This is an extended version of an opinion piece published in the Irish Examiner
The old market adage of “be greedy when others are fearful and fearful and others are greedy” goes to the heart of the fact that not all assets move in the same way. In fact, were all to move up or down more or less together then there would be really very little scope for diversification. Diversification is a process whereby instead of putting all your eggs in one basket one spreads the eggs, across different baskets. One of the assets that has shown the most remarkable growth in value over the last number of years is gold. from approximately US$300 per ounce in 2000 Gold has shown a steady increase in value, reaching US$600 per ounce in 2007 and subsequently having moved close to US$2000 per ounce. When one considers the performance of stock markets in particular over the last four years this simultaneously inspires greed and fear. The greed element comes from the natural human desire to be in on a winning thing, and the fear is that this is yet another asset bubble.
One of the interesting aspects of gold was that it is not simply, nor even mainly in historical terms a financial asset. Gold really has at least four main uses: is of course very familiar to all of us as adornment through jewellery, it has historically been used as a currency, it has significant industrial usage, and it is of course a well-recognised store of value. In fact, of these uses it is jewellery which is the largest, accounting for between 50 and 60% of world gold demand. Traditionally gold as an investment was held by central banks, sovereign wealth funds, and very large investors in the form of physical bars, the “Fort Knox” approach. With increasing financial sophistication and in the face of growing demand, over recent years there has been an increase in the ways in which other investors can hold gold, such as via certificates of holding, through gold funds, or through more exotic gold backed investments.
this situation, where demand leads to innovation which leads to demand which leads to price appreciation which leads to demand, is often seen by some as being a key characteristics of a bubble. However it is not all clear that gold is a bubble. Just because something has risen a lot does not a bubble make. A bubble is where an asset has a persistent a valuation over its fundamental value, which cannot in the longterm continue. And, its not clear what is the fundamental value of gold, other than what the market suggests. This does not mean its value is zero, merely that absent any yield from holding gold its valuation is more complex than say that of an equity or bond. Although the nominal price is now heading towards US$2000 per ounce, in real terms gold is not at or near an all-time high. If we adjust for US inflation, which on the surface seems reasonable given that gold is priced in US dollars, it would have to rise to US$2500 per ounce to achieve a new real gold high.
In addition one might wonder as to whether or not it is the US inflation that is important. If gold is truly a currency, as it has been in the past and that some are proposing for the future than it should have its own inflation rate. However as nothing is actually traded in terms of physical ounce of gold then we cannot observe its intrinsic inflation rate, and so it’s all “real real” price remains unknowable.
There has been an explosion of academic research on gold as an investment. The key findings of this research are threefold. First like any asset gold will show increases and decreases in price over the short and even the medium-term, and therefore the short-term dynamics in terms of people taking profits or buying dips will act in the gold market. No asset rises or falls continuously (well apart from Irish bank shares…). Secondly gold over long-term can play a valuable role in even small portfolios, with a suggested allocation from most research being in the area of between 5%-10% of total asset holdings for an investor focused on medium to long-term wealth preservation. Third, gold acts as a safe haven in times of stress in other asset markets, particularly equity and bond markets. In particular, when equities show large falls gold tends to be rising. Thus an investor who holds a portfolio consisting of both gold and equities has a degree of inbuilt shortterm wealth preservation.
Does this mean that gold is not in a bubble? So long as people wish to adorn themselves with gold, so long as in the short-term equity markets and bond markets suffer from the inability of politicians to effectively manage economies, for so long as people expect, as they have been doing for the last 10,000 years, that this rare and useful metal will continue to be seen as valuable by others than the long-term trend of gold would seem to be upwards. Of course, as Keynes said, in the long term we are dead, and markets can stay irrational longer than investors can stay solvent. Thus, investors in gold need to keep two eyes open – one focused on the long run, one on the short.