Brad Pyles
Into Perspective

An Overview of Gold

By, 01/14/2011

Despite gold's increasing popularity (gold-dispensing ATMs!), the yellow metal's investment characteristics are often misunderstood by investors. Therefore, below are answers to some common questions.

Why do investors typically make up a larger percentage of gold demand than other commodities?

While investors are present in a wide variety of commodity markets, it is difficult to take direct delivery of most of them, especially in quantities investors desire. This limits direct investment options. Consider attempting to store hundreds of barrels of oil or thousands of pounds of aluminum just to invest $20,000. By comparison, this sum would purchase roughly a pound of gold, which can be easily transported and stored by virtually anyone. This ease of delivery and storage naturally increases investor demand.

Another key part of gold's allure is its historical role as a medium of exchange. Tied to its rarity (all of the gold mined in history can fit in a 67 foot cube), malleability (it's easy to cut a big piece into smaller pieces of a chosen size), and ease of storage, gold has often been used as currency throughout history. Gold coins are first thought to have been minted back in the 6th century BC in present day Turkey. Though no country still uses gold as an official currency (a good thing), it retains its reputation as a cash substitute and is often demanded when uncertainty surrounding a fiat currency system rises (e.g., due to high inflation or financial crises).

What are gold's returns historically, and how do they compare to stocks and bonds?

Gold has only traded freely since November 1973. The Bretton Woods agreement following World War II pegged the dollar to gold at $35/oz. and the rest of the world to the dollar—a kind of global gold standard by proxy. Nixon first devalued the dollar to gold in 1971, but the tie wasn't fully severed until late 1973. Though its role as a currency ended, gold has often since been viewed as a cash alternative, and its returns reflect this. Since its deregulation in 1973, gold has significantly underperformed stocks and bonds. This should be expected of a cash substitute and can be seen in Exhibits 1 and 2.

Exhibit 1: Comparing Total Returns (11/30/1973-12/31/2010)

Exhibit 2: Comparing Stocks, Bonds, Gold, and Inflation

To realize even these returns, gold investors have required extreme patience or exquisite timing. Gold's returns have largely been bunched in six distinct moves, representing only 18% of the period (79 of 445 months from 11/30/1973–12/31/2010). If you remove these boom periods, gold's cumulative return is -67.6% or -3.6% annualized.

Exhibit 3: Gold's Limited Boom Periods

If attempting to time a gold investment, it's worth understanding Exhibits 4 and 5, which show how gold has performed relative to stocks in bull and bear markets. As a cash substitute, it should come as no surprise that gold underperformed stocks in virtually every bull market, but outperformed stocks in virtually every bear market. The primary exception, when gold outperformed stocks in a bull market, was in the inflationary period of the late 1970s when a substitute for paper money was in extremely high demand.

Similarly, the one time gold underperformed stocks in a bear market was the early 1980s as inflation expectations were suddenly lowered tied to the Federal Reserve's decision to dramatically increase interest rates. This reduced the demand for cash substitutes.

The one period where gold's relative performance to equities did not coincide with expected over or underperformance of a cash substitute was the bull market of 2002 to 2007. This appears to be tied to declining supply growth and a one-time structural increase in gold demand as gold ETFs lowered transaction costs and liquidity risk (more on this below).

Exhibit 4: Gold vs. Equities in Bear Markets

Exhibit 5: Gold vs. Equities in Bull Markets

So what does gold typically outperform in a period of low inflation and rising economic growth like we've seen over the last year?

Not much. Because gold's end markets are primarily investments and jewelry, it has relatively little sensitivity to the economic cycle. Therefore, during periods of economic expansion, most items with greater economic sensitivity outperform gold and vice versa during economic contractions (the exceptions are typically when changes in supply overwhelm the demand impact). This can be seen in Exhibit 6, which compares the ratio of silver to gold and the MSCI World stock index. During periods of economic growth when the global stock market is rising, silver typically outperforms gold (when the silver/gold line is rising) because nearly half of silver consumption goes to industrial uses (silver has the greatest electrical conductivity of any metal).

Exhibit 6: Gold vs. Silver as a Market Indicator

Source: Thomson Reuters

What are the supply and demand drivers for gold and how have they changed in recent years?

First, let's take a look at supply. During the 1980s and 1990s, gold production significantly increased tied to the liberalization of China and the former USSR, which opened new areas for exploration and development. New technologies in leaching (affecting the efficiency in which gold is separated from rock) also improved recovery rates at mines, adding to supply. However, from 2001 to 2009, global annual gold production declined 9.6% as new mines were slow to develop and ore grades declined at older mines. Lackluster supply growth appears unlikely to change significantly in the near future and has been one of the primary reasons gold miners have been confident enough about the stability of prices to remove most of their hedges in recent years.

Exhibit 7: Global Annual Gold Production

Source: US Geological Survey

On the demand side, the situation is a bit less stable. Gold has two primary drivers: jewelry and investments. The rise of the middle class in Emerging Markets has supported jewelry demand and appears likely to continue. But recently, investors have been the more important demand driver—the rise of investments as a percentage of global gold consumption can be seen in Exhibit 8—and investment demand is much less stable.

Increased investor demand is partially tied to the development of gold exchange-traded funds (ETFs) in 2003, which allow people to invest in gold without taking physical delivery or having to arrange and pay for transportation, storage, and insurance. The ETF does all of this on the investor's behalf for a small fee. This arrangement has proven to be extremely popular and has significantly decreased transaction costs and increased the liquidity of gold investments for retail investors. The effects of this process have been dramatic—but given the market has now had over seven years to adjust, they are diminishing rapidly as a driver of future demand growth. Additionally, as investors again become more comfortable with fiat currencies (i.e., the recent panic fades further), gold demand could fall significantly.

The development most likely to maintain growth in investment demand appears to be the creation of gold ETFs in China. Chinese citizens are not allowed to invest outside of their country and therefore have not been able to invest in gold ETFs to date, but this appears likely to change in 2011. While unlikely to have the effect of the initial introduction of gold ETFs, it could marginally increase gold demand.

Exhibit 8: Percentage of Gold Consumption by End Market

Source: World Gold Council

How do central banks affect the supply and demand of gold?

Central banks and governments around the world are major holders of gold, but their actions have rarely been a good predictor of gold prices. This is because they realize their potential to affect the gold market and are typically careful not to suddenly dump or buy large quantities of gold.

Exhibit 9 shows that since the end of Bretton Woods, governments and central banks have progressively been selling down their reserves. To increase transparency and stability, central bank gold sales have often been locked in and telegraphed ahead of time by central bank agreements, such as the existing European Central Bank Agreement. This agreement is the third five-year agreement in a row, runs from 2009 through 2014, and mandates members' combined annual sales will not exceed 400 metric tons.

Exhibit 9: Global Central Bank and Government Gold Reserves*

Source: World Gold Council. *China no longer consistently reports its gold holdings. For example, in 2009 China reported its gold holdings increased 76% y/y, but it had in fact been increasing those holdings since 2002, the last time it had provided an update on its holdings.

Do long-term holdings in gold qualify for capital gains taxes?

Always consult your tax adviser for how an investment might affect your particular tax situation, but in the US, gold (including gold ETFs) is typically considered a collectible and taxed accordingly. Therefore, depending on an individual's tax situation, long-term gold holdings may be taxed at rates above long-term capital gains rates.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.


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