Friday, 11 November 2011

Understanding the true value of Gold

Investments, although very difficult for most of us to theoretically understand, practically apply and emotionally stick to as to what asset allocation should we follow (stocks, bonds, real estate, commodities etc) or what time frame to adhere to and what are the risks attached to it; but there is one thing which most of us, particularly Indians, love and also believe they understand it – is Gold. A common person may not understand the benefits of investing in stocks for long term wealth creation or bonds to enhance the purchasing power in a deflationary environment or hoard cash to preserve capital in an uncertain economic world but the same person might easily understand and believe that he / she knows the value of Gold. And we Indians have traditionally been the largest consumers of Gold. Importantly, most of us believe that Gold prices can just go up – our parents have taught us to invest in Gold because that is one thing which never falls and financial advisors recommend Gold as a hedge against inflation. Now, let us really understand whether this is true or a myth. Let us understand how to value Gold and if we cant value it then how is the value of Gold determined. And let us appreciate the fact that whether Gold prices can also fall or it is some sacred investments which can never go down.

The value of any asset is the cash flows which is produces during its lifetime and then discounted to present value. If that is too difficult to understand or compute, then simply the current and future earnings capacity of the asset and then applying a proper Price / Earnings ratio or capitalization rate. Different assets produce different types of cash flows. For example, a bond (fixed deposit) gives interest, equities give dividends, house gives rent etc. But, what cash flow does Gold give – probably nothing. Most assets have some use like steel is used in construction and auto industry, oil in running autos and factories, power in running machines, copper in making wires etc but what is the industrial use of Gold. Besides making “golden tooth”, the industrial use of Gold is practically nothing. Then what is the value of Gold – why is it so costly – why do we pay thousands of rupees to buy few grams of Gold. Its simply because we believe the value of Gold will go up in future, we will be able to sell it in future at a higher price to another buyer (the greater fool theory) or more better we don’t ever need to sell Gold – it will be passed on to our children and the future generation. Actually speaking, Gold is a totally speculative commodity with negligible real use and whose value is because of it being treated as a safe heaven – as an alternate currency. Its value is high because Governments and Central Banks (led by the US Fed) are running their money printing machines continuously, relentlessly and at a brisk speed. The US Dollar has lost 97% of its value against Gold over the past 38 years! Hence, its not Gold which has gone up but it’s the US Dollar which has gone down because of the discriminate money printing by the US Fed. And since, internationally Gold is valued in US Dollar terms, if the value of US Dollar goes down then naturally the value of Gold has to go up and that is what has happened. In an effort to illuminate a different aspect of the gold story that somebody might have probably not seen, let’s focus on other currencies. Let us compare the price of Gold with other major international currencies over the past decade. Take a look at Exhibit I, which shows the percentage gains of gold priced in US Dollar and six other major currencies.

Exhibit I: Gold vis-à-vis Major World Currencies


It’s kind of difficult to digest, but there’s a huge disparity between the US dollar’s loss of gold-purchasing power (more than 450%), and the Swiss Franc’s loss of gold purchasing power (less than 200%). Hence, the price of Gold is nothing but as expressed as a percentage of some international currency and globally it is a general practice to express it as against the US Dollar.

Now, has Gold risen consistently over the past few decades. No, not at all. Youngsters would have not seen more than 10-years price history and even the elderly persons would not remember it more than 30 years – and that is the time when “Indian” Gold prices have been stable to upward. I say “Indian” Gold prices because it would be a matter of shock to many Indians to note that international Gold prices crashed from US$850 per ounce in 1981 to US$250 per ounce in 2001, negative return over a long 20-year period. However, the “rupee value” of Gold was up during the same period – why is it magic. No. Simply, because the Indian Rupee which was Rs.8 per US Dollar in the year 1981 crashed to Rs.45 by the year 2001 (Kindly note, rupee going up against the dollar means the rupee weakening against the greenback and vice versa). Hence, because the Indian currency lost significant value against the US Dollar, that’s why Indian Gold prices in rupee terms went up while actual international Gold prices in US Dollar crashed during the same period. And has God given great returns over a long term 20-year period. No. Indian Gold prices are up by 8.9% CAGR over the last 20-years while the BSE Sensex has given returns of 15.3% CAGR over the same period. Infact, over the past 20-years Bank FD might have given better returns than Gold. 

Lot of the so called financial experts will educate you that Gold is a hedge against inflation. However, that may not necessarily be the case. Its not directly related to inflation but to “real interest rates” (nominal interest rates – inflation) of US Dollar denominated assets like US Treasuries. When the real interest rates is down and close to inflation – Gold is likely to appreciate in value because to hold Gold (which does not give any cash flow), the investor has to forego interest on his / her investments and hence real interest rates have to be low or negative so as to induce the investor to hold onto something which does not give any real cash flow. Exhibit II brings out the last 30-year history of US real interest rates, gold prices and US stock markets. It clearly brings out the fact that Gold performs well when real interest rates are very low to negative and vice versa.

Exhibit II: The Time when Gold rises in Value

US Real Interest Rate
Gold Price
US S&P 500*
+32% p.a.
-7% p.a.
+7% p.a.
+18.5% p.a.
-3% p.a.

Source: US Federal Reserve, * Excluding Dividends
To sum up, the following factors determine the value of Indian Gold:

1)       Value of the US Dollar: Since Gold is internationally quoted in US Dollar, the weaker the US Dollar, the higher the price of Gold and vice versa.
2)       Real Interest Rates in US Dollar denominated assets: Low or negative real interest rates results in higher Gold prices and vice versa.
3)       Indian rupee vis-a-vis US Dollar: Since, Indians buy Gold in Indian rupees, the weaker the Indian rupees against the US Dollar, the higher will be the price of Gold and vice versa.

Future prices of Gold
I am here not trying to predict the future price of Gold because as mentioned earlier it’s a speculative commodity with no real industrial usage whose value depends on the value of US Dollar, real interest rates in the US which in turn depend on nominal interest rates and inflation over there and then the value of Indian rupee against the US Dollar. Till the US Fed continues to print money the US Dollar will remain weak, till there is uncertainty in the global economy the money printing will continue, till the US Dollar remains weak some shift from Asian Central Banks like China, India etc will happen from US Dollar denominated securities to hard asset like Gold, till there is uncertainty around people will move to the so called safe heaven of Gold, till the Indian rupee remains structurally weak against the US Dollar over the long term, Indian Gold prices would be supported in rupee terms and till the woman in India keep loving Gold ornaments there would be demand for Gold which otherwise hardly has any real industrial use. So, the next time you invest in Gold, weigh all these factors before doing it – and remember that Gold may go up in value like any other asset – but it is certainly not a sacred asset that its value will never come down – like any other asset its value will go up and also come down depending on the conditions which affect its prices. And if I have to compulsorily predict Indian Gold prices, then I feel that international Gold prices might almost double over the next few years from around US$1600 per ounce currently to US$3000 per ounce.

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