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Does gold have a limit? - Outside View by Asad Dossani
 
 
Does gold have a limit?

In the last couple of months, gold has continued to make new highs. The spot price nearly closed at Rs. 20,000/10 grams earlier this month and now is trading a bit lower, but still near its all time highs. So how can we explain what's going on here?

The biggest driver of the increase in gold prices has been the US Federal Reserve talking about implementing an additional dose of quantitative easing. Effectively it means they are going to print more money, and a lot of it. As currencies get devalued, it means higher values for gold and other precious metals.

If we want to ask the question whether gold has a limit to how high it will go, we need to determine its fundamental value. Think about how we approach investing in a stock. We look at a company and make an estimate of what its future earnings will be. Then we translate that estimate into a price today, (which is its fundamental value). Finally, we compare its fundamental value to its current market price, and buy or sell the stock if there is a large difference between the two.

Let's try and do the same with gold. When you invest in gold, what kind of return should you expect? Well, most of the world's gold is stored in vaults. So it actually doesn't generate any cash flows. In fact, investment in gold is unproductive from an economic point of view. When we invest in a company, the company uses the cash to employ people and make products. Even when we put our money in a savings account, that money is lent out by banks to people who want to start their own businesses, buy a home, etc. But when we buy gold, the gold just lies there. It doesn't do anything productive.

This presents us with a problem. How do we place a value on something that doesn't generate any value itself? Are there other methods we can use to value gold? We can look at historical data this gives us an idea of how gold tends to vary with stocks, GDP, inflation etc. Then we can determine the value of gold relative to other variables based on historical data. Valuing gold through other assets is helpful, but still it does not give us a fundamental value for gold. It doesn't tell us what gold is worth if we just consider the asset on its own.

So to answer my original question as to whether gold has a limit, the clear answer is that it does not. Because of the difficulty in deriving a fundamental value for gold, it is impossible to say whether it is overvalued or undervalued at the moment. Therefore, there is no bound to how high it can go. It can go up as long as people are willing to pay higher prices for it.

Keep in mind that the limit works both ways. There may be no upper limit, but there is also no real lower limit either. This is for the same reason, that determining a fundamental value is difficult.

The conclusion from this article is that gold is likely to be a risky investment going forward. It could be one that has a very high return if gold continues to rise the way it has, or it could just as easily come crashing down.

Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!

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9 Responses to "Does gold have a limit?"

wilson

Nov 14, 2010

Mr Dassani is completely right. Gold has no limits either way. It has only sentimental value and half the population ( females) believes in Gold which takes it to the higher side. Otherwise it has no utility.

Like 

Debapriya

Nov 12, 2010

Certainly gold is not an utility. It is linked with human beings as a taboo from its discovery. This may be changed only if another taboo can overcome it.

Like 

Sharafudheen

Nov 12, 2010

Availability is one of the factors which decides the value of some of the assets. If consider land as an example, Investing on it is dead since it doesn't generate any income by its own unless it is used for some purpose, still the value of land keep flying up. The fundamental behind this raise is the demand and supply ratio. Likewise, gold is also having the same fundamental in price deciding factor.

I agree with Amitabh's comment about this article.

Like 

Kunal

Nov 7, 2010

I do not agree with the author. Even though Gold does not generate any cash flow by itself neither does Coal/Oil/Copper. But they have values based on their utility. Similarly, Gold has its own utility. Hence, we should be able to determine the right value of Gold. It is like saying, OIL if bought & kept in a barrel, does not generate cash flow, hence, we will not be able to determine the price of Oil. Similarly, Gold, its industrial utility is less but its intangible utility is very high.
I am no geek in financial analysis to myself determine the price of Gold, but certainly the above article except for the facts presented does not make sense.

Like 

ramheg

Nov 6, 2010

Gold's essential function in modern times is as a geopolitical hedge. When there are economic dislocations, gold tends to retain its value whereas all other assets generally lose value. For example in 1991, when the rupee was devalued by almost 50% overnight (from around Rs. 22 per USD to Rs. 30 per USD), the entire indian economy devalued by that much. But Gold? It retained its value by simply jumping by 50%!
-Ram

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Amitabh

Nov 6, 2010

A report , be it intelligence , business or financial should attempt to do one of 2 things .
One, it should tell how to play catch up if someone's trailing.
Two, it should tell how to maintain a lead .
Despite an attempted theoritical explanation , this report as with so many others , falls short on both counts!

Like 

omkar

Nov 4, 2010

Appreciate your thoughts.
It is just a qualitative thing! Our life, Business or whatever, everything can go ahead without GOLD, Gold is not curtial for anything (unlike oil or any other commodities).
Moment people's perception changes, everythind will be upside down.
- Omkar

Like 

JiJo

Nov 3, 2010

I do agree completely with him. I think its fundamental value can be indirectly derived based on USD valuations. So if we can predict USD movement we can derive Gold valuation

Like 

Satya

Nov 3, 2010

I agree that it is difficult to put a value on gold and therefore technicals alone end up deciding the price.

But it does have a fundamental value but extremely complex for analysts too to compute.
If it has, it should be based on the ratio of idle gold in ounces to idle money in the entire world in USD

-Satya

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