“Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.” This statement ascribed to the fabled investor Warrant Buffet sums up the frustration of modern investment managers with gold.
Conventional investment managers do not like gold. For the simple reason that conventional valuation models such as discounted cash flow, book value, and earnings growth do not apply to gold. There is no interest flow, no dividend, no maturity value, nothing. What you see is what you get--a shiny piece of metal, too expensive to be used for anything other than jewelry.
As I write this, we have lived through the “Flash Crash” in gold on 12th and 13th April 2013, which caught every one by surprise. Gold dipped to a low of $1321 per troy ounce before attempting to build base around this level.
Prior to the sharp decline, gold had been drifting lower for almost six months from a level of $1794 in October 2012, attempting intermittent bounces along the way on various negative news flows, but resuming a gradual downtrend thereafter. In the immediate past we had gold positive news in form of Cyprus bail out, the North Korean tension, and Bank of Japan (BoJ) bond buying. But gold continued lower, and the selling spree coincided with the breaking of technically important levels around $1525, resulting in the sharpest fall in over three decades.
Is the gold bull run over? Which factor that was driving gold for last 12 years suddenly disappeared on April 12th? How do we value gold?
Perhaps the more relevant question now would be how do we value the US dollar. The statement on all currency notes issue by sovereign States says: “promises to pay the bearer a sum of…” . The US dollar however claims that ”this note is a legal tender for all debts, Public and Private.” There was a time when the dollar was backed by gold, but now it does not even promise anything,
Despite reckless printing of trillions of dollars, out of habit market continues to accept the dollar at face value, just like a proverbial Pavlov’s Dog.
Just as people accept the legal tender of a country, they also accept gold as a tender. Ultimately it boils down to faith, trust and belief. There is nothing divine or superstitious about this belief. It just so happens that gold has been an accepted tender for most of recorded history except over last 3- 4 decades.
Why The Extended Rally?
The biggest mistake everyone makes is in believing that gold’s price moves up or down. In reality gold does not go up or down in value. It is just a store of value. Other assets gain or lose value against gold. Gold merely holds a mirror to other assets. If there has been rally in gold prices over last 12 years, it is on account of currency devaluation by central Banks and governments across developed the world. All currencies have lost value versus gold due to excess money printing.
Periodically other asset classes outperform gold. Outperformance can range from months to years. A champion investor would exit gold when any alternate asset class begins to outperform and switch back in to gold after exiting at the peak. Imagine if you had cashed out of Sensex at 21,000 in 2008 and got into gold at $900. In reality very few manage to do this, and those who do have Lady Luck on their side.
Why Has It Come Down?
There is a large group of short term traders (read large investment banks and hedge funds) who try to front-run long term investors exaggerating market moves like circus jesters. When pace of absorption by long term investors slows for some reason, they panic and scramble for exit all at once.
Gold refused to move higher despite bad news as mentioned earlier. In addition to which there were several negative reports like from Goldman Sachs which reduced the target price of gold. For some reasons the traders convinced themselves that US is about to pull the plug on quantitative easing (QE) in other words a dollar printing spree.
The run-up prior to October 2012 was partly fueled by fear of imminent breakup of the euro-zone. As the European Central Bank (ECB) managed to survive the scare, we went through a period of fairly stable economic conditions. When central bankers appear to win, gold always underperforms. Clearly this round was won by central banks.
Traders who had built up positions in anticipation of rally lost heart. With no significant global economic disruption visible in near future, longs exited.
But the manner in which the exit occurred, all at once, without any news or logic, does give rise to suspicion as has been alleged by “gold bugs”, from 400 tonnes worth of shorting (in futures) within a time frame of 30 minutes, to spot market shut down due to technical glitch and defaults on spot delivery by leading banks. Some market analysts blame the crash on strengthening US economy and an imminent withdrawal of QE.
Will Gold Soar Again?
Paradoxically, the good health of the US economy is bad news for gold and other risk assets. Even a partial withdrawal of QE would most certainly result in a relapse of US economy into recession. Triggered by hardening of US Treasury Yields, which would mean bursting of US Bond bubble, which in turn would erode value of trillions of dollar worth of bonds and other assets sitting on Fed’s books along with massive losses to all those who hold US debt. Remember the toxic mark-to-model assets sitting in books of leading Banks? All those would get discounted at higher yields, resulting in fresh round of write offs. It is difficult to see how consumer confidence would survive such a wholesale massacre. Clearly the end of QE is not an option without similar alternative stimulus to take its place.
Germanic austerity in face of ongoing slowdown in euro-zone trouble spots, make deficit reduction a mathematical impossibility. While ECB has bought some respite with “promise of whatever it takes”, it will not be long before things erupt again. The question is, when, not if.
Domestically things have miraculously fallen in place for the time being, with a fall in commodity and crude prices on one hand and FII flows on other, aiding current account balancing. Suddenly the current account deficit does not look too perilous. But the fundamental reasons why we landed in such a difficult situation remain very much in place. Reforms that are on the anvil look increasingly difficult to pass with the government only enjoying a wafer thin majority. It is at the mercy of a disparate group of regional parties. RBI has most likely fallen behind the curve again in loosening interest rates. Anecdotal evidence suggests the slowdown is far more than anticipated on back of tight liquidity and government spending curbs. In such a scenario, medium term outlook for the rupee still is bearish. Meanwhile Bank of Japan has embarked on its own version of aggressive QE.
Fundamentally nothing much has changed. The conditions which drove gold prices so far may have receded a bit, but by no means have they gone away. The most important thing to remember is that, the continuing efforts of central banks around the world is to trigger inflation.
If they succeed, obviously gold would recapture its role as inflation hedge. In the event they don’t, which would mean deflation, every asset class would crash. Which one would you be more comfortable holding?
What Should You Do?
As mentioned earlier, gold is a hedge against central bank printing presses. In modern times, central banks usually have won, creating money out of thin air, at the same time keeping inflation low. Over the last 4-5 years since the Lehman/sub-prime contagion, the edifice has looked like collapsing. Though for the time being apocalypse looks like has been averted, if you look closely at the fundamentals, the foundation looks shakier than ever before.
While experts advice 5-10% of one’s portfolio allocation to gold, it boils down to individual choice and risk perception. If you aren’t adequately stocked up on gold, this is a great opportunity for some course correction. That’s because rarely do we see gold depreciating internationally while the rupee simultaneously goes up.
During the crash, gold has sliced through several technically important levels, which makes it difficult for a quick recovery. At every bounce it would face selling pressure from the longs that are stuck. Hence there will be plenty of opportunity to accumulate at lower levels for all those who missed the bus earlier.
When someone like Paul Volker comes to helm of Federal Reserve, and developed economies accept a period of severe pain, global excess capacity is allowed to close down, paving way for regeneration. There would be little reason to hold on to gold. But when everyone wants to take the easier route, and the answer to all ailments is to run the printing press on three shifts, I will be happy polishing, admiring and adding to my own shiny pile of the dense metal.