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Goldeneye - Key Insights to Understanding Gold
This Featured Article is aimed at providing you with a deep understanding of gold, its history, its role as a medium of exchange (money) and as a store of value, our estimates of intrinsic value for gold and what we think about the metal at the current price of just under $2,000 an ounce.
The article is long, so we have split it into readable sections with an index at the start. You can read the article from top to bottom or select sections that interest you by clicking on the links.
- The Physical Attributes of Gold
- The Five Characteristics of Money
- Gold & Cryptocurrencies
- Gold's Place in the Five Traditional Asset Classes
- Is Gold an Inflation Hedge?
- If Gold is Money Why do we Need Paper Currencies?
- Where Does Inflation Come From?
- The Principal Drivers of the Gold Price
- Estimating Gold's Intrinsic Value
- Can I Time an Investment in Gold?
- GillenMarkets View of Gold at $1,970 an Ounce
The Physical Attributes of Gold
Gold is the heaviest metal; it has the highest density. It is virtually indestructible, and its melting point is 1,064 degrees Celsius. It is the most stretchable metal known to man - a single gram of gold can be crafted into a sheet one metre squared, so thin that the sun can shine through. It does not oxidise (rust) in air or water; it has no taste in its purest form and it is an excellent conductor of electricity and heat. Its robustness and dependability mean it is in demand in complex industrial applications where cost is less of a consideration and its physical beauty has seen it in demand as jewellery for thousands of years. And its rarity, durability, divisibility and ease of transport mean that it has also been accepted as money for thousands of years.
The Five Characteristics of Money
As far back as 330 BC, Aristotle, the great Greek philosopher, defined the five characteristics of good money as durability, divisibility, convenience, consistency, and has use value in and of itself. And not much has changed in the intervening 2,000 plus years. Gold's alternative use value, of course, is principally as jewellery, so that even if gold was never used as money it has always had a basic use, which can validate its value.
Today, it costs circa €900 on average to get an ounce of gold out of the ground. Table 1 details the average cost of producing an ounce of gold in 2019 as reported by the top 6 gold producers globally. Data from the World Gold Council corroborate these figures. Add in the miner's profit margin and you could argue that gold's replacement value for jewellery purposes is circa $1,200 an ounce. So, in our view, that alternative use validates a price for gold. Given gold's physical characteristics, it has been accepted as money (a medium of exchange) and it has been a store of value for thousands of years.
Gold & Cryptocurrencies
Cryptocurrencies may have three out of the five characteristics of money - they are divisible, convenient and consistent. However, it is far too early to say that they are durable. And they have no alternative use value, without which they arguably have no value at all. Some argue that as the supply of, say, Bitcoin is limited, they have value. There's the semblance of an argument in that, but it depends on their being demand. And without an alternative use how can you be sure there will always be demand. In addition, while there may be a limit to the number of bitcoins, there's nothing to stop one from producing imitators. It seems to us that cryptocurrencies are potentially a medium of exchange, but we have yet to hear a reasoned argument as to why there are a store of value.
Gold's Place in the Five Traditional Asset Classes
In our view, there are five assets classes that make up a truly balanced portfolio - equities, fixed income government bonds, inflation-linked government bonds, bank deposits and gold.
Equities are businesses (and include property companies) and business in aggregate should earn returns well in excess of non-risk assets because business involves risk; the risk that you don't get your capital back, the risks in an unknown future and so on. So, equities are for growth, but they don't come with a guarantee. If you are an optimist, you might invest exclusively in equities given that, if not overvalued when you invest, they are likely to provide the best returns over the medium to long-term. Certainly, that's been proven over the past 150 years in the developed, democratic world. On the other hand, if you want to, or need to, cover the major economic and political risks that all economies and investors face then the other four asset classes cover those risks for you.
Fixed income government bonds cover an investor for the risk of deflation. It makes little difference what state the economy is in if you own a fixed income government bond as they provide certainty of income and a guarantee of your capital back. Deflation might be defined as a continually contracting economy leading to continuously weakening business and property prices. If you own fixed income government bonds you have covered this risk.
Inflation is an economic risk and that risk can be covered by owning inflation-linked government bonds. Your return should at least match inflation given that you have a government guarantee on it. Bank deposits benefit in a period of rising interest rates, which normally occurs when an economy is overheating, and the central bank is raising interest rates to try and cool the economy. So, bank deposits cover an investor for the risks of economic recession, which can occur when interest rates are rising.
But government bonds are dependent on the financial health of the government that has issued them, and bank deposits are dependent on the health of the bank. Both are, in effect, I.O.U.s and your capital is only as secure as the institutions that have promised to repay you. Think of Germany post World War 1, think Argentina, Russia, think Venezuela today! So, while government bonds and bank deposits are normally considered non-risk assets in democratic countries there is always a residual risk that the government or bank defaults on its promise to you.
Gold, on the other hand, is not an I.O.U. from anyone. It is an asset in its own right and lies outside the government and banking systems. It's an asset with an independent value. And it covers you against economic chaos or wars, which can often lead to a breakdown in government and banking systems and their related currencies and lead to confiscation of capital through currency debasement, inflation or wealth taxation. And gold is a transportable asset that can be traded across the world with a known price. Gold is probably the only asset that cannot suffer a permanent loss.
Of course, as an investor, if you choose to cover all the major economic and political risks you have to accept that in all likelihood your returns will be lower over the medium and long-term than those offered by equities. Chart 1 highlights the value of €10,000 invested at the start of 1995 to end 2019 (i) in global equities and (ii) equally across the five asset classes. Over that particular 25-year period, your returns from equities were indeed higher. Your returns from an equally weighted balanced portfolio made up of the five major asset classes were lower but far smoother, as you would expect.
Is Gold an Inflation Hedge?
Yes, gold is an excellent inflation hedge, but only over the very long-term. Table 2 highlights the returns from gold versus inflation over several decades going back to 1935. From 1935 to 1969, for example, the price of gold was fixed against the US dollar. So, although annual inflation in the US over that 35-year period averaged 2.9%, the gold price remained fixed at $34 an ounce. An investor in gold over that period did not get compensated for inflation and an ounce of gold in 1969 bought you a lot less than it did in 1935 in terms of purchasing power. As another example, in the US inflation averaged 5.5% annually in the 1980s and 3.0% annually in the 1990s, yet the gold price ended 1999 substantially lower than at the start of 1980. That's a 20-year period where an investor in gold was not compensated for inflation. As Table 2 highlights, however, from 1935 to 2019, gold not only matched inflation but it added a little on top with a 4.6% compound per annum return compared to annual inflation of 3.6%.
Gold is a rare metal and gold supplies only increase by circa 2% per annum. Over time, its scarcity, durability and divisibility mean that it maintains its purchasing power, and keeps up with inflation, at least. But this does not hold over shorter timelines. In 1980, for example, the gold price was far above the level that could have been justified by US inflationary trends since, say, 1935 principally as a result of the sharp rally in the 1970s (see Chart 3 below). The overvaluation of gold at that time relative to long-term US inflationary trends led to losses from there as the gold price reverted back to, and below, the price justified by those long-term US inflationary trends.
If Gold is Money Why do we Need Paper Currencies?
Gold is an excellent store of value but it is not an ideal medium of exchange for settling trades between parties. As we already mentioned, the supply of gold only increases by circa 2% per annum and it is becoming increasingly rare, so that the annual supply of new gold in the future could decline even from the current modest levels. So, the supply of gold has never been able to expand at the same rate as global trade. In order to facilitate an increase in global trade something else was needed. Enter bank credit. A bank provides a loan to a business to facilitate the settlement of trades and the bank gets repaid when the business generates cash flow from selling on its own goods or services. Without credit, the growth in global trade would be much slower.
As an example, an importer of fresh fruit will need to pay his overseas supplier before he can sell the goods locally. The importer gets a loan/credit from the bank, pays his supplier and then repays the bank when he sells the fruit. An increasing amount of trade needs an increasing amount of credit.
Credit, of course, is an asset of the bank, but it has value only so long as the borrower can repay. So, credit is an excellent medium of exchange, but it is not always a reliable store of value. This risk reared its head in 2008 when loans provided by banks (in the developed world) could not be repaid (imprudent lending to overvalued property assets). When depositors began to realise that their deposits might have been imperilled through poor lending practices at banks, they started asking for their money back. They start bank runs. As banks lend over long timelines but are financed mainly by short-term customer deposits initially there was a global liquidity crisis. As the loans made were actually not going to be repaid, many banks became insolvent.
Bank deposits normally pay the depositor an interest rate. And so they should as the depositor is taking risk - the risk of non-repayment and the risk of inflation eroding the purchasing power of his/her savings. There are no such risks with gold, so gold has no need to provide an income (interest rate). And despite paying no interest, Chart 2 highlights that a $1,000 investment in gold in late 1933 has still compounded to a higher value today compared to US bank deposits. Over that 87-year timeline, gold provided a 4.6% compound per annum return compared to 3.6% compound per annum from US bank deposits.
Where Does Inflation Come From?
Too much money chasing too few goods or assets is normally likely to result in higher prices of those goods or assets. Banks can create credit (money) and too much credit creation can result in inflation. Central banks can also create credit and arguably since 2008 they have created asset price inflation. But all that central bank money printing since 2008 has not led to much inflation in goods and services, probably because the money never got into the real economy, so that it didn't boost economic activity. Following Covid-19, however, it's highly likely that the spending power provided by governments and central banks will find its way into the real economy. In fact, it's almost certain it will given that governments have actually placed cash - printed out of thin air - into peoples' bank accounts. The recipe for inflation is there, and only time will tell whether it gets out of hand as it did in the 1970s.
The Principal Drivers of the Gold Price
The principal drivers of the gold price include:
- Inflation in the long-term
- The direction of the trade-weighted dollar index
- The level of real interest rates (i.e. interest rates after inflation)
- The need for insurance against currency debasement, politics, war and other issues that might lead to the confiscation of wealth.
The Impact of Inflation
Chart 3 above highlights the price of gold since 1934 (orange line) and compares it to what the gold price would have been had it simply tracked the rate of US consumer price inflation over that period (dotted green line). There's little doubt that gold adjusts upwards in price for inflation. But it does not do so each year, it does so over time. And the rationale for that has been outlined already; due to limited supplies of gold it keeps its purchasing power. As the old saying goes 'an ounce of gold bought you a good quality suit in New York in 1900, and it still does'. Chart 3 also highlights that gold wanders around the price justified by long-term US inflationary trends - sometimes well below that trend and sometimes well above it (as is the case today).
The Impact of the Dollar Trade-weighted Index
For historical reasons, gold is traded in dollars and if the dollar weakens it makes sense that the gold price goes up to offset that dollar weakness. After all, an ounce of gold is not dependent for its value on the dollar, so that pronounced weakness in the dollar trade-weighted index has generally been reflected in a rising gold price. Chart 4 highlights that covering the period from 1968 to 2020. In the chart, it is evident that a downward trend in the dollar trade-weighted index is normally reflecting in an uptrend for gold and vica versa.
The Level of Real Interest Rates Also Matters
If US bank deposits are offering you a return that is above inflation, it's harder for gold to compete for investors' savings. But it's a lot easier for gold to compete for investors' monies if the interest rate on bank deposits is lower than the rate of inflation. Chart 5 highlights that. It can be no coincidence that the gold bull market in the 1970s was during a period of negative real interest rates and that the current gold bull market is taking place at a time when interest rates after inflation are, once again, negative. So, negative real interest rates are an upward driver of the gold price.
The Need for Insurance
Regardless of the trend of inflation or the dollar, political uncertainty and/or wars will drive demand for gold, if people fear that their assets could be lost or confiscated. Post World War 1 in Germany, war reparations were so high that the German Government just printed money to fund its spending, thus eventually destroying its own currency. And when Hitler came to power in 1932, his government continued to spend well beyond Germany's means.
In Germany from 1919 to 1945, there was really only one asset that could protect a German saver, and that was gold. Property was not a store of value in that war and German government bonds and bank deposits became worthless due to the amount that were being printed out of thin air. Today, we have Argentina, Venezuela and Zimbabwe as recent examples where politics and war wreck havoc on the nation's savings and assets. Gold is alone in providing a reliable store of value to savers in such countries.
Estimating Gold's Intrinsic Value
Gold generates no income, so that it does not compound in value in the traditional way. Nonetheless, it has intrinsic value and there are three approaches we use to estimating an intrinsic value for gold:
- The cost of production
- The US inflation rate
- The cost of an average residential home in the US
We feel that these three approaches represent basic anchors of value for gold around which the gold price trades.
In Table 1 above, we highlighted that it costs, on average, circa $900 to get an ounce of gold out of the ground. Below that price, and miners will not explore, or mine, for new gold, so that new gold supplies would dry up and demand would then force the price higher until demand and supply come back into balance.
In Chart 3 above, we highlighted that, due to limited supplies, the gold price rises overtime to compensate for inflation. If we start in late 1933, when the dollar had been devalued against gold (and moved up from $26 an ounce to $34 an ounce at that time) and adjust the then gold price of $34 for US consumer price inflation (CPI) since, we find that today's inflation-adjusted gold price comes out at $800 an ounce. Some argue that US consumer price inflation has been under recorded over the years, and we have some sympathy with that argument.
Of course, asset price inflation is not generally caught in the CPI Index. A comparison between gold and a similar non-income producing dollar asset, like US residential property (as represented by the US House Price Index - which tracks the average US house price), can indicate whether gold represents good value or poor value compared to the average US home price at the current time. Chart 6 highlights that over the 50-year period from 1970 to 2020, the ratio of the US House Price Index to Gold has averaged 5.6, which suggests a gold price today of $1,244 an ounce.
As a rough guide, then, these three approaches suggest an intrinsic value for gold today of between $800 to $1,250 an ounce.
Can I Time an Investment in Gold?
Given that it is hard to value gold in the traditional way, it can make sense to own gold only when it is in a defined uptrend (as it is today) and to sell out of gold when it has entered a defined downtrend. We have three separate technical indicators to assist us in that regard:
- The Dollar Index:
- Buy gold when the price is above its 30-week moving average (and when the moving average is rising) and when the dollar index is below its 30-week moving average (and the moving average is declining).
- Sell out of gold when the price is below its 30-week moving average (and when the moving average is declining) and when the dollar index is above its 30-week moving average (and the moving average is rising).
- When not invested in gold, place your monies in US 3-Month treasury bills.
This indicator is in 'Buy' mode today, and the strategy has outperformed a 'Buy & Hold' gold strategy since 1968 with a 9.8% compound per annum return (before costs) compared to 7.9% compound per annum for a 'Buy & Hold' strategy from 1968 to 2020 (28th August).
- US Real Interest Rates:
- Buy gold when the US real interest rate is 2.0% or below and when the real interest rate's 30-week moving average is below the 50-week moving average (i.e. to ensure a downtrend in the US real interest rate is in place).
- Sell gold when these conditions no longer exist.
- When not invested in gold, place your monies in US 3-Month treasury bills.
This indicator is in 'Buy' mode today, and the strategy has outperformed a 'Buy & Hold' gold strategy since 1968 with a 10.4% compound per annum return (before costs) compared to 7.9% compound per annum for a 'Buy & Hold' strategy from 1968 to 2020 (28th August).
- The Coppock and 30 & 50-Week Moving Average Indicators:
- Buy gold when either the Coppock Indicator or the 30 & 50-Week Moving Average Indicator gives a 'Buy' signal.
- Sell gold when the 30 & 50-week moving average indicator gives a 'Sell' signal (the Coppock Indicator does not give sell signals).
- When not invested in gold, place your monies in US 3-Month treasury bills.
This indicator, too, is in 'Buy' mode today. And as Chart 7 highlights, this strategy has been the most effective over the long-term, outperforming the other two technical indicators and a 'Buy & Hold' gold strategy since 1968. The strategy has returned 11.9% compound per annum (before costs) compared to 7.9% compound per annum for a 'Buy & Hold' gold strategy from 1968 to 2020 (28th August).
These three technical indicators are explained in more detail in our booklet titled Intelligent Gold Investing.
GillenMarkets View of Gold at $1,970 an Ounce Today
All three of our technical indicators on gold are in 'Buy' mode. And it's not hard to see why. Demand for gold is outstripping supply today reflecting an increase in investor demand against a backdrop of potential monetary disorder. Central banks globally have printed circa $18-20 trillion out of thin air and, if this is not reversed at some stage in the future, it is potentially highly inflationary. In contrast, the entire stock of gold in the world is valued at circa $5-6 trillion today, a fraction of what central banks have printed in just a decade. Investors are usually happy to buy US dollars (the World's reserve currency) if they are paid some interest - some return for the risks of money printing and inflation. But today, US bank deposits and US Government bonds pay minimal interest. In addition, if you were a central bank, what currency reserve would you rather own today - dollars (with potentially an unlimited supply) or gold (where new supplies are strictly limited)?
In our view, the gold price may well be ahead of its intrinsic value, but it is in a bull market until proven otherwise. As Newton's law of motion states 'A body in motion stays in motion until a force acts against it' (or something to that effect). Today, we don't see a force against gold. The gold price may be above intrinsic value, but insurance against currency disorder is what is driving demand and until there is evidence of an end to central banks' money printing we can't see what's likely to reverse the investment demand for gold anytime soon. Of course, a 'Sell' signal from any one of our technical indicators (which are outlined above), were one to appear, may be the first indication that investors believe central banks are regaining control over money printing. Until then, gold looks as if it's heading higher!
28th August, 2020