From America’s gold-teeth-rappers, Lil Wayne and 50 Cent, to miners, individual investors, and bankers—everyone seems to want gold for different reasons. It is of no surprise that every investment newsletter and financial television channel tells you that gold is back in vogue. Actually, it is almost impossible to find gold bears. A quick look at gold’s monthly chart reveals its formidable ascent over the few years.

The 20th century brought some significant changes to gold’s role, a shift from currency to investment vehicle. The Bretton-Wood conference in 1944, which established the basis of the post-war monetary system, decided that only the US dollar remains fixed to gold, while the other currencies were fixed against the dollar.

In the 1970s gold became less significant to the financial system, as US President Richard Nixon suspended the dollar’s convertibility into gold. Despite gold’s transformed role, its value remained stable over time. According to the World Gold Council (WGC) in the 1830s, the price of gold was around US$450 per troy ounce, with the real terms price much the same in 2005, more than a century and a half later. Since the move to floating exchange rates in the early 1970s, gold has been significantly influenced by the fluctuations in value of the US dollar. The IMF (International Monetary Fund) estimated that 40- 50% of the fluctuation in the gold price since 2002 was dollar-related, with a 1% change in the effective external value of the dollar leading to a more than 1% change in the gold price. The logic behind the existence of this strong relationship is that a lower dollar increases the purchasing power of non-dollar area countries, while a rising dollar reduces the non-dollar countries’ purchasing power, driving up prices of commodities including gold. Furthermore, in periods of dollar weakness, investors look for an alternative store of value, driving up gold prices. This includes dollar-based investors concerned about possible inflationary consequences of a weak dollar.

Demand

Unlike other metals, such as silver and platinum, only a small percentage, in fact just 10% of gold has industrial uses, while 60% of gold is used for jewelry making, hence the bling. Strong demand comes from India and China, mostly because in developing countries gold jewelries represent a status symbol and a mean of saving, due to lack of trust in local banks. Nevertheless, individuals are not the only ones who hoard gold for rainy days: central banks and institutional investors do it too - 30% of gold is used as investment vehicle.

WGC found that there is fundamental shift in demand from central banks, “After being large net sellers of gold for two decades, central banks turned a net purchaser in the second quarter of 2009. Several key central banks such as China, Russia, India and the Philippines have all purchased substantial amounts of gold over the past two years; meanwhile, sales of gold by European central banks have ground to a complete halt.”

The world’s central banks currently hold an approximate cumulative 11% of their foreign reserves in gold. Nevertheless, developed countries hold around a third of their reserves in gold, while the rest of the world holds less than 5% of their reserves in gold with some developing Asian countries holding less than 2%.

Supply

Gold supply comes from mining and recycling. As the chart below shows major gold discoveries have declined in spite of increased exploration budget.

Still, recycling is a significant source counting for about one third of the world’s global supply, since gold is accumulated, instead of consumed.

As with any other commodity, gold’s supply and demand are influenced by its price. When the price appreciates, exploration and mining companies find new projects or re-open old mines. Generally speaking, it takes about 7 to 8 years for a price increase to cause exploration and sufficient new output to compensate for exhaustion of existing mines. When gold’s price is low, miners abandon or postpone projects.

Financial asset

Gold is an unusual financial asset because unlike stocks and bonds it does not earn yield (dividends or coupons). Nevertheless it is tangible, easily stored, liquid, and most important: free of default risk.

As a financial asset gold is influenced by real interest rates; since gold lacks a yield of its own, it is more advantageous to invest in gold during periods of low, as right now, or negative interest rates, as in the 1970s, than during times of higher interest rates. Furthermore, brokers accept gold as collateral, just as they accept treasury bonds.

The popularity of gold as an investment vehicle is perfectly exemplified by the success of the ETF SPDR Gold Shares (symbol GLD, listed on the NYSE and cross-listed in Mexico, Singapore, Tokyo and Hong Kong) that was launched in 2004. SPDR Gold exceeded $55 billion in assets under management, holding 1280 tons in December 2010, making it the sixth largest holder of physical gold behind France and more holding than China. 

Jens Tholstrup, Managing Director, UK of Oxford Economics, believes that gold’s appeal as an investment is attributable to “its lack of correlation with other financial assets, important role played in stabilising the value of a portfolio and protection against extreme events such as high inflation and financial market distress.”

The latest financial turmoil showed us that gold is one investment of choice during turbulent times because, unlike stocks or bonds, gold is free of default risk and more liquid than real estate. A recent report published by WGC found that gold performed relatively well compared to other assets during high inflation as well as deflationary period.

Trading Gold

Australia is one of the world’s major gold producers. Dr. Gould, chairman of the South Australian Minerals and Petroleum expert group and Chancellor of the University of South Australia, believes that Australia’s role is underrated: “We are an unrecognised major gold producer and potentially a much larger one in the future, since South Australia is a significant producer of gold as a by-product of its copper mining.”

At least in the near future, Australian gold’s prospects are bright. In 2011–12, increases in exports of both Australian-produced and overseas-sourced gold are forecast to result in export volumes rising by 18% to 410 tonnes. The value of Australian gold exports is forecast to rise by 15 per cent to $15.0 billion in 2010–11, in response to a significantly higher Australian dollar denominated gold price and the modest increase in export volumes. In 2011–12, the value of gold exports is forecast to rise by a further 12 per cent to $16.8 billion as the rise in export volumes is partly offset by a lower gold price.

Some exploration, development and production companies listed on ASX are Bright Star Resource Limited (BUT), Castle Minerals Limited (CDT), Gold Road Resources Limited (GOR), Morning Star Gold (MCO), Drummond Gold Limited (DGO), Aphrodite Gold Limited (AQQ), ABM Resources (ABU), YTC Resources (YTC), Catalpa Resources Limited (CAH), to name a few. BHP Billiton’s Olympic Dam mine has the world’s fifth largest gold resource. You can find more information about the above-mentioned companies in Resource Capital Research’s (RCR) reports and other publications.

From my experience, gold and oil are the most well publicised commodities out there and the easiest ones to find information on. Most brokers have daily newsletters that follow the major commodities markets. They also offer access to gold futures and options, for example MF Global.

Many brokers- FXCM, GFT and IG Markets to name a few - have gold CFDs. Australian Securities Exchange (ASX) has gold CFDs, a gold ETC (exchange traded commodities) and S&P/ASX Gold Index (XGD) - a weighted index made up of twenty-four Australian gold producing and exploring companies.

RCR has a bullish view in near term on the index, “We believe they are now in a moderately oversold state, and we may see a period of outperformance relative to the gold price, particularly if we see further corporate activity.”

Conclusion

It is interesting to note that the last gold bull market lasted twelve years, from 1968 to 1980, while the current one has been around for ten years. After a 10-year bull market, is it prudent to invest in gold?

John Hathaway, founder and manager of Tocqueville Gold Fund with almost $3 billion dollars in assets under management and an average return of 29% over the past 10 years gives us the answer to the first question. His fund has outperformed the market by finding mining stocks that tend to be smaller and at an earlier stage of their development than the average mining stock.

These are the kind of stocks that, if properly picked, can smash through benchmarks. Hathaway believes that gold prices will hold up as long as the U.S. and other major Western political leaders adopt practices which result in devalued currencies, high-budget deficits, and untamed inflation. At the very least, each portfolio should contain at least 5% gold holdings, considering that the Eurozone sovereign debt crisis is still unfolding, political instability in the Middle East and persistent global financial uncertainty.

Resources

http://www.igmarkets.com.au/cfd/get-started.html
http://www.asx.com.au/documents/products/asx_commodity_cfds_and_codes.pdf
http://www.igmarkets.com.au/cfd/get-started.html
http://www.mfglobal.com.au/
http://www.rcresearch.com.au/documents/gold/reports/0/australia/

>>Back to the newsletter to view other articles - July 16th 2011