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Why Gold Prices Keep Rising

Why Gold Prices Keep Rising

Gold has returned more than 120% over the last five years. Find out why some analysts think this investment still has room to grow.

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By Investopedia.com 23.05.2011

Over the past five years, stock market returns have been close to flat, but gold has returned more than 120%. The return disparity is also visible over the past 12 months, as gold has returned approximately 35%, while the stock market is up only about 12.5%. So far in 2011, the gap has narrowed, but gold is up 10% while the S&P 500 has returned just over 8%.

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Inflation Fears

The multi-year rally in gold has been driven by a jump in demand due to inflation fears across the globe. Gold is seen as a strong hedge to inflation and a store of value as other asset classes, including bonds, currencies and cash, all of which can see their values eroded in an inflationary environment. Economic uncertainty, including the 2007-2010 U.S. financial crisis, spread to the rest of the world, and has also played a role and investors have turned to gold, given it is a physical asset that can be held on to and stored in a safe deposit box or other physical location. A collapse in real estate prices has also lowered the appeal for residential and commercial property, even though both are good inflation hedges, as they are physical assets and see their values rise along with inflation.

Debt Worries

More recent fears include worries over debt levels in Europe - specifically in Ireland, Greece and Portugal - that have fueled economic uncertainty. In the U.S., excessive federal, state and local municipality debt levels have stoked fears over fiscal discipline and dampened the appeal of U.S. Treasury securities and municipal bonds as investments. These fears have also driven demand for gold as an investment, and it is seen as a refuge from uncertainty and volatility in other investment classes, as well as a lack of confidence in the U.S. government and its ability to keep the U.S. dollar strong.    

Market Demand

Emerging market demand for gold has also been strong. India is one of the top consumers of gold, as its citizens like to buy gold jewelry and gold for investment purposes. It is estimated to account for a quarter of global gold demand each year. The investment appeal has also been quite strong in China, and with wealth rapidly increasing in these countries and across Asia, demand is seen as growing increasingly robust going forward.

Speculation

The most recent rally in gold was attributed to speculation that China would begin diversifying its trillions of dollars in foreign exchange reserves into precious metals including gold and silver. Gold rallied to just over $1,519 per ounce. In other words, lower demand for other investments and strong trends in gold have continued for some time and are still taking place.

Fundamentals

The key question for investors currently is whether the fundamentals support a continued rally in gold and related precious metals. Demand from China, India and other emerging markets will likely remain strong and grow over time. Concerns over U.S. fiscal discipline are also likely to remain for some time, as are inflationary worries as emerging markets, including China, are already experiencing higher rates of inflation.

On the negative side, global uncertainty has already declined dramatically, as world economies have recovered quickly from the credit crisis. Additionally, demand for gold as a use for jewelry has been far outpaced by its jump in appeal for investment value, which could easily subside as other asset classes become more appealing. And perhaps most importantly, gold prices are simply a function of what people are willing to pay for it. Other assets, including stocks, bonds and real estate generate income can so be valued by discounting their future cash flows back to the present. This is not possible for gold as it just sits there.   

The Bottom Line

At the recent Berkshire Hathaway shareholder meeting in Omaha on April 30, Warren Buffett estimated the global value of all gold that has ever been mined at $8 trillion. He also estimated that the value of all farm land in the United States stands at $2 trillion and 10 Exxon Mobil's would currently be worth about $4 trillion. Buying this farm land and 10 of the largest publicly traded oil firms in the world would cost $6 trillion and still leave $2 trillion left over to sock away for a rainy day.

In Buffett's mind, the exercise is intended to illustrate that buying $6 trillion in income producing assets and having $2 trillion left over should be far more valuable to investors than purchasing $8 trillion in gold. The non-gold investments generate cash flow, and their value can therefore be more easily estimated. For gold, investors have to wait for another investor to buy them out at a higher price. Right now, rising prices are creating their own excitement and, though impressive and quite profitable for existing investors, can't be relied on much for future gains.

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