The Enigma of Gold
Since we established Parkview in 2011, we have often debated whether we should include gold in our standard asset allocation. We have not done so. I have always taken the view that because gold is an asset that does not generate a return, it is not possible to value it with any degree of consistency. Nonetheless, we recognise that gold has a special place in the imagination of some investors. For investors who have a very strong conviction for such an allocation, we have accommodated their requests.
We are not alone in pondering this question. A casual look at databases of academic journals will find a flood of articles arguing the case for gold in investment portfolios. You don’t find this question addressed in the same way for equities or bonds. Everyone takes it for granted that equities and bonds are investments, and research is focused on articulating the best ways of investing in them. The fact that there is a lot of research about whether gold belongs in an investment portfolio is ipso facto evidence that the answer is not clear cut.
In this note, I will share my thoughts on several questions. How can one value gold? What are the market dynamics for gold? Is there an objective case for allocating to gold? Why has gold rallied over the past year? What do we recommend investors do with their gold allocations? Why does gold attract so much attention?
What’s gold worth?
An investment is an allocation of money with the expectation of generating an income, a profit or appreciation in value over time. As gold is an asset that does not generate an income, it doesn’t meet the first definition. Unless there is an unusual arbitrage opportunity between markets, making a profit by trading gold—a highly liquid commodity—is also difficult for most investors. Thus, from the strict definition of what an investment is, the main reason to invest in gold – on a standalone basis- is the expectation that the price will go up. To take a view on the direction of the price of gold, one needs to have some way to value it.
When investing in bonds or equities, there is general agreement that valuation involves discounting future cash flows. People can disagree about the assumptions underlying the methodology, such as the discount rate or the growth rate. In the case of gold, however, there is no consensus on the right methodology to consider valuing the asset. Therefore, gold does not have a universally accepted “fair value”. There are four commonly used methodologies.
First, some people use the ratio of the price of gold to some other asset. I have seen gold valued in relation to silver and to oil. Why there should be a fixed ratio between two unrelated commodities requires some logical acrobatics. But it works for some people.
The second methodology often used is that of the opportunity cost. If interest rates are low, then the opportunity cost of holding an asset that has no yield is low. Gold becomes more attractive. The reverse is true. This has very intuitive appeal. It helps explain the direction of gold prices some of the time. But it does not help determine if the current price is fair, low or too high.
A third methodology is to use tail-risk valuation. This really applies to institutional investors and is simply saying that it’s a subjective valuation based on whatever the investor is willing to pay for protection against a rare but severe market event.
The fourth methodology is to look at supply and demand dynamics. The supply dynamics of gold mining are well understood. The supply dynamics from investors who are selling, and demand from those who are buying is a complicated story.
Why do people buy gold?
There are three broad sources of demand for gold. The stock of the world’s gold is currently estimated to be distributed as follows: Jewellery and fabrication uses (60%), private investments (22%) and official central bank reserves (17%). Each of these categories has its own independent demand dynamics.
Jewellery and other fabrication uses
Gold jewellery is purchased for its aesthetic value in most advanced economies. However, most of the demand for gold for this purpose comes from other regions. Europe and North America represent 10% of global demand, equivalent to that of the Middle East. India and China represent 65% of global demand. Demand dynamics in these regions are much more complex, and it is not all about aesthetics.
In economies where the government or banks can’t be trusted, gold is useful. I have firsthand personal experience with this. Growing up I recall our housekeeper, a Kurdish migrant, wore about 15 thick gold bangles. These were her family’s life savings. There was never a question for her to think about trusting a Baathist-state bank in northern Iraq with the savings from her hard work.
India has historically been the country which consumes the most gold. Gold demand there is possibly better studied than anywhere else. Indian culture has traditionally valued gold, but studies of consumer behaviour show a very complex web of factors driving demand. The future price of gold is one driver. However, its use by the tax averse is very significant, along with its perception of safety. None of this is surprising in a country where access to banking in rural areas is dominated by a few badly managed state-owned banks. I have a haunting memory of an emaciated young girl, perhaps 14, begging at a Mumbai traffic light. She was wearing what appeared to be a single stud gold earring.
In the past decade, China has surpassed India as the world’s largest consumer of gold. Why did it take China so long to surpass India, despite having much higher per capita income? It’s interesting that gold consumption accelerated as China’s economic horizons got cloudier.
Gold has an aesthetic value. It also has a social status signalling value. But wearing gold jewellery is not some atavistic echo of walking about in a Gucci logo plastered track suit. In most of the world, I would argue that gold demand can be as much a function of economic insecurity as economic success. From this perspective, global economic prosperity may raise or lower the demand of gold.
Central Bank Reserves
Writing the Tract on Monetary Reform in 1924, Keynes dismissed gold as a “barbarous relic”. He was prescient. While gold was resurrected as a monetary anchor after the WWII, it did not last. In the 1960s, half of the world’s gold was owned by central banks. Today it is about 17%.
Why do central banks hold gold? There was a period in the late 90s and early 2000s when many major central banks started selling their gold reserves. The reason was simple: why hold an asset that earns zero returns? Central banks tend to hold gold at historical prices because introducing gold's price volatility into their balance sheets would be problematic. By selling gold, they could recognise a profit from book value and invest the proceeds in interest-bearing foreign bonds.
In recent years, central banks in some emerging markets have started buying gold. This started in 2009, after the global financial crisis, and was followed by a jump in the aftermath of Russia’s invasion of Ukraine. To a significant degree this is political. Diversification away from the dollar started by some countries that have seen an increase in political tensions with the US. Russia started selling dollars for gold and other assets in the aftermath of the invasion of Crimea. China accelerated gold purchases after the coordinated freeze of Russian central bank assets by the US and Europe.
Central banks in advanced economies have notably not added to their gold reserves. Studies of central bank reserve managers have shown that the main reason for buying gold is the perceived value as diversification at times of economic stress, and importantly the risk of financial sanctions.
Gold as an investment
Commonly cited reasons for investing in gold tend to revolve around two distinct arguments. First, there is a widespread perception that gold is a store of value. It is argued that gold offers a hedge against inflation and protection against a declining currency. Second, that gold can be a useful hedge against extreme events, and because gold’s correlation to other assets is low, it offers useful diversification benefits in a portfolio.
There is a logical fallacy, in my view, in arguing that gold as a store of value makes it an investment. Investing is about generating a return, not about “storing” anything. The most common chart that gold enthusiasts like to share is to show how the price of gold has gone up over decades in USD terms. Indeed, it has, but this is comparing gold to holding physical cash. Holding cash is what you do when you don’t invest: it’s the anti-investment. When you compare gold to either bonds or equities over long periods of time you will find that gold lags. More importantly, for something to be a good store of value, it needs to exhibit some stability. The gold price can often be as volatile as the stock market.
The question of whether gold offers a hedge against inflation is more debatable. There are times when the gold price did indeed offer protection against inflation. Interestingly, during the most recent bout of inflation it didn’t do that. The gold price fell by 4.17% in 2021 when inflation jumped from 1.4% to 7%. It fell by another 0.77% in 2022, a year in which inflation remained above 6%.
Whether gold offers protection against a depreciating currency depends on one’s point of view. Gold fell in 2021 in USD terms, but it rose slightly if your reference is the Swiss franc. It was hugely profitable to hold gold if your reference is the Turkish Lira. From this perspective, it is not obvious why someone concerned about their own currency would find better protection with gold than a foreign currency. The exceptions to this, of course, are extreme situations. A friend’s mother recounts how her father escaped the Bolshevik revolution and made his way to Quebec with whatever gold coins and diamonds he could get his hands on hemmed into the lining of his overcoat. Today, for a Russian concerned about the economic implications of the invasion of Ukraine, it might make a lot of sense to buy some gold.
Gold’s properties as a hedge in extreme situations and a diversifier in portfolios offer some of the more robust reasons for including it in a portfolio. The idea here is simple. Because gold demand dynamics are different from other assets, its price movements can be uncorrelated with other assets. This makes it a good diversifier because it can help reduce overall portfolio volatility. This idea is very appealing. But there are some caveats. The benefits depend on the markets in question, as well as the type of assets in the portfolio.
Gold offers better diversification for portfolios that are heavy with equities than portfolios that have large, fixed income allocations. This is because there are times when bonds and gold are highly correlated. If interest rates fall, the opportunity cost of holding gold diminishes. In such a scenario, gold and bond prices can rise in unison. This also works in stress scenarios. For example, during the 2008 financial crisis, gold rose by almost 6%, protecting investors in equities. US Treasury bonds rose by 13%.
Over the long term, including gold in a portfolio of equities and bonds can lower volatility at expense of some return. Including gold can raise the “Sortino ratio”, which is the measure of return per unit of downside risk. This matters to institutional investors who look at such ratios carefully. In my personal experience, however, the resonance of these abstractive concepts with most individual investors is limited.
Whether investors experience these benefits also depends on the markets in which they are located. For example, one study of the diversification benefits of gold found that it works in Canada, Germany, Italy, the UK and the US. Interestingly, it was not found to work for Japanese or Chinese investors. Across countries, and in normal times, the degree to which gold serves a diversification role is dependent on the interest rate conditions and the shape of the yield curve.
To wit, gold offers a very particular form of portfolio protection. Whether and how it’s included in a portfolio, and how to size a position, is something that entails considerable subjectivity and personal preference.
Why has gold been rallying?
Gold is a relatively scarce commodity. It’s also expensive to mine. As a result, over short-term periods, we can assume that the physical gold market will behave as though the supply is completely fixed. When supply cannot increase to meet a jump in demand, price movements are sharp and rapid. With most of the world’s gold stock floating around in the form of jewellery and heirlooms, and a portion locked deep in the vaults of central banks, the supply of gold that is physically traded for investment purposes is very limited indeed. This only exaggerates price movements in both directions.
Looking at total global demand for gold, there has been no sharp spike recently. Final demand continues to grow at about 4500 tons per year, not far from its average over the past 10 years. This is slightly below the supply from mining and recycling. The increase in gold purchases by central banks after 2022 was counteracted by net selling of gold by ETFs. Demand for gold bars, and jewellery is steady. How can gold rally by almost 40% over the past year when the physical market is slightly oversupplied?
The answer lies in sentiment and the derivatives market. Trading in gold futures and derivatives have exceeded the value of physical trading by about 50%. There is nothing unusual when the notional derivatives exceeding the value of the underlying assets. The same is true of the oil market, where the value of derivatives routinely exceeds the value of physical supplies, sometimes by a factor of 10 to 1. The derivatives market is the preferred route for institutional investors to allocate to gold, given its liquidity and lower custody costs. Have institutional investors started prioritising Sortino ratios en masse?
There is clearly a lot of speculation going on, and there is a lot to speculate about. Speculation about whether President Trump will impose tariffs on gold imports created an unusual arbitrage opportunity between gold prices in London and New York, leading to a surge in US gold imports. More generally, the economic uncertainty engendered by tariffs, the future of NATO, and other important events lead some to think of worst-case scenarios.
There is long running scepticism in America around gold reserves. Ever since Roosevelt ordered citizens to turn over their holdings of gold coins and bullion to the government in 1933, people have speculated about what the government did with all the gold. The secrecy around the security arrangements of Fort Knox, and the fact that the last audit of gold reserves was done in 1953, provides fertile ground for conspiracy theorists. Conspiracy theories about the existence of the gold in the early 70s reached such a level that the government was compelled to allow a few journalists to visit the vaults at Fort Knox. Yet, the theory keeps coming back, like a meme. Some were spooked when Treasury Secretary Mnuchin tweeted “Glad gold is safe!” after visiting Fort Knox in 2017. It does not help confidence when President Trump and Elon Musk suggest that the gold should be audited.
How can investors think about gold today?
Speculative manias are notoriously difficult to call. In the case of gold, this is far more complicated than any other asset.
If a stock price is trading at a P/E of 100, someone can reasonably argue it is a bubble. Someone else can equally argue that earnings will grow at such a pace that the stock is good value. Based on an objective metric - the P/E - both of these opinions are equally valid and differ only because of differences in subjective underlying assumptions.
How can you reach a plausible conclusion with respect to gold? There is no framework on which people can even agree on how to value the asset, even if they agree about the underlying assumptions about the future.
Will the gold rally continue or reverse itself? This is not a question an analyst can answer with any pretence of objectivity. This leads otherwise smart analysts at venerable financial institutions to be reduced to reading chart trends as though they are Tarot cards.
The gold price reflects various fears and beliefs of individuals. None of this may be rational or remotely linked to reality, but it can be self-fulfilling. George Soros famously popularised Popper’s “Oedipus effect” as “reflexivity”: if enough people believe in something, they can change market behaviour and even reality itself. Betting against the herd is a dangerous game. Joining the herd depends on whether you think you have the instincts to exit before the turning point. If your objective is portfolio diversification, however, I would suspect that adding gold at the advanced stage of a speculative rally will not help your Sortino ratio.
A personal reflection: why does gold attract so much attention?
"And they came, both men and women... every man offering an offering of gold unto the Lord." (Exodus 35:22)
There is something visceral about gold. Humans have thought of it as a desirable asset for thousands of years. Yet this desirability is also strange. Unlike other metals, gold is too malleable to be of any industrial or functional utility.
Gold was treasured by ancient civilisations, from ancient Egyptians to the Mayas in Mexico. Gold was mentioned almost 400 times in the Old Testament. Its uses were uniformly aesthetic, symbolic or ceremonial.
Gold was never a currency until about the 6th century BCE, when it was minted in Lydia, and started to be used as a medium of exchange and store of value around the Mediterranean. There’s a notable absence of the use of gold as a currency in ancient China (where copper and bronze were used). The same is true of the ancient civilizations of the Americas.
Gold’s role as a currency was often rudely interrupted, because gold does not possess the characteristics required of a currency. Its supply is limited. Unless its supplies grow in line with all goods in the economy, it will create deflation. When a new discovery of gold supplies is found, it will create inflation. The flood of gold from the Americas into 16th century Spain triggered the inflation that became known as the “Price Revolution” throughout Western Europe.
Nonetheless people often talk wistfully of some glorified bygone era when gold was the basis of “sound money.” The reality is that there were eras of great prosperity when gold happened to be a currency. Correlation is not causation. Benjamin Disraeli summed up the Victorian era: “It is the greatest delusion in the world to attribute the commercial preponderance and prosperity of England to our having a gold standard. Our gold standard is not the cause, but the consequence of our commercial prosperity.”
So why does gold keep attracting attention? I can only speculate. There is something unique about gold. Unlike silver and copper, it does not tarnish. Unlike iron, it does not rust. Unlike diamonds, if you break it, you can still melt it back together again. Gold is indestructible, and so somehow eternal. Eternity is a powerful concept. I often wonder if there are no gold investors, only gold believers.
