In Gold We Trust (But Should we?)

People are running for cover.

Increasing stock market volatility (serious swings in stock prices) seems to be sending investors to gold. The precious metal has risen quite a bit since the start of the year – and the high level of trading activity indicates that it could climb even higher.

Of all things…why gold?

People have long had a fascination for the yellow metal. Gold has moved entire societies into action and inspired works of art and terrible violence in equal measure. Gold has many uses: as currency, jewelry and even for industrial purposes.

Gold was used as a currency as early as the 1st century B.C.  It has certain properties that make it particularly attractive as a currency – it can be easily melted down, molded and shaped. It is also chemically inert (won’t turn radioactive and give you weirdo super-powers). We’ve actually used gold as a currency for so long that it was only after World War II that gold-backed currencies were replaced with fiat currencies!  FYI: Fiat money is currency that is backed only by the trust of the people in the government. Astonishingly, Switzerland was the last hold-out, clinging onto their gold-backed currency until 1999.

But…why are investors putting their money, and by proxy their faith, into gold?

Think about the current market environment right now. Stock markets worldwide have seen large dips, even recessions in some parts of the globe. There’s a lot of fear and anxiety about where the market is headed. People are paying very close attention to the U.S. Fed and what their role in this whole thing is going to be. U.S. government bonds, considered a super safe investment, have seen their yields (or return) go down. That means that people are putting more of their money into bonds. (Think: when yields go down, it means prices are increasing. If prices are increasing, it’s because people are buying and demanding more of that good).

Now: if you’re a trader or savvy investor who sees that yields on safe assets (bonds) are going down…you might be tempted to invest elsewhere. Somewhere you can get more bang for your buck. And you might look to commodities.

The school of thought is that commodities, and gold, are a good hedge against inflation. Think about it: if you think inflation is going to rise, eating away your returns in equities, then you might be interested in allocating some of your cash to gold. Likewise, if the dollar is very strong (as it is now), you may imagine that it has nowhere to go but down, then you might see gold as a good investment. When the value of a dollar goes down, gold tends to go up.

So we’re told…

The real deal on gold

Gold has a lot of uses, but studies have shown that as a hedge against inflation…it just doesn’t pass muster.

gold

Source: The Golden Dilemma, Financial Analysts Journal, Volume 69, Number 4

If you look at the figure above, which looks at the month-end value for inflation and the gold price over a 40-year period, you can see that on average: when inflation is high, the price of gold is high. Additionally, though, there are plenty of instances where inflation is high and gold prices are low…and times when inflation is low and gold prices are also low. That’s not how a good hedge should work!

If gold were a good hedge, you’d expect it to hold its value over time.

What about gold versus currency fluctuations?

gold

It’s hit or miss.

Gold seems to work pretty well after 1995 – you can see that the real dollar index and gold move in opposite directions, i.e. they have an inverse relationship. When one is rising, the other’s falling. Prior to 1995, the relationship doesn’t seem to work as well and they basically move together. If you bought gold in 1985 thinking it would hedge against a falling dollar…you’d have to wait 15 years for that relationship to work in your favor.

The reasons why these relationships break down is outside the scope of this article. It’s safe to say, though, that you can’t just take the conventional wisdom at face value. If you’re an investor looking for a safe bet, you might want to think twice before dumping money in gold. Gold could stop working as a hedge versus the dollar at any moment and could stop working for a decade.

What about equities?

gold

Source: The Golden Dilemma, Financial Analysts Journal, Volume 69, Number 4

The above graph plots the monthly return of the S&P500 versus the return on gold in the same month. The result is a cloud shape – indicating that any relationship between the returns on gold and stocks is a random one.

What does this all mean?

If gold, as we’ve shown, is sort of useless as a hedge in all the ways that people typically believe it is…then why do people continue to buy the stuff?

Good question.

Many researchers consider gold to be a speculative asset. The reason gold prices go up is because gold prices are going up. In other words…the reason people buy gold is because other people are buying gold. People are essentially gambling, and buying into the herd mentality that causes speculative bubbles to form in assets.

Ultimately…the biggest lesson is if you’re going to invest in gold, you have to be very aware of the meta-game that is going on. Investing successfully in gold requires a thorough understanding of how people tend to behave in different investing environments. What makes this difficult is that you also have to know how people behave in regards to buying gold when they perceive that environment is changing, as is the case now. If you can do that, then you might stand a chance.

 

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