• OCTOBER 13, 2010

Golden Truth: Up, up but not (yet) away

As I walked down Nariman Point one evening, I was quite surprised at the street fair that this financial hub of Mumbai turns into after sunset - horse rides, joy rides, junk food, and yes - bubbles. While a kid pesters his mother for a bottle of bubble water, I can't help but wonder how different a "Bubble" means to the vendors here, as compared to what it means to the corporate crowd that occupies the surrounding buildings. The vendor who hawks soapy water in plastic bottles sees small transparent spheres that simply go up, up and away; while the analyst whose pulse rates are in tandem with the Index movement, sees the threat of a crisis.

Well, you would agree that the asset most speculated of being in a bubble state is gold, since its decade long bull run remains quite misunderstood.

All Rise

Before you ask - Is Gold a Bubble? - Maybe you should understand the reason behind its price rise.

As the only currency whose supply is highly constrained gold is rightly increasing in nominal value, since it is simply adjusting to the changes in global monetary conditions.

How this happens is; when a central bank increases its money supply, other currencies including gold adjust upwards. Currently, with most currencies, this process of price adjustment is muted because most of the players have been in a race to devaluation. For instance, in 2008, the US monetary base increased by more than 100%, but the Euro-Dollar exchange rate did not double in value during the adjustment process because the European Central Bank was also printing money in tandem.

In such an environment, where economies are set to devalue their currencies by increasingly printing more of it, gold as the only supply constrained currency has to adjust to such monetary expansion almost entirely through price. To add to that the growth in supply of gold has been negligible over the past few years.

Frankly, I do not understand why people are startled to see the price of gold up by 68% during a period when the Fed's balance sheet grew by 155%?

Chart: Increase in Fed balance sheet and Gold
Source: Bloomberg

It's not only the US

The US is not alone in embarking on an expansionary policy; there are other nations too who are in the same league.

Source: World Gold Council

This chart should show you the alarming rate at which aggregate money supply has been increasing. Recently these increases have been to a greater extent, causing gold to adjust to this increase by rising in nominal value.

The World Gold Council has a study which suggests that a 1% change in growth of US money supply six months prior, on an average has an impact of 0.9% on the price of gold. It also concludes that a 1% change in money supply in India and Europe six months prior, affects the price of gold by 0.7% and 0.5%, respectively.

Nations have embarked on monetary expansions to stimulate their laden economies. And in tandem, gold too is moving higher in response to increasing supply of other currencies. Its price is simply adjusting upwards.

In fact, given the current price levels, I would go to the extent of saying that, at the most, there is a possibility of gold being fairly priced. But yet the current price of gold is not yet close to fully discounting the adverse future effects of the current fiscal policies in practice. Gold might most probably continue to look bullish on a medium to long term basis.

Let me share a simple thumb rule to know where gold prices are headed - just keep a watch on how much new money (created out of thin air a.k.a freely printed without any backing) comes into existence.

A preview of Historical bubbles

Over the last several years, most of the bull markets continued moving higher despite reaching fair valuations.

As seen in the above chart, the gold's current bull market looks tiny as compared to other bubbles and even to the gold price increases that we saw in the 1980s.

Back to blowing bubbles

Speculators may be disappointed, because the bull market in gold is still intact. It's nowhere close to becoming a speculative bubble. Rather, the price increases are fundamentally supported. No! That does not mean that prices will not fall. Corrections and consolidations have been part of the current bull run, and may continue to be so. As investors, these small dips in the steep gold run, should give you opportunities to add more gold to your portfolio.

And so before I return to routine, maybe I will spend some time watching the vendor blow bubbles in the air, no golden ones though, just transparent shimmering spheres of joy.

Chirag Mehta is Fund Manager, Commodities for Quantum Mutual Fund and manages the Quantum Gold Fund ETF and the Quantum Gold Savings Fund among others.


The views expressed in this Article are the personal views of the author Chirag Mehta and not views of Quantum Asset Management Company Private Limited(AMC), Quantum Trustee Company Private Limited (Trustee) and Quantum Mutual Fund (Fund). The AMC, Trustee and the Fund may or may not have the same view and DO not endorse this view.