Tuesday, August 31, 2010

Gold as an investment

With gold only few dollars shy of marking another all-time high, it's appropriate to review the investment and central banking ramifications of gold at $1250/oz.

When approaching gold from the point of view of an investor, the first thing you should ask yourself is whether you think gold prices can rise by enough in the future to at least equal the returns you can lock in on risk-free investments. (I'll ignore transactions and storage costs for the sake of simplicity.) To be attractive, any risky investment needs to at least promise to do better than the risk-free alternative, and Treasuries are effectively the "gold standard" of risk-free investments, the benchmark against which all risky investments need to be evaluated. (Those who think the U.S. will default on its Treasury obligations may be excused from this class.)

A central bank pursuing a gold standard might ask itself a similar question, but from a different perspective: is today's interest rate environment sufficient to leave investors indifferent between owning Treasuries or gold?

Investors who buy gold need future gold prices to exceed the hurdle represented by, say, 10-yr Treasury yields. With 10-yr Treasuries trading today at 2.5%, an investment in gold makes sense only if gold prices rise by at least 2.5% per year over the next 10 years. Central bankers following a gold standard are content as long as investors in aggregate can't decide whether gold will outperform Treasuries, a condition which if met results in relatively stable gold prices, but interest rates that change to offset investors' changing perceptions of gold's potential price performance.

This chart shows the historical price of gold in blue, and is plotted with a semi-log scale for the y-axis to facilitate the comparison of annual returns. The slope of the colored lines represents the hurdle price of gold that an investor at different points of time must expect gold to exceed. Gold is good investment when future prices exceed today's hurdle rate, and a bad investment if future prices fall below today's hurdle rate.

From 1970 through 1980, gold beat its hurdle rate almost every year, except for 1975-78. By 1979, investors were so anxious to buy gold, figuring it would have another winning year, that gold prices briefly soared to $850/oz. in early 1980. By this time, however, the Fed had taken a hugely restrictive policy stance, with the result that 10-yr Treasury yields had reached double-digit levels.

With the huge hurdle rates that resulted from tight money, gold investors were by and large extremely disappointed from 1980 through 2001, as gold consistently underperformed Treasuries. Not coincidentally, inflation fell from 14.8% in early 1980 to a mere 1.1% in early 2002.

Since 2002, gold has consistently exceeded its Treasury hurdles, leaving investors emboldened and anxious for more. Unlike the situation in 1980, however, the Fed has done the opposite of tightening, pledging instead to keep interest rates very low for an extended period. That means that the future hurdle rate for gold is so low that it shouldn't be too hard to beat. Thus, gold prices are still rising, and will probably continue to rise until such time as the Fed decides to change course. I should note here that in real terms, gold is still significantly below its peak price in January '80 (which I calculate would have been $2370 in today's dollars), so it's not unreasonable at all to think that gold could reach $1500 or even $2000.

I have said as much in the past (e.g. that gold is likely to rise further), but have also cautioned that with gold at these levels, it is a very risky investment and not for the faint of heart. As a retired person and a long-term investor, I have decided to eschew any exposure to gold, but a more adventurous speculator would likely find gold attractive. For my part, I think equities hold out the better promise of long-term expected returns.


Public Library said...

The Fed is going at it with the pedal to the medal. No pun intended.

QE2 is a tough sell with Gold at $2,000 and commodities soaring but I doubt this will thwart Helicopter Ben.

Benjamin Cole said...

Reading this post, one would wonder if the globe consisted of one economy and one central banker--the USA and the Fed.

According to the World Gold Council the Indians have emerged as heavy buyers of gold, for use in jewellery. China is the second-largest buyer. The USA is a bit player.

Jewellery, not investment, comprises the lion's share of gold sales (though, I suppose, one could argue that for many in traditional cultures, gold jewellery is a form of savings). I recommend perusal of the World Gold Council website.

Forever, gold bugs have told tales about inflation and gold. Now that we are facing deflation, and have enjoyed relatively low inflation rates for two decades, gold is booming.

Read that again: Inflation is dead, but gold is booming.

Jeez, we have reached a situation in which inflation above 1 percent is a "cause for concern." Yet gold is booming.

I wish I had invested in gold--with the benefit of hindsight, the rapidly rising disposable incomes of Asia are translating into heavy gold jewellery demand.

That suggests the bull market in gold will last as long as the economies of China and India keep growing. What happens in the USA is less important. What the Fed does may be irrelevant.

There are 2.4 billion Chinese and Indians, most enjoying rising incomes. They seem to be creating pro-business cultures. I suspect the greatest wealth boom in history, dwarfing anything that took place before, will unfold in the next two generations in Asia.

Who knows? Maybe the best investment is in some classic, Asian-style jewellery, that you can sell in a couple decades.

I do suspect that bona fide Chinese antiquities will soar in value as well--and no, soaring values of Chinese antiquities will not reflect what the Fed is doing.

It will reflect Chinese buying power. You know that old Chinese vase of your great-aunts? Treat it gingerly.

Public Library said...


The move in gold probably reflects the dry tinder box of reserves pilled up in the system. Have they caught fire, nope. Do they have the potential to wreak havoc? Absolutely! Like nothing we have ever witnessed before in this country.

You can only debase the dollar so much before it become credibly useless in the global economy. Everyone knows the end is nigh but the difficulty of finding an alternative in the meantime is proving even more difficult. But the time will eventually come.

Benjamin Cole said...

It ain't that bad. We need structural reforms yes--less rural welfare and subidy, less defense spending, no more mortgage interest tax deduction, no more Fannie/Freddie, less regs in general.
But, compared to most other eras, this one is pretty good.
Inflation cures the debt bomb.
Bring on inflation.

Public Library said...


"According to Mr. Bernanke, money, properly defined, must exhibit three characteristics: it must be a medium of exchange, a unit of account, and a store of value.[2] The US paper dollar certainly meets the first two requirements but it fails miserably on the last."

The dollar is toast because 1 and 2 are predicated on the confidence in 3.

You will get your inflation but it will not be the kind you'd hope for in the x-mas stocking.

Benjamin Cole said...

You have the last word.
Back at-cha on the morrow.

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