Gold: A Financial and Investment Perspective
Gold is undeniably a unique element in human society. From its use in burials six thousand years ago, to its role in underpinning the global financial system after World War II, gold has held a special fascination for us.
While gold is no longer used as currency, it remains relevant as an investment, for jewelry, in circuit boards, and even in dental work. Whether it's 2024 BC or 2024 AD, regardless of the complexities of the financial market, people invariably turn to gold as a safe haven whenever uncertainty arises.
In this article, we'll delve into the world of gold from financial and investment perspectives. This is a rather lengthy video, so let's establish a framework first. We'll begin by examining the supply and demand dynamics of gold – who's producing it and who's buying it. Then, we'll analyze the factors influencing and determining gold prices.
Naturally, this will lead us to discuss the recent surge in gold prices. Finally, we'll put on our investor hats and assess gold's characteristics as an asset class, along with some fundamental principles of gold investment. Of course, this is not investment advice.
The article progresses from basic information to more in-depth investment logic. Ideally, you'll find it beneficial to follow this flow. However, feel free to skip to sections that pique your interest.
Let me emphasize that I cannot predict the future direction of gold prices. However, I'm confident that this article will provide valuable insights into gold, the financial world, and even human nature. By the end, you'll grasp the essence of gold trading. Why such a bold claim? Watch till the end and see for yourself.
Gold Supply: More Than Meets the Eye?
Let's address the common notion of gold's scarcity. Just how rare is it? If all the gold ever mined – approximately 21,000 tons – were gathered and spread across a standard football field, it would form a layer just 1.5 meters high, barely reaching my height! That's all the gold in the world, compact enough to fit within a 22x22x22 meter cube. It's a surprisingly small amount, wouldn't you say?
Astonishingly, two-thirds of this gold was mined after World War II. The modern gold rush began in 1848 in the United States. It all started when a sawmill owner stumbled upon gold by a river. Overjoyed, he began feverishly panning for gold, hoping to keep his discovery under wraps.
However, word got out, and within a few years, California saw an influx of over 30,000 people from the eastern US, Mexico, Chile, Germany, Italy, and even China. These prospectors, who arrived primarily in 1849, came to be known as the "Forty-Niners."
Shortly after, gold was discovered in Australia, further fueling the global gold rush. These two discoveries led to a tenfold increase in annual global gold production, from 20 tons to 200 tons.
The Reign of South Africa: A Golden Legacy
While the US and Australia played significant roles, the undisputed champion of gold mining is South Africa. A single glance at historical gold production data reveals South Africa's dominance. This nation alone accounts for a third of all gold ever mined.
South Africa is blessed with an abundance of natural resources. Not only is it a gold powerhouse, but it's also a leading producer of diamonds, platinum, chromium, manganese, and various other minerals. This mineral wealth has propelled South Africa to become one of the most developed countries in Africa.
However, despite its natural advantages, South Africa grapples with economic challenges, facing an unemployment rate exceeding 30%. Is this related to gold? We'll delve into that later.
Since the 1980s, South Africa's gold production has declined, while global production has continued to rise as other countries ramp up their mining operations. Currently, the world mines around 3,000 tons of gold annually, with China, Russia, Australia, Canada, and the US leading the pack, each extracting a few hundred tons per year.
You might think discussing historical gold production is just a fun fact, but there's a method to my madness. This information provides context for understanding gold supply. The seemingly dramatic increase in gold production over time spans two centuries.
Zooming in on the past decade or two, we see a different picture. With advancements in mining technology, global gold supply has become remarkably stable.
Unlike oil, where OPEC meetings and geopolitical maneuvering influence production levels, gold operates in a relatively free market. Most mining companies follow a simple principle: if it's profitable to extract, they'll mine it. Once a deposit is depleted, they move on to the next.
The Allure of Gold: A Tale of Two Demands
We've covered supply, so let's shift our focus to demand. Who are the primary buyers of gold? What drives their demand?
Gold's ascent to the throne of metals, the "chosen mineral," stems from its unique combination of attributes: stability, rarity, ease of manipulation, and, crucially, its captivating beauty. This brings us to gold's first major use: jewelry.
While discussions about gold often revolve around investment and gold bars, jewelry fabrication still consumes nearly half of the global gold supply. Try using US dollars for that! You can't exactly fashion dollar bills into necklaces and bracelets, can you?
During the Bretton Woods system era, when global currencies were pegged to the US dollar, which in turn was backed by gold, the insatiable demand for gold jewelry posed a significant headache for central banks.
Why? Imagine a scenario where global prices are tied to gold, and suddenly, grandmothers worldwide decide to treat themselves to a few extra gold bracelets. This surge in demand could potentially constrict the global money supply, leaving central banks with limited options.
When it comes to gold jewelry consumption, China and India are the undisputed champions, together accounting for approximately 60% of global demand. However, on a per capita basis, their consumption pales in comparison to the Middle Eastern powerhouses of Saudi Arabia and the United Arab Emirates.
Central Banks and Gold: A Love-Hate Relationship
But even the wealthiest Middle Eastern oil barons can't match the gold hoarding prowess of our next protagonist: central banks. This brings us to the second major source of gold demand: official investment.
Beneath an unassuming building on Liberty Street in Manhattan lies the world's largest gold depository, housing over 5,800 tons of gold – a staggering 4% of the global total. Even if you were to withdraw $1 million every single day, this treasure trove would last you ten thousand years. That's enough to purchase 35,000 luxurious 4,000-square-foot apartments in New York City!
Buried 24 meters underground, this fortress boasts walls 2 to 3 meters thick, with a single entrance secured by an 82-ton revolving steel door. This is the Federal Reserve Bank of New York's gold vault, one of the most secure locations on Earth.
While located in New York and belonging to the Federal Reserve, a significant portion of this gold actually belongs to other countries. This vault safeguards the gold reserves of 36 central banks from around the world.
Why would nations entrust their gold to the United States? Part of it is rooted in history. Prior to the 1970s, under the Bretton Woods system, global currencies were pegged to the US dollar, which in turn was backed by gold.
Central banks could readily exchange their US dollar holdings for gold at a fixed price. Given the logistical challenges and risks associated with transporting and storing large quantities of gold, most central banks opted to open accounts at the Federal Reserve Bank of New York's vault.
Think of it as each country having its own designated space within this massive vault. Exchanging gold between central banks simply involved moving it from one designated area to another.
Although the Bretton Woods system eventually collapsed, many countries chose to keep their gold at the Federal Reserve. Gold still constitutes approximately one-sixth of global central bank reserves, although it's sometimes excluded from official statistics.
The amount of gold each country holds varies widely. Take Japan and China, for example. While their gold reserves are substantial in absolute terms, they account for less than 5% of their total foreign exchange reserves, indicating that gold doesn't hold a central role in their strategies.
Contrast that with countries like the United States (over 8,000 tons), Germany (3,350 tons), Italy, and France (over 2,400 tons each), where gold represents nearly 70% of their foreign exchange reserves.
The US holding a large percentage of gold is understandable since other countries primarily hold US dollars as reserves. European countries, facing their own economic struggles, have surprisingly maintained significant gold holdings.
These European countries have essentially held their gold reserves dormant for the past half-century. China, on the other hand, has been steadily accumulating gold as its foreign exchange reserves have surged in recent years.
However, the global landscape changed in 2022. With rising inflation risks and a decline in the perceived reliability of the US dollar, central banks worldwide turned to gold, driving historic purchases of over 1,000 tons in both 2022 and 2023. Central banks now absorb approximately one-fourth of annual global gold production.
Interestingly, Turkey has displayed a rather erratic pattern in the gold market. While most central banks buy or sell gold gradually, Turkey's central bank has been a whirlwind of activity, emerging as a major buyer in 2022, a major seller in 2023, and then back to being a top buyer in early 2024. The reasons are complex and we can explore them another time.
Private Investment: Physical vs. Virtual Gold
While central banks are significant players, the real action in the gold market lies in private investment. Individuals invest in gold either by purchasing physical gold or through gold-linked financial products, often referred to as "paper gold."
Physical gold primarily takes the form of gold bars and coins. It's not uncommon to hear tales of wealthy individuals stashing away gold bars in their safes. Financial institutions and banks offer their own standardized gold bars. Even Costco, the American wholesale retailer, has jumped on the bandwagon, offering gold bars that have been selling surprisingly well.
Central banks typically deal with larger gold bars, weighing around 400 ounces or 12.4 kilograms – essentially gold bricks! At current prices, a single brick is worth a cool $1 million. Talk about a high value-to-weight ratio!
You could theoretically carry gold bars worth millions of dollars in your pocket and stroll around without drawing too much attention. Even a $1.5 billion fortune, if converted entirely to gold, could fit inside a large suitcase. But good luck getting that past airport security!
While compact, that suitcase would weigh a back-breaking two tons – equivalent to a small SUV! Even if the airline and your suitcase could handle it, your arms probably wouldn't.
From a purely investment standpoint, physical gold carries relatively high transaction costs. Buying and selling gold on the open market usually involves a spread of around 3%. This spread, along with other fees, represents your transaction costs.
Purchasing from jewelry stores or other retailers can push these costs even higher, often exceeding 10%. Additionally, storing and transporting physical gold incurs costs, primarily due to the risk of theft or robbery. Safeguarding your investment often requires additional security measures, adding to the overall expense.
However, owning physical gold offers a distinct psychological advantage: peace of mind. Investing in stocks or funds can be nerve-wracking, but holding a tangible gold bar provides a sense of security and satisfaction.
The Rise of Virtual Gold: Futures, ETFs, and OTC
I used to believe that most investors now favored virtual gold, such as gold futures, over physical gold. However, I was mistaken. Surprisingly, over two-thirds of annual net gold investment flows into physical gold. It seems I underestimated the enduring appeal of holding tangible gold.
Let's examine investments in virtual gold – financial products linked to gold's price. Essentially, this involves trading ownership rights to gold held securely in vaults, eliminating the need to physically move it. This streamlined process significantly reduces transaction costs.
While virtual gold doesn't attract the same level of net investment as physical gold, its trading volume dwarfs even that of US Treasuries, considered the benchmark for global interest rates. The virtual gold market buzzes with activity 24/7 as traders engage in a constant dance of buying and selling.
There are three main avenues for virtual gold investment: Over-the-Counter (OTC) trading, futures markets, and Gold ETFs.
Don't let its relative obscurity fool you; OTC trading accounts for roughly half of all gold transactions. Think of it as a wholesale market for gold, where major suppliers and traders execute large-scale deals.
These transactions primarily occur in London through the London Bullion Market Association (LBMA), making London the epicenter of global gold trading. Unlike stock markets, which are often fragmented with multiple exchanges within a country, gold trading is highly centralized.
This concentration stems from the fact that gold trading involves physical transportation and storage. Conducting these activities in a central location minimizes costs, naturally leading to a more consolidated market.
The LBMA, for instance, stores the gold it trades in a network of certified vaults in London. These vaults collectively hold over one million tons of gold – even more than the Federal Reserve's hoard! If you were to withdraw $10,000 every day, it would take you over 200,000 years to exhaust this golden treasure.
While intriguing, OTC trading is largely irrelevant to the average investor. The two options that concern us are gold futures and gold ETFs. To put it simply, futures offer lower transaction costs but demand a higher level of expertise. ETFs come with slightly higher fees but provide a user-friendly experience akin to trading stocks.
Futures markets dominate virtual gold trading, with ETFs, despite recent growth, remaining a small fraction of the overall volume. Two exchanges reign supreme in the world of gold futures: COMEX in New York and the Shanghai Futures Exchange. Combined, they control a staggering 97% of global gold futures trading.
To recap, the three major global gold trading hubs are London, New York, and Shanghai. Private investment, encompassing both physical and virtual gold, constitutes approximately one-fifth of total gold demand.
Beyond Bling and Investment: Gold's Diverse Applications
Aside from jewelry and investment, the remaining 15% of gold demand comes from a variety of sources. The most prominent among these are electronics and industrial applications. Gold's exceptional properties – high ductility, excellent conductivity, resistance to corrosion, strong acids, and alkalis – make it indispensable in certain electronic components, despite its high price.
Then there's dentistry. Who could forget those gleaming gold teeth? Some Indian restaurants even sprinkle fine gold dust on their dishes – edible gold, if you will. If it's truly pure gold, it's safe to consume. Just don't expect it to magically transform your digestive system.
In summary, almost half of global gold demand comes from jewelry, followed by official investment, private investment, and other uses. This breakdown provides a snapshot of the forces shaping the gold market.
Deciphering the Enigma of Gold Prices
Now, let's attempt to untangle the complexities of gold pricing. Since gold doesn't generate cash flow or have a traditional valuation model, analyzing its supply and demand dynamics is key.
We've established that gold supply is relatively stable and can be disregarded for our purposes. On the demand side, jewelry, investment, and other uses each play a role. However, "other uses" represent a small and historically stable portion of demand, allowing us to focus on the interplay between jewelry and investment.
Interestingly, these two demand drivers exhibit a strong negative correlation, creating a fascinating balance. In robust economic times, with increased wealth and optimism, people tend to splurge on gold jewelry, watches, and other luxury items.
Conversely, during economic downturns, demand for gold jewelry wanes. However, the need for safe-haven assets and wealth preservation drives up investment demand for gold. The early days of the COVID-19 pandemic in 2020 provide a prime example. Jewelry demand plummeted while investment demand, particularly for gold ETFs, skyrocketed.
Theoretically, this inverse relationship between jewelry and investment demand should contribute to gold price stability. However, while physical gold trading volumes remain relatively steady, gold prices exhibit significant volatility. This volatility primarily stems from fluctuations in investment demand.
The Psychology of Gold Investment: Beyond the Numbers
Let's delve deeper into the motivations behind gold investment. Why do people invest in gold in the first place? Several factors come into play.
First and foremost is inflation hedging – protecting wealth against the erosion of purchasing power caused by currency depreciation. Central banks accumulate gold not necessarily out of sheer adoration, but as a hedge against the potential consequences of excessive global debt and money printing. It's a way to safeguard their nations' wealth.
This inflation-hedging characteristic manifests in the negative correlation between gold prices and the US Dollar Index. When the dollar strengthens, gold typically weakens, and vice versa.
Another key driver is risk aversion. Risk aversion in this context doesn't imply hoarding gold in anticipation of an apocalypse. The "risk" can range from wars and financial crises to a general sense of unease about the future.
Imagine you're considering investment options but are wary of the risks associated with real estate or the stock market. Gold, with its historical track record of preserving wealth over the long term, often emerges as a comforting alternative. This behavior, this mindset, exemplifies risk aversion.
In terms of price action, gold tends to exhibit a negative correlation with other asset classes. For instance, when stock prices fall, gold prices typically rise. This inverse relationship reflects gold's safe-haven appeal during times of uncertainty.
Both inflation hedging and risk aversion are deeply ingrained in our collective psyche. But does gold truly live up to its reputation as an inflation hedge and a safe haven? The answer is a resounding yes, but with a significant caveat: it only works over very long time horizons.
The Long and Winding Road: Gold's Price Volatility
This brings us to a crucial aspect of gold's price behavior: its remarkably long cycles. Over the past half-century, from 1970 to the present, gold has undoubtedly trended upwards, generally keeping pace with inflation. However, this upward trajectory has been anything but smooth.
Consider the period from 1980 to 2001, when gold prices endured a grueling 70% decline, spanning a full two decades! Anyone unfortunate enough to have bought gold at the peak of the 1980s crisis would have endured years of frustration.
As the decline persisted, pessimism gripped the market, with many believing that gold's downward spiral was unstoppable. While this example highlights a particularly brutal bear market, it underscores the cyclical nature of gold prices.
Decades of gains can be followed by decades of losses, making it challenging to profit from short-term price swings. For gold to effectively hedge against inflation, investors need a time horizon of 15 years or more. Over shorter periods, the correlation between gold and inflation is tenuous at best.
The same principle applies to gold's relationship with the stock market. While a long-term inverse correlation is evident over the past 50 years, zooming in on any given 5-year period reveals a mixed bag of positive and negative correlations, making it difficult to discern a clear pattern.
Why does it take so long for gold's inherent properties to shine through? The answer lies in the significant "noise" that obscures its long-term trends. Gold's price is influenced by a multitude of factors, many of which are difficult to quantify or predict.
Unmasking the Hidden Drivers of Gold Prices
Two hidden drivers play a pivotal role in shaping gold's short-term price movements. The first, for lack of a better term, is love – a deep-seated, almost primal affinity for gold.
Whether rooted in historical significance, cultural norms, family traditions, or simply its aesthetic appeal, people harbor a fondness for gold that defies easy explanation. For many, owning gold brings a sense of comfort and satisfaction, regardless of its investment performance.
Some financial analysts use the term "gold bugs" to describe those with an ardent passion for gold. However, this label feels somewhat misleading, implying that only a small, eccentric group truly appreciates gold. In reality, most people possess at least a latent fondness for gold, waiting to be awakened.
This latent love is precisely why gold prices can be so volatile. It creates a vast reservoir of potential demand just waiting to be unleashed. Unlike stocks or bonds, which some view with skepticism or fear, gold enjoys near-universal appeal.
While love itself might not fluctuate dramatically, its ability to mobilize large segments of the population creates significant price swings.
This widespread appeal sets the stage for the second hidden driver of gold prices: speculation. Many individuals, enticed by rising gold prices, jump into the market hoping to profit from short-term price movements. Their motivations often stem from a desire to "get in on the action" rather than any deep understanding of gold's fundamentals.
This speculative frenzy often manifests as a self-fulfilling prophecy. As prices rise, media coverage intensifies, further fueling public interest and attracting new buyers. This influx of capital pushes prices even higher, creating a cycle of buying that can quickly spiral out of control.
However, speculative bubbles are inherently unsustainable. When prices inevitably reverse course, panic selling ensues, often leading to even sharper declines.
The combination of love and speculation injects a high degree of unpredictability into gold prices, making them challenging to forecast.
Gold as an Investment: A Nuanced Perspective
So, how does gold stack up as an investment? Setting aside emotional attachments, let's objectively assess its merits.
Gold's most compelling attribute is its low or negative correlation with other risky assets. Despite its volatility, gold serves as a valuable hedge, reducing overall portfolio risk. Combined with its high liquidity, gold is well-suited for portfolio diversification and risk management.
However, despite these advantages, professional investors remain wary of gold. Studies suggest that over 80% of institutional investors steer clear of gold altogether. Those who do venture in typically limit their exposure to less than 5%, primarily for hedging purposes.
Why are sophisticated investors so reluctant to embrace gold? Several factors contribute to their skepticism.
The Challenges of Quantifying Gold
Firstly, as previously mentioned, gold's price is notoriously volatile, translating into higher investment risk. In finance, risk and return go hand in hand. Investors demand higher potential returns to compensate for taking on greater risk.
Given gold's volatility, which often surpasses that of the stock market, investors question whether its long-term return potential justifies the risks. From a purely quantitative perspective, allocating a significant portion of one's portfolio to gold is rarely the optimal strategy.
It's crucial to emphasize the words "long-term" and "significant" in this context. Holding a small allocation of gold, say 5%, to dampen portfolio volatility can be a prudent strategy. However, excessive exposure can actually increase overall risk.
Institutional investors who do hold large gold positions typically engage in short-term trading, aiming to profit from price fluctuations. They might also temporarily increase their gold holdings for specific hedging purposes, but these moves are usually short-lived.
The Black Box of Gold: Frustrating for Fund Managers
Secondly, gold's lack of quantifiable metrics poses a significant challenge for professional investors. As we've discussed, factors like sentiment, speculation, and risk aversion heavily influence gold prices, making it difficult to pinpoint a "fair value" or identify overbought or oversold conditions.
This lack of clarity can be frustrating for fund managers accustomed to relying on data and models to make investment decisions. While some basic metrics like central bank purchases and trading volumes provide insights, they offer limited guidance for forming a comprehensive investment thesis.
This inability to quantify gold's value creates a dilemma for fund managers, even those who personally believe in its long-term potential. They face difficulty justifying large gold allocations to their clients.
Imagine explaining to your clients, after a period of underperformance, that you invested heavily in gold based on your gut feeling about market sentiment or inflation expectations. Without concrete data to support your decisions, you risk appearing incompetent.
Conversely, even if your gold bet pays off, it might not earn you accolades. Clients seeking market-beating returns might wonder why they're paying hefty management fees for something they could have easily done themselves.
Gold: Finding Your Comfort Zone
In essence, gold presents a unique challenge for professional investors. Its unpredictable nature, driven by a multitude of hard-to-quantify factors, makes it difficult to analyze and even harder to justify to clients.
However, what professional investors perceive as a drawback can be a source of comfort for individual investors. Gold's lack of transparency levels the playing field, eliminating the fear of being outsmarted by institutions or falling victim to Wall Street manipulation.
When an asset's price is influenced by so many unpredictable variables, perhaps the best approach is to simply trust your gut. If, after careful consideration, you believe gold belongs in your portfolio, then invest accordingly. However, if you identify more promising opportunities, don't hesitate to allocate your capital elsewhere.
Key Takeaways for Gold Investors
In conclusion, here are some key takeaways for anyone considering adding gold to their portfolio:
- Volatility is the Name of the Game: Be prepared for significant price swings. Gold is not for the faint of heart.
- Patience is a Virtue: If your goal is wealth preservation, think long-term – 10 years or more. Gold's price can double or halve within those 10 years, so buckle up for a bumpy ride.
- Transaction Costs Can Bite: Factor in the relatively high costs associated with buying and selling physical gold, typically ranging from 5% to 20%.
- Don't Put All Your Eggs in One Basket: Diversification is key. Limit your gold exposure to a reasonable percentage of your overall portfolio.
- Technical Analysis: Proceed with Caution: Be wary of relying too heavily on technical analysis to time your gold trades. Gold's price movements are often driven by sentiment and speculation, making them difficult to predict using traditional charting techniques.
In this article, we've explored the multifaceted world of gold, from its supply and demand dynamics to the psychological factors driving its price. We've delved into the reasons behind its recent surge and the reasons why professional investors often keep it at arm's length.
I'd like to conclude by commending the World Gold Council for their excellent website, a treasure trove of valuable information on all things gold. Their data is comprehensive, well-organized, and even downloadable in Excel format for further analysis. And the best part? It's completely free!
That's all I have to share about gold and gold investing for now. I hope you found this information insightful and helpful in navigating the complex and often perplexing world of precious metals.