Let me start by making a confession: I invested heavily in gold in the summer of 2018 as I thought stock markets were overvalued (yes, this was a common opinion even back then) and there was simply more upside in gold. It took me quite some time to tell people around me that I had actually done this, especially because I had just told them I also invested in Tesla (and I did not want to get kicked out of the family just yet).
Looking back this entry point was incredible for both gold and Tesla, but for this story I want to focus on gold. I want to start with a short introduction on gold and how its price developed over the past 100 years. Then, I want to show you what has changed for gold over the past months (believe me, this data is incredible) and share my view on what might happen next.
An Introduction to Shiny Metals
In ancient Egypt, other empires, and even in the United States gold has been used as a currency, leading to gold its current reputation as the original store of value (as the common saying goes: “gold is money, everything else is credit”).
The properties of gold – its scarcity, shiny looks, malleability and longevity (it does not corrode nor rust) – make it a metal that has the power to take control of people’s minds. Today, gold is even used as an industrial commodity as it is one of the best conductors for electricity. Just think about the way gold is part of our language (golden opportunities, being worth your weight in gold, etc.) and lore (Midas, pirate treasures, etc.) to see how important this metal once was in society.
Gold has been discussed a lot in the academic world of finance. It has been described as a lot of things, but something the academic literature can agree on is that gold is a terrible investment. Gold may be seen as a store of value, a hedge against inflation, or a commodity by the finance community, no study has been able to prove any of these properties useful for an investment portfolio. It has only been proven that gold is an inflation hedge on the long-term. However, this ‘long-term’ is often so long that it extends the time horizon of most portfolios or even a lifetime.
Even Warren Buffett once shared his opinion on gold. He sees gold as an asset that does not produce cash flows, and thinks gold is therefore not worthy of an investment. In short, gold will remain gold and will only make you money if you manage to sell it to someone else at a higher price. Are you willing to take that risk?
I am not going to debate science and one of the greatest investors of all time. Yet I think every controversy offers an opportunity. Thus, with the gold price nearing all-time highs, I thought it was time to take another good look at the price of gold.
“Every controversy offers an opportunity”BeursWolf
Explaining the Gold Price Chart
Historical gold data going back to the 1920s is hard to come by, so for a start I will use images of two charts from macrotrends.net – one inflation adjusted and one not inflation adjusted – and a chart from longtermtrends.net with historical real interest rates.
In these charts, one of gold’s flaws becomes visible immediately: its volatility. The academic literature emphasizes this quite often, as this leads to lower risk-adjusted returns. Personally, I think this can be explained along the historical timeline, which I have divided into five periods. To understand these, it is important to see what the real interest rate has been doing over the same time period, which is why I added that chart to the mix.
1. Misery and Prosperity around a stable Gold Standard
In the first part of these charts, you can see that the not inflation adjusted price is hardly going anywhere (aside from the strong uplift around the great depression). This is because of the gold standard and the Bretton Woods system, of which the latter was in place until President Nixon ended the system in 1971.
The gold standard meant that each US dollar could be exchanged for a fixed amount of gold. The Bretton Woods system slightly changed this into a system where all foreign currencies had a fixed exchange rate to the US dollar, while the US dollar could still be exchanged for a fixed amount of gold (before this system, many global currencies had their own gold standard, which explains why so many central banks still own so much gold). This explains the incredible stability (and the declining inflation adjusted trendline) in part one, despite real interest rates and inflation showing extreme ups and downs over the same time period.
By ending the Bretton Woods system, the US dollar and all other global currencies tied to it became fiat currencies (a currency issued by the central bank without underlying assets – or intrinsic value – gaining its value from the collective trust in the institution that issues the currency). I personally think this caused gold to become a competitor to the US dollar (and with that US Treasuries) as they were no longer complementary but substitutes for one another (in terms of safe havens), which brings us to part two.
From part two onwards, an important relationship to understand is that US Treasuries become more attractive than gold as a safe haven when the (nominal) interest rate is above inflation (i.e. a positive real interest rate). This will drive down the demand for gold relative to US Treasuries and the US dollar. The other way around, US Treasuries are unattractive when inflation is higher than the nominal interest rate (i.e. a negative real interest rate). This will in turn (at least in theory) drive up the demand for gold relative to US Treasuries and the US dollar.
P.S.: If you want to learn more on the specifics of the history of gold, I can highly recommend you to watch some YouTube videos from Mike Maloney (just make sure you are not sucked into the conspiracy theories).
2. The Experimental Decade
After the Bretton Woods system ended, a decade of stagflation followed where inflation was high and real interest rates were more often negative than positive due to slow economic growth, altogether meaning that the US dollar lost value over time. As gold is perceived to not be directly influenced by inflation nor interest rates, and the emotional component of gold might still have held a place in people’s hearts at the time, this caused gold to soar to its highest inflation adjusted price point to date, at above $2,200 per troy ounce. This gold rush ended at the beginning of the 1980s.
3. Globalization and US Dominance
Even though the Bretton Woods ended, the US dollar was still the world reserve currency, meaning that most of the global transactions take place in US dollars. For example, when Japan and South Africa would exchange goods or lend money to one another, they were likely using US dollars instead of their own respective currencies (the US dollar was an independent third party means of exchange). Also, the petrodollar system meant that all exchanges involving oil had to take place in US dollars, leading to further dominance of the US and the US dollar in the global economy.
It should then not come as a surprise that in these decades of increased global trade, the introduction of the internet and high economic growth, gold lost terrain relative to the US dollar as the demand for US dollars skyrocketed. The real interest rate being in positive territory for decades meant that owning gold lost you money compared to owning US Treasuries. As the fiat currency system proved itself over this period (and the emotional attachment to gold also may have worn off a little), the gold price plummeted to an inflation adjusted price of below $400 (and a not inflation adjusted price of below $300). But then, something incredible happened.
4. Crisis and Financial Engineering: A Golden Resurrection
From 2000 to 2011, the gold price went from below $300 to above $1,800. Just imagine that an asset class that was once known for its stability went up six times in just over a decade. The first part of this rally can be explained by the dot-com crash in the stock market and the negative real interest rates (and historically low nominal interest rates) that followed afterwards.
Looking at the previously described history you may have expected that the gold price should have retracted from 2003 onwards as nominal and real interest rates started to move up again. However, this was not the case as 2004 marked the introduction of a new financial instrument for gold: the exchange traded fund. State Street Corporation introduced their gold ETF in 2004, making investments in gold more accessible to the public. As storing gold could also be centralized through exchange traded products (or these products did not have to be backed by physical gold at all) the storage and distribution costs associated with gold became less of a downside as well.
Gold gained global demand and started its rally to a not inflation adjusted all time high of above $1,800 in 2011, which was further boosted by the 2008 financial crisis and a new phenomenon that puts it in today’s era: excessive money printing.
5. Unchartered Territories?
I think we can safely say that gold was overbought in 2011, causing much of the pullback despite the real interest rate still being negative. Global equity markets started to show strong recovery signs, meaning that investors confidently shifted their funds back into the stock market. The nominal interest rate also started to pick up again, leading to further headwinds for gold as US Treasuries were, again, a more attractive alternative as a safe haven in an investor’s portfolio.
Yet, under the surface the money supply of US dollars was expanding. Many people (including the previously mentioned Mike Maloney and the notorious Peter Schiff) predict doomsday scenarios resulting from this practice. However, the increase in the money supply has not yet lead to a sharp increase in inflation, according to economists (the quantity theory of money) as a result of low velocity.
When looking at the graph depicting the M1 Money Supply from tradingeconomics.com, there does not seem to be a direct relationship between the money supply and the gold price (especially since the gold price stagnated after 2013, while the money supply was still heavily expanding). Finally, at the end of stage five we can see that the decrease in nominal interest rates seems to have caused another upward move in the gold price, almost back to the previous all-time highs.
Personally, I think a true catalyst for even higher gold prices would be an actual increase in inflation – and not just money printing itself – as this will truly push investors away from holding cash (US dollars) and US Treasuries.
China and COVID-19: What’s Next?
The United States is undoubtedly losing its dominant place as the global political and economic leader. Global trade slows and multilateral relationships are replaced by (trade) disputes with China and bilateral relationships. As the US takes a step back on the world stage, the US dollar may suffer for it. And that, probably combined with the increase in the money supply, is exactly what we are seeing now.
Usually in times of uncertainty, and with a lot of uncertainty caused by a pandemic, the US dollar gains value as a safe haven. But as this was the initial response in March with gold losing relative to the US dollar (in a true panic sell), investors may have found a replacement for the US dollar. Gold.
When the market crashed in March as a result of COVID-19, the gold price dropped in line with the stock market. Soon afterwards the gold price recovered, faster than the stock market. What is interesting to see in the chart below is that the gold price return in Euros in 2020 used to be almost consistently higher than the return in US dollars. Over the past month, the divergence completely went the other way around, implying that the increase in gold demand may be caused by a sharp decrease in the value of the US dollar.
Another interesting observation is that the steep increase in the gold price over the past week looks similar to the sharper increase just before the market crash at the end of February. This is pure speculation, but it looks like uncertainty is on the rise again in the investor community.
The previous chart also shows that gold returns year to date are between 20% and 25% depending on your native currency (Euro or the US dollar). These returns are unusual for gold and can be explained by the increased gold demand, which is truly incredible to see.
These charts show the price and volume of gold futures over the course of 2019 and 2020. In 2019 and the years prior, the volume would be almost negligible, with some seasonal end of the month spikes below 400,000 (the pattern is explained by the underlying nature of the futures contracts). In 2020 this volume pattern changed completely. The seasonal pattern might have been there in the beginning of the year, but after the market bottomed at the end of March, the volume spiked up to over 200,000,000 (far over 500x the 2019 peak in November). Barely visible on the chart, the volume on the last depicted trading day in 2020 (22nd of July) was over 200,000,000 again.
What does this all mean? If I could predict the future, I probably would not be writing this blog. My best guess would be that the downturn in the markets we have seen over the last couple of days might very well not be the last volatility of this summer, and if the flight to safety is not going to be into US dollars but in gold, it is very likely that we are going to see new all-time highs in the gold price. The other way around, it could also be that this is the start of a devaluation of the US dollar, which would bring us only further into unchartered territories.
In short, I personally think history shows three catalysts for higher gold prices, of which the first two are present and we might have just seen a start of the third:
- Slow or negative economic growth (lower expected returns of stocks)
- Low nominal interest rates (lower expected returns of US Treasuries)
- Inflation and negative real interest rates (devaluation of the US dollar)
An Attempt to Value Gold
To close this post, it is worth mentioning that it is very hard to intrinsically value gold. Do you calculate the price based on a historical price point and extrapolate to today using inflation? Do you take the global wealth and divide it by the amount of gold? Do you just look at the production or extraction costs of gold for an indication of its value? All these methods have their shortcomings, which are similar to the problems in trying to value something like Bitcoin. In the end, it is worth what people want to pay for it.
Just as an exercise (for fun) we could take an approach through the US dollar M1 Money Supply today and the estimated amount of gold that has ever been mined:
- The M1 Money Supply according to the previously shown graph is approximately 5,250 billion US dollars
- The amount of gold ever mined is estimated at 190,000 metric tons, or 190 million kilograms
Using these numbers, we end up at $27,632 per kilogram of gold, or $859 per troy ounce (31.1 grams), which is over 50% below today’s gold price. Now you probably think that gold is overvalued and I am wasting time writing this piece, but remember that the Bretton Woods system could only be used for the gold that was actually owned by the US government.
The Wall Street Journal once reported that the US government owned around 6,200 tons of gold but that the actual number remains unknown. Another source reports 261.5 million troy ounces, or around 8,133 tons of gold. Using this 8,133 figure, we end up at a staggering $645,518 per kilogram of gold, or $20,076 per troy ounce, which is around 10x today’s gold price.
So I guess the question still remains: what is the actual intrinsic value of gold? The bottom seems to be significantly lower than today’s price, but the ceiling can hardly be defined either.
The gold price has historically seen more volatility than people may expect from a store of value, but I personally think this can be perfectly explained by the macro-economic trends and monetary policy. As higher interest rates are not in sight and negative interest rates may even be introduced on a wider scale, and uncertainty is still on the rise, I think the current economic and monetary circumstances will sooner result in higher than lower gold prices.
However, there are no clear fundamentals to show what the intrinsic value of gold should be, meaning that there is no clear roof on the gold price and only a questionable bottom price, which is significantly lower than what you pay today. Therefore, it is up to you to decide whether this metal earns a place in your portfolio. Personally, I am taking some gains out of my gold holdings because I do perceive an ever higher price as an ever higher risk given the past volatile performance of this shiny metal.
I am going to use Warren Buffett’s input to summarize this historical view in a more cryptic manner (hint: the first sentence applies to times of economic prosperity).
“The weakness of gold is that it will always be just gold. The strength of gold is that it will always be just gold.”BeursWolf