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Gold: Bubble or not? - Views on News from Equitymaster
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  • Sep 7, 2010

    Gold: Bubble or not?

    One commodity that seems to be in a permanent bull run is gold. The shiny metal has been setting new records every other day. It is a must have in any portfolio, be it that of an individual investor, an institution or even a country. The precious metal has seen some fantastic highs. And, this is irrespective of the economic situation. If the economy is euphoric, the demand increases for creating more jewellery. If the economy is in the dumps, gold is a glittering beacon of hope as a safe haven.

    But the question all of us want answered is if the price rise is a bubble, and is expected to burst soon? Or, is the price rise sustainable and based on sound long-term fundamentals.

    In our last article we mentioned certain key characteristics for a bubble. Let us now apply them to gold and see whether the commodity falls in the bubble category.

    High asset prices

    The commodity is definitely trading at high prices. In fact over the past 5 years it has risen 167%. If one were to invest right now, you would be investing at the top of the curve. But with prices rising rapidly, most investors believe that there is still room for upside. In fact according to the median in a Bloomberg survey, gold is expected to rise as high as US$ 1,500 next year, 20% more than the US$ 1,249.2 traded on 1st Sept in New York (source: Kitco). It definitely meets the bubble category on this one.

    Source: World Gold Council, Base: Jan 1998

    High demand

    Demand for the commodity is high, with everyone running after the precious metal. Demand and supply have been running almost neck and neck, according to the World Gold Council. Supply of gold is mainly through mining as well as from the sale of old gold scrap. Gold supply increases at a fairly constant rate of around 1.7% per annum (p.a.). During the last 50 years the largest annual increase was 2.1% whilst the smallest was 1.4%, according to data from gold-eagle.com. Irrespective of technological advancements, political changes etc., or even new mine discoveries, it is reasonable to assume that the total supply of gold will continue to grow at an average rate of 1.7% p.a.

    Gold demand is driven by jewellery, industrial and dental use, investment in gold bars & coins, and for exchange traded gold funds (ETFs). India and China are the main drivers of demand for jewellery. The festival season is just around the corner in India. As a result, demand is only set to go up in the coming quarter. Investment in gold has been largely driven by Europe due to economic uncertainty in the region. In 2QCY10, globally the demand for gold as an investment tool rose by 118% on a YoY basis. The biggest contributor to this rise was in the ETF segment, which saw a growth of over 4 times QoQ.

    Source: World Gold Council

    In 2QCY10 the demand for gold from an investment purpose was over 50% of total gold demand, with jewellery just accounting for 39%. This is a big contrast from 2009, where the situation was reverse. With all the news about currency debasement, and quantitative easing around, holding a 'real asset' like gold is becoming all the more important. The only direction for demand for this commodity seems to be upwards!

    Intrinsic value of the asset < than its traded price

    Gold is a precious metal. It doesn't oxidize or corrode, it is relatively scarce, and it is attractive to look at. Most importantly, it has been proven to hold its value over long periods. It has been able to maintain its purchasing power relative to other items over time. Thus, it is able to safeguard against inflation or economic uncertainty. If a country goes bust, and its currency is rendered useless, gold will still have some value attached.

    Price in a free market is determined by demand and supply. Pure gold is a natural element that needs to be mined, and cannot be artificially produced. Since, its supply will always be limited (1.7% p.a. growth), and demand is high, prices will be on the higher side.

    Low supply & High Demand = Prices rising above equilibrium

    If a similar situation took place with other commodities, e.g. crude oil, prices would soar above rational levels. However, gold differs in this aspect. A large portion of gold is not consumed (as opposed to oil). Rather it is accumulated for investment. Therefore, the entire stock of gold, which has been mined, is technically available for supply. Even 'old gold' is valued at the same as 'newly mined gold'. This is due to its near indestructible nature.

    The willingness of owners to sell accumulated gold at a particular price is dependent upon numerous economic, political and psychological concerns. The willingness of others to purchase gold for investment at a specific price is dependent upon similar considerations. With so many variables affecting its price, it is extremely difficult to determine the exact intrinsic value. But, if prices rise beyond its perceived 'intrinsic value', people who have been accumulating gold all this while will start booking profits. Thus, we believe that the metal trades close to its intrinsic value. Else people would sell and buy other commodities which have more value vs. price. And with gold demand rising, this does not seem to be the case.

    With global uncertainty, currency devaluation, political tension, etc. in the world, gold seems like a safe bet in a 'real asset'. The perceived 'intrinsic value', especially as a 'safe haven' is only set to go higher as total global recovery is still far away. Legendary investors like Jim Rogers, Marc Faber, George Soros, and central banks like the RBI, all own tons of gold. Values of currencies are all over the place, so gold definitely seems a good store of value in these uncertain times.

    Verdict: George Soros calls it the 'ultimate asset bubble. But, we feel that there is still some room before this bubble bursts. If ever.



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    1 Responses to "Gold: Bubble or not?"


    Sep 15, 2010

    In this article you are mentioning 167% return for investment in GOLD from 2004 to current date.
    But look at this link,
    mutualfundsindia.com and go to performance/compare funds
    A comparison of GOLD ETF's.
    All of these Gold ETF's are showing around 26% return for the last three years. How this works ?

    Your comments will be greatly appreciated.
    - Omkar

    Equitymaster requests your view! Post a comment on "Gold: Bubble or not?". Click here!

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