Ten years ago, gold was languishing at around $US400 an ounce. But since 2006 the price of gold has skyrocketed, reaching above $US1,800 an ounce last year, and sitting on $US1,613 an ounce this week.
The availability of gold funds
Gold has historically offered protection against inflation and elevated levels of social or political uncertainty. The downside has been the limited opportunities for ordinary investors to dabble in gold. This changed when a number of exchange traded funds (ETFs) became available that focused on gold. EFTs are managed funds listed on the Australian Stock Exchange and other exchanges around the world, which typically aim to replicate a particular market index such as the S&P / ASX200 Resources Index or the Gold Price.
These EFTs made it easier for investors to buy into the precious metal, thereby increasing the popularity – and the price of gold.
A defence against inflation
Amid continuing economic uncertainty, many central banks have invested in gold as a form of protection against depreciation in the value of major reserve currencies, in particular the US dollar.
The interesting aspect of gold is that while the yellow metal is a relatively good conductor of electricity, it has very little intrinsic value. In fact, as an investment gold has significant shortfalls including the absence of ongoing return, meaning it does not pay any income or dividend.
Traditionally, gold producers would ‘cap’ the rise in the price of gold by hedging production costs. This was achieved by selling exchange traded futures contracts when the gold price was attractive.
However, as the price of gold continued to accelerate – partly as a result of increased demand for gold driven by the economic prosperity and increased household wealth in India and China – the resulting price appreciation forced producers to liquidate these futures hedges with significant drawdowns.
Since then, gold producers have not been participating in futures hedging as actively as they once did. The exponential growth in EFTs in futures-based commodity investing has resulted in gold now behaving much like any other financial asset, meaning it has lost its original value as a real asset and/or a hedge against inflation or adverse currency movements.
Be wary of a gold ‘bubble’
So while gold may offer psychological comfort to investors, the transition of gold to a fundamentally ‘paper’ asset underpins the need for caution. In particular, investors need to be on the lookout for the turning point when the price of gold reaches ‘bubble’ levels and perhaps, with a corresponding rise in the US dollar. Investors should also pay close attention to regulators who may not hesitate to act to dampen excessive speculative activity in derivative markets.
Source: Data Perth Mint
Undoubtedly at that point, gold will quickly lose its lustre among investors and the price of gold could fall rapidly. And if speculators bale out of the market en masse, a turnaround could happen quite swiftly.
Remember if it looks and smells like a bubble it usually is. As for gold, remember Rule Number 1: Don’t buy expensive assets.
If you are keen on understanding the market for gold, please do not hesitate to call Equitas Wealth and discuss with Rob on (02) 9492 0444.