen above the rate of inflation.

    Year

    gold Price

    Inflation Rate

    Interest rate (Approximate average)

    1990

    0.00%

    5.39%

     

    1991

    -5.91%

    4.25%

    6.00%

    1992

    -5.32%

    3.03%

    3.00%

    1993

    4.43%

    2.96%

    3.00%

    1994

    6.31%

    2.61%

    3.00%

    1995

    -0.05%

    2.81%

    4.00%

    1996

    1.04%

    2.93%

    5.00%

    1997

    -17.16%

    2.34%

    5.00%

    1998

    -12.50%

    1.55%

    5.00%

    1999

    -5.47%

    2.19%

    5.00%

    2000

    0.05%

    3.38%

    5.00%

    2001

    -2.98%

    2.83%

    6.00%

    2002

    12.49%

    1.59%

    4.00%

    2003

    14.76%

    2.27%

    2.00%

    2004

    11.31%

    2.68%

    2.00%

    2005

    7.87%

    3.39%

    3.00%

    2006

    26.30%

    3.24%

    3.00%

    2007

    13.22%

    2.85%

    5.50%

    2008

    20.25%

    3.85%

    2.00%

    2009

    10.32%

    -0.34%

    0.50%

    2010

    20.59%

    1.64%

    0.50%

    The disparity here becomes more extreme when we compare the compound returns of gold, against the compounded rate of inflation and interest rates.

    Indexed at 100 in 1990 compounded gold returns did not overtake inflation returns until 2006. The price of gold - despite its rapid gains between 2002-2006 was only playing catch up.

    Even now, an investment in cash would still be outperforming an investment in gold.

    (click to enlarge)

    Historically then, gold is a worse investment than cash.

    In reality the price of gold should have risen in-line with inflation, to reflect the rising production costs. Indeed gold was uneconomic to produce until recently, as the cost of extracting the metal was usually larger than the selling cost.

    Another example of the unpredictable nature of gold is its reaction during times of crisis.

    It is well known that in financial crisis, all assets become highly correlated and should all move to the downside.

    Gold does not; historically it has no definitive trend.

    The closest we have come to financial meltdown in recent times was in 2008:

    01/01/2008-01/01/2009 - Source:MarketWatch

    The financial crisis of 2008 saw the price of gold fall in-line with the financial markets. This fall was accelerated by a rise in the value of the dollar caused by a risk off trade. The price of gold only recovered after a fall in the value of the USD.

    The debt crisis during 2011 and the market rally at the beginning of 2012 show a more mixed picture however.

    01/01/2011-01/01/2012 - Source: MarketWatch

    August and September of 2011 saw gold spike with the debt crisis. The price of gold then rallied with the rest of the market at the beginning of 2012.

    The period of March - May saw the price move in the opposite way,falling once again in-line with the market. However recently the gold price has rallied with the market, but is now falling on dollar strength.

    These erratic movements show that there is really no correlation between the price of gold and the markets.

    If there was a market crash, the price of gold could follow the market downwards. Historic data shows it can go either way.

    These examples however, do show there is a correlation to the price of gold and the US dollar. As gold is priced in USD there should be a high negative correlation - as the value of the dollar rises, gold becomes expensive, pushing the price down. When the value of the dollar fall's the price of gold should rise.

    In reality however this is not always the case, bringing into doubt the case for gold investment as a hedge against hyperinflation and a hedge against financial crisis

    Gold has both a positive and negative correlation with the dollar.

    The price of gold has no solid correlation to the value of the dollar. However gold does have a bias towards negative correlation. The price of gold is more likely to move in the opposite direction to the value of the dollar.

    I assume from this data that in a crisis, the value of the dollar would rise on a safe haven trade, pushing down the price of gold. This happened in 2008 but did not happen in 2011 - where the price of gold rose with a rise in the value of the USD. Proving again the whole situation is totally unpredictable.

    In a hyperinflation scenario, supposedly the value of the dollar would fall, inflating the price of gold. However the lack of strong historic negative correlation could provide an argument against this theory.

    There is some speculation over whether or not the US will encounter hyperinflation. With the banks needing to recapitalise and large amounts of toxic debt still sloshing around the system.

    Most inflation right now is coming from food and oil prices. Even with some of the biggest monetary easing operations in history now going on around the world, there have been almost no countries suffering hyperinflation. Japan has undergone one of the biggest and longest monetary easing operations and the country is still stuck in a deflationary spiral.

    All these examples show that the price of gold is totally unpredictable and is driven through multiple factors. None of which provide a historic pattern that is certain to be repeated in the future.

    There are also issues around the pricing of gold itself, and the market that is responsible for it. There is widespread risk of market manipulation and high use of derivatives traded on margin makes the price of gold very unstable.

    The prospect of market manipulation is a very real possibility and hashappened. Recently on 28th November this year 24 tonnes of paper gold was dumped on the market, causing a $24 dollar drop in gold in 5 minutes. There is widespread speculation that this was manipulation.

    The other issue with investment I believe, is the lack of access to the market the average investor has. Many investors favor (NYSE:GLD), however there is large amount of speculation surrounding the actual holdings of this fund as it is very secretive.

    In August, billionaire hedge fund manager John Paulson, purchased an extra 4.53 million shares of the SPDR gold Trust . Now Paulson's $21 billion hedge fund is more than 44% invested in gold or gold related securities. Meanwhile a less bullish George Soros increased his position in GLD to 884,400 shares from 319,550 shares. Although these managers do not have the best track record of investing I am sure they know what they are buying, mitigating some suspicion.

    There are lack of other investment vehicles available to investors. Bullion itself needs to be brought in larger quantities; incurring storage costs. Derivative contracts are highly volatile and traded on margin.

    The last issue I have with gold investing is the charts. Due to the lack of fundamental information freely available, technical analysis gains more weight in a deciding factor for investment.

    (click to enlarge)

    Gold has been trading in a channel for a year now. With demand supposedly soaring around the world, the fundamentals should support a record price. However the gold price remains stubbornly below its 2011 high. With production supposedly falling and consumption rising the price should be significantly higher. It is this strong channel pattern that supports the theory that the majority of gold is traded over a short time frame distorting the pricing mechanism. If this is the case, then it would be impossible to predict the future movements of the gold price based on fundamentals alone.

    The other issue raised about the gold price is the bubble like pattern that has formed on the chart. Both gold and silvers peak in 2011 has not been surpassed and silver more than gold has seen a rapid climb down from its high. Although gold's run up in price is longer, silver is currently exhibiting all the qualities of an asset bubble.

    Summary

    Historically overall gold has been unpredictable, and that's why I'm not buying. Even though future returns could be different, the tail risks, costs and possibility of market manipulation make future forecasts very difficult to follow and believe in.

    Realistically though gold is only worth as much as people are willing to pay. If the precious metal goes out of fashion like many other commodities have done in the past, it will have no fundamentals or income to support the price.

    Gold has too many speculative factors as well as an unpredictable history. For a long term investment I would rather buy equities.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Tags: GLD
    Dec 13 1:11 PM | Link | Comment!
Full index of posts »
Latest Followers

StockTalks

More »
Posts by Themes
Instablogs are Seeking Alpha's free blogging platform customized for finance, with instant set up and exposure to millions of readers interested in the financial markets. Publish your own instablog in minutes.