John Maynard Keynes famously labeled gold a "barbaric relic." After bottoming in the summer of 1999, the relic has rebounded, more than doubling in value by the spring of 2006. Since gold began to emerge from the doldrums, important changes have been underway in geopolitical, economic and capital market conditions. What is the sustained rise in the gold price telling us? Common wisdom links its price movements to a familiar list of usual suspects: jewelry demand, asset class diversification, geopolitical risk. Many of these factors can be readily observed. Other drivers are more elusive, with puzzling inconsistencies. The rise of this precious metal offers lessons to curious economic detectives. As financial planners assemble an overall picture, gold provides clues about both the obvious, and the less visible forces at work.
A Useful Indicator
Aside from its beauty, durability and emotional appeal, gold has valuable features as an indicator of the larger economic picture.
As a tiny asset class and scarce commodity with limited supply, changes at the margin show amplified effects. Two-thirds of total world gold production--constituting 3.4 billion troy ounces--has been mined over the past 50 years. "In 2005, mines produced about 2,500 tons, with the remainder coming from central banks' selling and gold scrap sales," says Rob Lutts, president and chief investment officer at Cabot Money Management in Salem, Mass.
Slow supply cycles reinforce the impact. At a certain level, added demand must create an inflection point and stimulate new mining activity. Building a mine, however, is labor- and capital-intensive. It takes an average of 10 years and presents environmental and regulatory challenges.
Both demand and supply sides can move sharply. For example, during the Asian contagion crisis of 1997 and '98, consumers dramatically reduced jewelry consumption by a "whopping" 46 percent, Lutts points out. And in another case, when European central banks agreed to limit gold sales in 1999, the price spiked up $70 that autumn.
Gold, therefore, serves a signaling function. It can send messages to market observers at an early stage about where other asset classes may be heading. Financial advisors should attentively monitor the price of gold as one of the measuring tools that provide clues to overall market direction.
Some of the important price drivers are plain to see. It is incontrovertible that economic growth and per capita income have been racing ahead in emerging markets such as China and India. Consumers in those countries and the Middle East have been snapping up gold jewelry, which is part of the Indian wedding tradition. Since last year, China has liberalized ownership laws, allowing citizen to store their own caches.
While 75 percent of bullion usage goes to jewelry, the 10 percent dedicated to industrial purposes, like electronics, is less than that of other metals. "Because of low industrial use, gold is less exposed to the overall rise in commodities linked to the Asia boom," says Axel Merk, manager of the Merk Hard Currency Fund in Palo Alto. Indeed, other metals such as copper, zinc and nickel have actually eclipsed gold in their own recent price surges.
It is no secret that energy- and resource-rich countries like Russia and Saudi Arabia are building reserves, replaying an old game of recycling petrodollars. Money from oil sales, priced in dollars, is now finding its way into gold investments.
The two newly minted exchange-traded gold funds loom large as another salient factor. They have whetted investor appetite by making it much easier to own bullion. "Investors are appreciating strategic portfolio allocation better, and gold has virtually no statistical correlation with equities," says George Milling-Stanley, manager, Investment and Market Intelligence at the World Gold Council. From 1976 to 2005, the correlation co-efficient to the S&P 500 was a mere 0.008.
Investors in gold ETFs should keep a couple of caveats in mind: The securities, unlike many mining stocks, pay no dividends. Advisors should also note that the IRS classifies the gold ETF as a collectible, subject to a tax of 28 percent, rather than the usual 15 percent long-term capital gains tax.
According to Frank Holmes, CEO of U.S. Global Investors funds in San Antonio, Tex., pension fund committees have been keen to switch from owning mining stocks to owning the ETFs. "That way, they can avoid investment decision risks and Sarbanes-Oxley concerns. They also sidestep environmental and social critics who disapprove of mines in locations like Indonesia."
Finally, geopolitical risk is usually cited as a perennial reason for owing precious metals. For instance, in January 1980, when the gold price spiked, the Soviets had just invaded Afghanistan. It is difficult to compare risk in different eras, but the world did indeed seem safer to many on September 10, 2001.
Those are the obvious culprits. Digging deeper, other, more complex factors appear to be buoying the gold price. Like the canary in the coal mine, the price movements reveal latent imbalances that may not be fully recognized. Or, as the economist Joseph Schumpeter remarked, "The modern mind dislikes gold because it blurts out unpleasant truths."
Investors traditionally hold gold as a hedge against inflation. But where is the inflation today? Although no one is predicting hyperinflation, investors heed the direction and future expectations on their radar screens. Perception is all important. Norman Obst, professor of Economics at Michigan State University, describes a conspiracy in the 1990s among the U.S. and European central banks who wanted to suppress inflation expectations. "People perceived a rising gold price as a sign of trouble. It is unlikely to be a coincidence that whenever gold began to rise, a central bank would start selling."
The modest core rate is now reported as running at about 2 percent year-over-year in the United States. The "headline" rate, which includes food and energy, is trotting more briskly at 3.6 percent. "All economists take the core rate as gospel, but try living in a world without food and energy," argues Jeffrey Saut, chief investment strategist at Raymond James & Associates. Consider anecdotal evidence of increasing costs, like education and health. Saut believes headline inflation is substantially higher, at 6 or 7 percent.
So far, most economists have been focusing on wage acceleration and labor productivity, rather than basic materials. Obst emphasizes the rise in wholesale commodities, particularly energy. "Will it spill over into non-food and energy items?"
Signs of stealth inflation worry Merk, who focuses on the generous incentives each administration has been giving to consumers, allowing them to keep spending to support their lifestyles. While the market downturn in 2000 led to a corporate recession, consumers basked in a wave of liquidity. A pegged exchange rate from Asia flooded U.S. markets with cheap goods, while monetary and fiscal policies were driving up indebtedness and promoting cheap credit. "No policy official wants to call an end to that party," Merk warns. "Globalization helps, but does not eliminate inflation."
Higher interest rates could contain inflation. Should the Fed be taking more preemptive action, and paying greater heed to higher commodity prices? But the central bank may not be able to raise rates high enough to kill inflation, without stifling the economy.
It is critical to identify the real interest rate, with regard to purchasing power, adjusted for inflation. Although nominal interest rates are going up, real rates might not have increased sufficiently relative to inflation. Obst explains that the 1970s Federal Reserve "lost control" because it was not focused on real rates.
The Fed may not be the only central bank behind the curve. The European Central Bank and Bank of Japan, albeit at different stages in the rate cycle, are likewise "walking on eggshells," reports Rhona O'Connell, Managing Director at London-based GFMS Analytics, a precious metals consultancy.
Uncontrolled inflation implies poor fiscal/monetary management, which would not bode well for the dollar. So far the greenback has been holding up relatively well. It is not in anyone's interest to see it plunge, which would threaten foreigners' lucrative exports and U.S. consumers' cheap imports. So far, there has been no run for the exits, but changes are occurring at the margins. According to Saut, from January 2002 until April 2006, the dollar index declined 26 percent, slithering from 120.06 to 89.6.
Other currencies are also in jeopardy, as governments try to inflate their way out of national debts. Investors, says Saut, are demonstrating a "healthy mistrust" of fiat currencies in general by accruing not only gold, but energy, diamonds and other tangibles.
Central Banks Tread Softly
The shadowy society of central banking plays another major role in gold markets. Central banks, including the International Monetary Fund, hold 20 percent, or just over 32,000 tons, out of the total of 150,000 above ground stocks. Since they typically move discreetly, any specific transaction out of the big "polynomial equation" is unlikely to roil markets, says O'Connell.
Transactions add up, however. Recent reports indicate that Russia, China, South Africa, Iran and Venezuela are in the process of beefing up gold reserves. Because countries report transactions to the IMF about two months in arrears, official confirmations are still pending.
Fuel stoked the fire at the London Bullion Market Association conference last November in Johannesburg, when South Africans mentioned they were considering adding reserves. Well-known Chinese economists have also suggested that their country should increase its gold proportion of foreign exchange reserves.
A move is clearly afoot. In late November 2005, Sergei Ignatyev, chairman of the Russian central bank, announced plans to buy gold, and Maria Guegina, head of the bank's External Reserves Management, predicted it would double its 5 percent reserves. That amount alone represents a lot of metal. Russia's 5 percent equals 500 tons, out of the 2,500 tons mined each year.
It is important to view these purchases in historical perspective. Most central banks in the Western industrial world have owned large gold stocks since the time of the gold standard, when they were the only global powers. In Asian countries, according to the World Gold Council, as of 2005, reserves only accounted for 1.1 percent in China, 1.3 percent in Japan and 3.6 percent in India. Compare that to U.S. holdings of 63.8 percent, and over 50 percent in France, Germany and Italy. With average central bank holdings at 11 percent, it was logical for some institutions to readjust their positions.
Russian reserves have run down from Stalin's day, when 2,000 tons were stockpiled. By the time Yeltsin got the keys, only 200 tons were left. "Since then, every Russian leader has committed to rebuilding them," says Milling-Stanley.
Aside from an effort to realign underweighted reserves, why should central banks be buying? It is plausible that darker motives may be prompting countries like Iran and Venezuela, who have political reasons to diversify away from the dollar as a reserve currency. Those with trade surpluses, like China--which will soon have a trillion dollars in reserves--are likely practicing prudent economics. "Asians have massive energy needs, and are working closely with Arab and African countries to secure resources," Merk notes. "They are realistic, recognizing the dollar will weaken."
The Investment Decision
The backdrop indicated by rising gold prices--higher inflation and interest rates, declining dollar--is generally not propitious for economic growth or capital markets. Yet gold may itself offer profitable gains as a hedge in down markets or an outperformer in lackluster investment climates.
Commodity booms do indeed move in multi-year cycles. Yet, after the metal's six-year sprint, is it too late to join the party?
Investment demand is growing, both from those who are chasing performance and those who are diversifying among asset classes. Lutts posits a hypothetical: Suppose endowment funds increased exposure by a paltry .5 percent. They would need to buy $9 billion worth of gold. Toss in a minute .25 percent from mutual funds. That equals another $25 billion in demand. "Those sources alone would create $34 billion in demand, meaning production would need to rise by 85 percent to meet it, all else being constant," says Lutts.
As of April 2006, equities, interest rates and precious metals are all up. "Somebody's lying!" comments Saut, who believes the S&P will drift sideways. He prefers all forms of "stuff," including metals, timber, cement, fertilizer, soybeans, grains and water.
Of course it is impossible to call the top of a secular trend, and anyone who tries to might as well flip a coin. Remember, however, that in almost every bull market, the peak exceeds the previous high mark, which was last $877 in 1980. That would translate to over $2,000 in today's inflation-adjusted dollars.
Moreover, markets oscillate from undervaluation to overvaluation. For a historical view, Saut takes the Dow Jones Industrial Average, and divides it by one ounce of gold. In May 1969, 28.2 ounces of gold bought one Dow share. In 1980, when the ratio bottomed, it took one ounce. By July 1999, you needed 44.7 ounces of gold to purchase one share, and right now you need 19 ounces.
Going all the way back to 1900, the ratio reveals a bottom between one and two ounces. Saut does not know how it will play this time, but in his view, "Gold's rally is likely around the third inning."
It looks like the barbaric relic may have some room to run.
Vanessa Drucker, who used to practice law on Wall Street, is a New York-based freelance writer specializing in capital markets, global economic issues, and management.
When the Civil War broke out, the United States suspended gold convertibility in favor of fiat money. After soaring wartime inflation, a long period of deflation set in. When the country went back on the gold standard in 1879, further deflation hit hard in the West. Farmers there, who were borrowing from the Eastern lenders, were vulnerable to credit crunches, exacerbated by the scarcity of gold. A Populist movement emerged, which advocated moving to the 'easier money' of a bimetallic gold and silver system.
"Over the past 50 years, an entire literature has grown up, based on the theory that L. Frank Baum's Wizard of Oz is a parable on populism and a monetary allegory," explains Professor Norman P. Obst of Michigan State University's Economics Department. Since Henry Littlefield published a seminal article on the subject in American Quarterly in 1964, scholars have continued to debate hidden references to turn-of-the-century society.
Many have claimed that the Wicked Witch of the East stands for eastern industrialists and bankers; the Tin Man represents the industrial workers; the Scarecrow is the western farmer; and the Cowardly Lion is William Jennings Bryan, the pro-silver presidential candidate. Oz is the abbreviation for an ounce of gold. The Emerald (or greenback) City could be Washington D.C. Is Toto short for teetotaler? The Prohibitionists were committed silverites. Although Judy Garland wore ruby slippers, Dorothy's slippers are actually silver in the boo.
Baum himself, who owned a dry goods store, was a Democrat Populist and marched in the famous torchlight parades for Bryan. "Of course the Yellow Brick Road was the gold standard itself," Obst says. It is the silver shoes that finally carry Dorothy home.