Fact and fiction about the value of gold

Those who promote gold talk of prices eclipsing US$2,000 an ounce. On the back of weak monetary policy that will devalue world currencies because there is no gold standard on which to secure paper currency. Scary stuff! But c’mon, it’s just spin to make a case for buying gold.

There is no linkage between gold bullion and paper currency. Why would anyone tie a nation’s economic growth patterns to some metal that is mined and minted for profit. That would be like tying the value of your home to say, the value of the asphalt used in your walkways. Without giving any consideration to population patterns, location, supply and demand. The world went off the gold standard 40 years ago. It was the right decision then, it is the right decision today.

In reality, gold is an asset class that typically moves, as oil does, counter cyclical to the general economy. But unlike oil, gold does not typically influence economic activity. Rather it acts as a barometer of economic activity.

As a barometer, gold can have a role. A counter cyclical asset class moving opposite the general economy, can smooth out short term fluctuations within a portfolio. But that makes it a tradable asset, not a long term hold.

In terms of what drives the price of gold, look no further than the US dollar. Gold has a low and often, negative correlation to the value of the US dollar. The US dollar rises, gold typically falls, when the US dollar is declining, gold typically rises. Making gold an excellent tool to hedge against a decline in the value of the US dollar.

That gold has gone from US$500 to US$800 in the last two years is nothing more than a US dollar story. In that sense gold is being driven by the same metrics that have supported the rise in the Canadian dollar. Metrics such as a US real estate collapse, the impact of higher oil prices on US inflation, the potential for a US consumer lead recession.

But as a hedge? Canadian investors were better off holding Canadian treasury bills than gold. Not to mention the interest earned on the T-bill strategy versus the cost of holding gold bullion.

As To The Future

Recession concerns are gaining momentum, as some analysts question whether the US Federal Reserve’s twin policy of interest rate cuts and liquidity enhancement, will work. But a recession by itself, is unlikely to spark a surge in gold. Unless, as before, it drives the US dollar significantly lower.

I doubt the latter scenario is likely. For a recession lead decline in the US dollar to occur, the recession would have to be confined to the US. I find it difficult to imagine a serious US recession not impacting the rest of the world.

On the other hand, if the US falls into a recession at a time when inflation is creeping in the back door, it sets up the possibility for stagflation. Which is to say, an economy that is slowing at the same time prices are rising. That’s a scary thought, because it is one of the hardest scenarios to overcome. And for the record, one of the best scenarios for gold.

I also do not put a lot of stock in the inflation debate. Most of those who raise this spectre, point to the inflationary outbreak that began in the 1970s and ended in the mid-1980s.

I suspect this time will be different. Not because of economic circumstances but because of the ability of corporate management to deal more effectively with price increases in the supply chain.
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The main reason inflation took hold in the 1970s was because corporate America was caught off guard. At a time when companies carried large inventories (something we do not see in today’s marketplace), unexpected price increases along the supply chain had to be passed along. Survival depended on it.

In today’s economy, competitive efficiencies like just-in-time inventory make it harder to pass costs along. Further, corporate managers, unless they have not read a newspaper or watched a financial channel for the past ten years, are keenly aware of inflationary threats. It is hard to imagine that anyone would be caught off guard.

If you buy the stagflation scenario – which is not getting a lot of play yet – the next question is how to hedge; with gold bullion or gold stocks? Historically, gold bullion has a lower – and often negative – correlation to equity markets. Gold stocks less so.

If you are looking for a tradable hedge, gold bullion is the better play. But for a derivative strategy, short-term at-the-money calls on gold stocks like say; Barrick Gold (symbol ABX, listed TSX) or Goldcorp (symbol G, listed TSX) are the better play.

But remember, this is a hedge… be ready to move in and out quickly.