If you pay attention to the infomercials played on financial news channels, watch the banner ads on websites or listen to certain well known hedge fund managers, you might think the answer is yes. But before you start filling your vault, you might want to consider the nature of Gold as an investment.

The first thing to look at is supply and demand.

There are two sources of supply for gold: existing holders and gold miners. Gold is a unique commodity because almost all of the gold ever mined is still in existence (estimated at 161,000 tons). Gold is hard to consume and easy to recycle and refine into different grades and alloys. As such, nearly all of the gold in existence is potentially for sale. Adding to that supply are the gold miners. Every year, approximately 2500 tons are mined (although that number can vary dramatically given high extraction costs).

There are three sources of demand for gold: jewelry, industrial uses and investment. India is often cited as the biggest consumer of gold at around 25% of an average global demand of 3,200 tons. This number inflated to 3,800 tons in 2008 and fell back to a still high 3,400 tons in 2009, as a result of increased demand for Gold ETFs, the largest of which is GLD. In addition to its traditional usage as “hard money” and jewelry, gold is an industrial metal due to its electrical, chemical and optical properties. However, demand for gold as jewelry and as an industrial metal is highly price elastic.

So, we have a commodity where the potential supply is over 40 times the size of even inflated annual demand. What makes it a good investment? Not inflation. Despite the chestnut of a well tailored suit always costing the equivalent of an ounce of gold, the price of gold has fluctuated wildly in the past 40 years. As an asset which produces no income (and in fact costs money to store), gold is actually a pricy store of wealth rather than a productive investment.

So when should you buy gold in your portfolio? Of course, whenever you will be able to sell it for much more in the not too distant future. How likely is gold to rise from current levels? Will we see the yellow metal double to US$2,200-2,400 an ounce in the next few years? Probably not.

We should not let our recent experience of the Global Financial Crisis (which hasn’t ended) color our perception. While it is true that the price of gold has doubled during the GFC (from US$600 to a recent peak of US$1,200), it is also true that the price of gold doubled from just under $260 in early 2001 to an average of $600 in 2006.

The first doubling was driven by new demand from India and China as both countries saw big gains in middle class wealth and income. Over the past decade, economic reforms in those countries have created several hundred million new potential buyers of gold. At the same time, there was a lag in new gold production as most miners have extraction costs in excess of US$300 per ounce.

The second doubling was driven primarily by investment flows as investors looked for return of capital instead of return on capital (hence the near zero interest rates on short term US treasury paper). Gold has been a store of wealth for at least 5,000 years and has often served as the backing of government issued currency. Now that governments have charged in with taxpayer commitments to bail out the financial system, investors have already reverted to a search for returns (as evidenced by the strong showing of high yield assets).

But how likely are either of these circumstances (or another gold doubling catalyst) to occur in the next three to five years?

With no new India or China on the horizon and the worst bits of the Global Financial Crisis exposed for all to see, gold bugs are falling back on the inflation argument. However, with the velocity of US dollars collapsing from just over 2.12x to the long term mean of 1.67x (via John Mauldin), industrial spare capacity around 30% and unemployment well over 10%, there are two problems with that argument. First, we may not see all that much inflation (although as we have noted in the past, hyperinflation and currency debasement is not impossible in weak economic times). And second, gold has not always served as a good inflation hedge.

So that brings us back to the beginning. Why are the Soros’ and Paulson’s of the world signaling their big positions in gold ETFs (through 13-F statements)? At this point it might help to remember the “peak oil” call in the middle of 2008 when oil touched US$140 a barrel. Goldman Sachs analysts, amongst many other “smart money” players, were calling for Crude Oil to rise to over $200 while placing bets in the other direction. That “peak oil” story ended a few months later with the price of oil just below US$40. Even though prices have since recovered to US$80, listening to “smart money” at the time would still have made for a disastrous trade.

Fast forward to today’s gold trade and perhaps the “smart money” investors, having executed on the first half of their strategy (Buy Low), are looking to execute the second part of their strategy (Sell High). Unless you have very good reasons for helping these investors liquidate their trade, nothing we see on the economic landscape or within our models suggests that you should be buying gold at this point.


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