The spring is in the air but the investors are still waiting for the green shoots to sprout. The global economic outlook remains weak despite of collective efforts in stimulus policies by the governments around the world. Meanwhile, the Fed’s quantitative easing measures along with rising budget deficit in the U.S. induce the skepticism in investors and consequentially, raise the inflation expectation in the market. In the backdrop of the weak US dollar and rising inflation expectation, investors turn to gold for the hedge and push gold price to the record high. The precious metal funds also experience significant fund inflows. The late commodity research released by Goldman Sachs and Morgan Stanley were bullish and predicted the gold price would reach 1,000 dollar an ounce by the end of this year. There are ample researches on the benefits of gold investment. Yet, little has been said about the risk of gold investment in short term. We intend to explore this with its given demand and price volatility.
Demand Story:
A Hedge Against Dollar and Inflation Prop Up Price of Gold in the LONG Run
The demand for gold has shifted from jewelry sales to investment over the past year by a huge margin. According to the World Gold Council, the demand for jewelry sales has slowed down while investment demand picked up exponentially last year. The statistics also attest to the enthusiasm toward gold investment. The inflows to gold futures and exchange traded products (ETPs) in the month of January and February of 2009 have outstripped that of the entire year of 2008. There are two main forces that drive the demand for gold as investment.
First and for the most, inflation hedge takes central stage.
Global inflation appears to be inevitable as the most common prescription for recession nowadays is to print money and the export-oriented economies actively engage with competitive currency depreciation with trade protectionism looming large on the horizon. Whether it serves the purpose or not, gold has become everyone’s favorite asset to hedge against inflation. As investment demand for gold grows, the world’s largest gold exchange traded fund, SPDR Gold Shares (GLD), has become the sixth largest gold holder, followed by Switzerland’s central bank in the month of March, 2009. As SPDR Gold Shares (GLD) also holds gold bullion directly, not only does its price move closely in line with the price of the actual commodity but also does it affect the price of the gold with its increase in bullion holding.
Secondly, central banks’ growing demand for gold reserve.
U.S. dollar remains the world’s dominant reserve currency but it has lost its luster lately. Meanwhile, we have seen more and more central banks diversify from the dollar by increasing their bullion holdings. It is lubricious to suggest a return of Gold Standard era but it attests to the fact that gold has become central banks’ favorite hedge against the weak dollar. The price of god is, therefore, buffeted by the disciplines of central banks in the long run. The CBGA (Central Bank Gold Agreement) signed by the 16 central banks, capitulates that the gold sales are decided through a concerted program over a period of five years. Their last agreement was signed in September of 2004 and specified that annual sales would not exceed 500 tons and total sales over this period would not exceed 2,500 tons. As of March 15th, these central banks only sold 80 tons of gold as of March 15, 2009 according to the data released by the World Gold Council.
Gold’s inverse relationship to the dollar has been anchored in the past decade. The price of gold and the value of the U.S. dollar tended to move reliably in opposite directions. But such a norm was challenged when risk aversion pushed up the price of gold and the value of dollar congruently earlier this year. As investment demand for gold continues to grow momentums in conjectures of falling value of dollar, institutional and retail investors alike seek safe haven in gold. Peter Munk, founder and CEO of Barrick Gold, the world's largest gold miner, set no limits on gold price. He contended that few factors can shake up the gold market, for example the gold price could reach $2,000 an once if few central banks have decided to diversify away from the dollar and invest in gold.
The Volatile Rally: Risk of Gold Investment in Short Term
Gold has outperformed other commodities by a huge margin lately. But we have also seen the volatility overshoot for this supposedly, relatively safe asset. Right after the demise of Lehman Brothers, the market expected the price of gold to stage a rally as the risk aversion shooting through the roof in October of 2008. Instead, we saw the gold price took a nosedive because the large gold sales by hedge funds to meet their redemption requests. The price of gold plummeted below $700 an ounce then. It surged to $1000 an ounce in the month of February before losing falling back to $930. Within sixth month, the price range goes as far as 40%. It shows gold’s price volatility during this rally.
When looking into the S&P GSCI Gold Index Spot for the past 40 years, it shows the price of gold appeared to be less volatile since 2005. Over decades, the price of gold remained relatively steady except for the year of 1980 when the energy crisis of 1979 trigged risk aversion and pushed up the index to hit a record high of 409.87 points. Although the index continued to climb over the years, the level of downside correction has also significantly increased since 2005. For example, the correction level is over 20% from its year to date performance. It reached its highest point this year at 583.49 on February 20th and lowest point at 471 on January 15th.
S&P GSCI Gold Index Spot : from 1969 to 2009 
Gold ETFs vs. Precious Metal Equity Funds
Although the performance of precious metal equity funds is correlated to the price of gold, the correlation level varies due to the difference in underlying assets. While some of precious metal equity funds may own gold outright, most portfolios concentrate on gold-mining equities and may have significant exposure to base metal mining equities as well. Some mutual fund investors may expect to capitalize the gold price rally by investing in precious metal equity funds but the truth of the matter is that the performance of precious metal equity funds does not correspond to the price of gold the way Gold ETFs do. And some precious metal equity funds may exhibit more volatility than the gold ETFs. We compare the performance of S&P GSCI Gold Spot Index with that of the SPDR Gold Shares and with that of the category average of precious metal equity funds in the past three years. The performance of the world’s largest gold ETF aligns with the index’s performance while the precious metal equity funds show the signs of decoupling from time to time. For example, the SPDR Gold Shares and S&P GSCI Gold Spot were down 5.91% last year while the precious metal equity funds were down 31.74%. The equity funds’ underperformance attribute to Barrick and Kinross Gold Corporation’s plummeting stock prices; both of them are frequently seen in the top 5 holdings among precious metal equity funds. Three year standard deviation of precious metal equity funds in average also shows glaring difference. Generally speaking, the precious metal equity funds experience more downside volatility than Gold ETFs.
| Name | Return (%, USD) | 3Year SD | ||
| YTD | 1 Year | 3 Year | ||
| SPDR Gold Shares | 6.87 | -5.54 | 70.89 | 20.45 |
| S&P GSCI Gold Spot Index | 4.74 | -5.91 | 64.25 | 21.73 |
| *Precious Metal Equity Funds (category average) | 2.27 | -31.74 | 20.45 | 36.31 |
| Barrick Gold Corporation | -21.48 | -42.3 | 13.63 | 45.81 |
| Kinross Gold Corporation | -15.74 | -39.17 | 69.6 | 55.65 |
The price of gold has reached its historical high. Price correction may occur in the near term. In addition, market sentiment dedicates the gold price ever since the invest demand for gold has outstripped the traditional demand in jewelry sales. All these reasons make us remain cautious toward the outlook of gold price in foreseeable future. Having said that, we do perceive the rising inflation expectations and falling value of dollar can buffet the gold price in the long run. One should evaluate his/her risk appetite along with financial goals before including it to one’s portfolio.
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