The price of gold is simply moved by a combination of demand, supply and investor behavior. That seems simple enough, yet the way those factors work together is sometimes counter-intuitive. For instance, many investors think of gold as a tool to save their money against inflation, ‘cos as paper money loses value gold on the other hand, increases in value or at worst remains constant.
Correlation to Inflation
During times of economic crisis, investors flock to gold. In their paper, titled The Golden Dilemma, Erb and Harvey note that gold has positive price elasticity. That essentially means that, as more people buy gold, the price goes up, in line with demand. It also means there isn’t any underlying ‘fundamental’ to the price of gold. If investors start flocking to gold, the price rises no matter what the monetary policy might be. That doesn’t mean that this is completely random or the result of herd behavior. There are forces that affect the supply of gold in the wider market – and gold is a worldwide commodity market, like every other commodity.
Almost all the gold ever mined is still around. There is some industrial use for gold, but that hasn’t increased demand as much as jewelry or investment. The World Gold Council’s 2017 figures show that total demand was 4,071 tons, with only 332.8 tons going to the tech sector. The rest was investment, at 371.4 tons, jewelry, at 2,135.5 tons, bar and coin demand of 1,029.2 tons, and ETFs et al, at 202.8 tons. Back in 2001, when gold prices were nearing all-time lows, jewelry accounted for 3,009 tons, while investment was at 357 tons, and tech required 363 tons of gold.
If anything, one would expect the price of gold to drop over time, since there is more and more of it around. So, why doesn’t it? Aside from the number of people who might want to buy it constantly on the rise, the jewelry and investment demand offer some clues. As Peter Hug, director of global trading at Kitco, said, “It ends up in a drawer someplace.” The jewelry is effectively taken off the market for years at a time.
Gold acts as a store of value, the people who buy it don’t regularly trade it. Jewelry demand tends to rise and fall with the price of gold. When prices are high, the demand for jewelry falls relative to investors demand.
Hug says the big market movers are often central banks. In times when foreign exchange reserves are large, and the economy is humming along, a central bank will actually want to reduce the amount of gold it holds. That’s because gold is a dead asset – unlike bonds, or even money in a deposit account, it generates no return.
Central banks have since tried to manage their gold sales in a cartel-like fashion, to avoid disrupting the market too much.
Besides central banks, exchange traded funds (ETFs) which allow investors to buy into gold without buying mining stocks – are now major gold buyers and sellers. Both offer shares in bullion, and measure their holdings in ounces of gold.
Speaking of portfolios, Hug said a good question for investors is what the rationale for buying gold is. As a hedge against inflation, it doesn’t work well, but seen as a piece of a portfolio, it’s a reasonable diversifier.
It’s also worth noting that the ‘rules’ of portfolio management apply to gold as well. The total number of gold ounces one holds should fluctuate with the price. If one wants 2% of the portfolio in gold, then it’s necessary to sell when the price goes up and buy when it falls.
One good thing about gold: it does retain value. Erb and Harvey compared the salary of Roman soldiers 2,000 years ago to what a modern soldier would get, based on how much those salaries would be in gold. Roman soldiers were paid 2.31 ounces of gold per year, while centurions got 35.58 ounces.
Assuming $1,600 per ounce, a Roman soldier got the equivalent of $3,704 per year, while a U.S. Army private in 2011 got $17,611. So a U.S. Army private gets about 11 ounces of gold (at current prices). That’s an investment growth rate of about 0.08% over approximately 2,000 years.
A centurion (roughly equivalent to a captain) got $61,730 per year, while a U.S. army captain gets $44,543 – 27.84 ounces at the $1,600 price, or 37.11 ounces at $1,200. The rate of return is –0.02% per annum – essentially zero.
The conclusion Erb and Harvey have arrived at is that the purchasing power of gold has stayed quite constant and largely unrelated to the current price.
If you’re looking at gold prices, it’s probably a good idea to look at how well the economies of the country is doing. As economic conditions worsen, the price will (usually) rise. Gold is a commodity that isn’t tied to anything else; in small doses, it makes a good diversifying element for an investment portfolio.