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Understanding The Real Value of Gold

01 May
Understanding The Real 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 to follow or what time frame to adhere to, there is one investment which most of us, particularly Indians, love and also believe they understand — gold.

A layman may not understand the benefits of investing in stocks or bonds or hoarding cash but the same person might easily understand and believe that he knows the value of gold.

Besides traditional options like purchasing jewellery or investing in gold bars and coins, there are now a plethora of new options available like the National Spot Exchange, Gold ETFs and also Gold Fund of Funds.

The gold bulls made a killing over the past decade with gold prices multiplying more than seven times in 11 years from USD 80/10 gm in 2001 to USD 600/10 gm by 2012.

However, the recent unprecedented crash in gold prices by a nearly 20 per cent in few days have left the most convinced gold bull question the yellow metal as a good investment option.

What do we mean by an investment asset? It would mean an asset which puts money in our pockets by generating income. For example, a bond gives interest, equities give dividends, house gives rent. But what cash flow does gold give? Probably nothing.

Therefore, gold cannot be termed as investment asset but merely a “speculative item” because the person buying gold is speculating that the price of the gold will rise in future and he will be able to sell it at a higher profit — there is simply no interim income from it.

Most assets like steel, oil, copper have industrial use but what use does gold have besides making golden tooth? If the industrial use of gold is practically nothing, why is it so costly?

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 per cent of its value against gold over the past 40 years. Hence, its not gold which has gone up but it’s the USD which has gone down because of the indiscriminate money printing by the US Fed.

Now, has gold risen consistently over the past few decades? No, not at all. International gold prices crashed from $850 per ounce in 1981 to $250 per ounce in 2001, negative return over a 20-year long period. However, the “rupee value” of gold was up during the same period, simply because the Rupee which was Rs 8 per USD in 1981 crashed to Rs 45 by 2001.

Hence, because the Indian currency lost significant value against the USD Indian gold prices in rupee terms went up while actual international gold prices in USD crashed during the same period. And has gold given great returns over a 20-year period? No.

Indian gold prices are up by 8.9 per cent CAGR over the last 20 years while the BSE Sensex has given returns of 15.3 per cent CAGR over the same period. In fact, 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” of USD denominated assets like US Treasuries.

When the real interest rate 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 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.

Till the US Fed continues to print money, the USD will remain weak. Till there is uncertainty in the global economy, the money printing will continue.

Till the USD remains weak, some shift from Asian Central Banks like China, India will happen from USD denominated securities to hard asset like gold.

Till there is uncertainty, people will move to the so called safe heaven of gold. Till the rupee remains structurally weak against the USD over the long term, Indian gold prices would be supported in rupee terms. Till women in India love gold ornaments, its demand will rise.

So, the next time you invest in gold, weigh all these factors and remember that gold is not an income producing investment asset but merely a speculative item whose price may go up or down depending on the conditions which determine its value.

What makes gold dearer

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

Real Interest Rates in US Dollar denominated assets: Low or negative real interest rates results in higher gold prices and vice versa
Indian rupee vis-a-vis US Dollar: Since Indians buy gold in rupees, the weaker the rupee against the US Dollar, the higher will be the price of gold and vice versa

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