surging gold price

The gold price has risen by almost 20% so far this year.  The advance is an unusual one, however, in two respects:

1.  Historically, the gold price has typically been stable in strong currency terms.  Much of the apparent strength has been related to depreciation of weaker currencies.  In practice, this has meant the dollar price vs. the euro (or its predecessor, the d-mark).  This year, in contrast, the dollar has been relatively strong.  Nevertheless, the dollar price of gold is up sharply.

2.  The advance is being driven not by demand for jewelry, which is usually the case, but by investment demand.  Last year, investment demand worldwide actually exceeded jewelry demand.  It may do so again in 2010.  Government mints are doing a land office business minting gold coins.  The SPDR Gold Trust ETF has over $50 billion in assets. And the Financial Times reports that commercial banks are considering expanding their vault space for storing physical gold for the first time in thirty years.

two big changes in the market

During the almost thirty years I’ve been watching (often from afar) the gold market, it has undergone two significant changes:

1.  The first is a product of the past seven years..  Thanks to the rise of ETFs, gold is much easier to buy today than it once was.  The SPDR Gold Trust ETF alone holds 1300 tons of the yellow metal, or close to half of the world’s gold production in a year.  It is traded not only in New York but also in Hong Kong, Singapore and Tokyo.  Vehicles like this eliminate the need to have a commodities account and solve the problems of physical storage, potentially high bid-asked spreads and the need to assay the gold on sale.

2.  Gold was money thirty years ago, but has been gradually losing that role since.  In developing countries, many citizens would use gold as a substitute for bank deposits.  Some had to little to be able to afford a bank.  Some worried about currency devaluation.  But many also feared either government seizure of their wealth, or attracting unfavorable attention (think:  China) from the authorities as being budding capitalists.

Wealthy individuals around the world have long since replaced gold holdings with financial instruments.  And greater political stability in large markets for gold like China or India has meant less fear-motivated demand for gold.  Jewelry demand (and not simply near-pure gold jewelry) has become the main driver of gold consumption.

why a price surge now?

Not now, though.  What are the main factors in increasing investment demand?

I think the main reason is that gold is the default choice for people who are worried about the current weakness in developed countries’ economies and don’t see what else they can buy.  Cash provides safety but almost no return.  Government bond yields are extremely low–and in the case of the euro have not delivered anticipated safety.  Stocks, after having come close to doubling since the lows in March 2009, are wobbling.  They also do best in times of strong economic growth–so they depend on conviction in economic expansion that investors don’t currently have.

What’s left?  a gold ETF plus …?

the risks

I’ve never been a real fan of gold.  As I’ve argued in other posts on this blog, I think gold price movements are ultimately driven by the ebb and flow of gold mining projects.  When prices are low, mining companies stop exploring.  When prices are high, they reopen shuttered mines and develop new deposits.

I think the case today is different.  I think investor demand is being driven by aversion to other liquid investments.  My worry about gold is what happens as/when sentiment about the course of the economies of the developing world improves.  To a great degree, generation-ago demand from the developing world for gold as money is no longer present.  The fact that gold has been very easy to buy through ETFs also means it is very easy to sell.  Remember, too, that there’s no assurance that the price you get in selling an ETF in times of distress will come close to net asset value.  Like any stock, your price will depend on where buyers are willing to make a bid.

what to buy instead?

From me, the answer should come as no surprise–stocks.