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!
More Views on News
Sorry! There are no related views on news for this company/sector.
Aug 10, 2017
Don't miss these proxy bets on growing companies or in a few years you will be looking back with regret.
Aug 10, 2017
Bill connects the dots...between money and growth, real money and real resources, gold and cryptocurrencies...and between gold, cryptocurrencies, and time.
Aug 12, 2017
The India VIX is up 36% in the last week. Fear has gone up but is still low by historical standards.
Aug 10, 2017
Bitcoin hits an all-time high, is there more upside left?
Aug 16, 2017
Ensure your financial Independence, and pledge to start the journey towards financial freedom today!