The latest four letter world on everyone’s lips appears to be “Gold”. Here are a few examples:
1. Two leading Indian mutual funds have just launched Gold Exchange Traded Funds (GETFs).
2. Over the past six weeks, two popular business magazines have featured gold as the cover story, both implying that gold prices had reached a permanently higher plateau and that it was still not too late to climb onto the bandwagon.
3. Hardly a day goes by without at least one of the business television channels featuring one gold bug or another. These cheerleaders often state that they would not sell their holdings just now but wait till the price of gold doubles from today’s levels.
4. Companies offering loans against gold are advertising like never before.
However, this spurt in interest amongst the investing community contrasts sharply with realities on the ground. An article in the latest issue of “The Economist” states that Indian consumers are keeping jewellers busy not by buying but SELLING their gold jewellery and this trend has only been increasing with the periodic price rises. In fact, the same article quotes some jewellers who say that the during the recent wedding season consumers are making do with only one set of jewellery instead of the customary three. I also read recently that recent high prices have also cooled off the Chinese consumers’ ardour for gold. Last year, indeed, was the first in which investment demand exceeded jewellery demand. Purchases of gold for jewellery dropped to 2,193 tonnes in 2008 and then to 1,758 tonnes in 2009.
So which camp is correct? I guess I would go with the consumers. Logic dictates that in the case of commodities (and yes, gold is a commodity even though the gold aficionados might consider my statement as heresy) price rises sustain only if end-user demand is robust. In late 2007 the first signs of the onset of the recession in the USA led to consumer demand for oil reducing but speculator demand caused the price to rocket to a peak of around USD 150. After the last of the “shorts” had squared off their positions, the price of oil sank like a stone. This situation was also repeated recently in the copper market where investor demand (fuelled by low interest rates and a belief in the “Restocking” theory) was not adequately followed up by actual consumer demand causing severe unwinding of positions. In gold too, for the past year or so, it is the ETF led demand which is at the forefront, and not consumer or industrial demand. Ease of entry and exit has resulted in investors treating gold just as they would treat any other financial asset. Higher prices are actually bringing in more investors, even as they simultaneously induce end-users to reduce their exposure. It appears that the “Greater Fool” theory is at work right now.
This incongruous situation cannot persist for long, especially in a commodity like gold which does not yield any income to the owner. So far, the most common reasons for the rise in price include (1) gold acting as aquasi-currency in the event of a severe devaluation of any of the key global currencies or (2) it being a good store of value in case of hyperinflation caused by the runaway increase in the indebtedness of the developed world.
However, so far neither of these two bogeys appear to be actually materialising. The longer such “Armageddon” is delayed, the greater is the likelihood of all the marginal investors / speculators losing patience. When that happens gold could fall like a house of cards.
I believe that gold should have a relatively small role to play in one’s portfolio. According it more importance than it deserves could reduce the lustre of one’s overall returns.