June 26, 2015
In 1971, the US government decided to unilaterally suspend the convertibility of the US dollar into Gold, opening a totally new monetary era where the value of money became purely based on faith. Whether this was a mistake or not remains to be seen, but since then, Gold has not behaved like a currency, being rather perceived as a store of value or an investment opportunity- although some money managers would dispute the very notion that Gold qualifies as an investment. This is because Gold is not very useful in any industrial or chemical process and offers no yield to its owner. Warren Buffett puts it quite clearly:
“You could take all the gold that’s ever been mined, and it would fill a cube 67 feet in each direction. For what it’s worth at current gold prices, you could buy — not some — all of the farmland in the United States. Plus, you could buy 10 Exxon Mobils, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?”
While the above is factually correct, it is also true that Gold has performed well (+10.4% per annum over the last 15 years) and that Gold is widespread as an investment. However, the basis for successful investments is to understand the conditions under which they work.
The financial conventional wisdom holds Gold as a good inflation hedge and a decent enough store of value. On paper, this makes sense, because Gold is a real asset. It is also largely inert, which means that it does not decay. Therefore, all other things being equal, the real price of Gold should be stable over time.
The empirical evidences however, directly contradict this proposition. The figure 1 below shows the impact of inflation over the price of Gold over four different time windows: 5, 10, 20, and 40 years. In none of these four periods has inflation explained more than 5.2% of the movement in Gold prices.
Figure 1: Impact of monthly change in OECD G7 inflation over the price of Gold.
Further, Gold cannot be considered a good store of value. This is because in the last 40 years, the price of Gold has changed over a year by an average of 19.3%. Its maximum peak-to-through loss has reached 61.6% (sept-99). In our view, such volatility disqualifies Gold as an appropriate store of value.
In the soon-to-be-published second part of this blogpost, we will discuss what, in our view, are possible drivers of the price of gold.