Gold: the rise of the anti-asset

Like the phoenix, gold has risen from its ashes where it was buried for most of the 1980s and 1990s. Since January 2000 it has provided an astonishing 13% return per year in US dollar terms according to the UBS investor’s guide 12 October 2007 edition. On Monday 1 October 2007 gold reached USD 747.20 per ounce. This was the latest high in a rally which has lasted for over seven years and given those who invested in gold back in January 2000 an average return of 13% per year in dollar terms.

There are at least three good reasons that might explain why gold has started to perform again: fundamentals (supply and demand mismatches); inflation and other fears; and finally, a bubble.

 

Fundamentals

Almost all commodities have experienced a revival since 2000. The explanation for this new interest in the oldest of all asset classes is obvious: large emerging markets like China and India have started to catch up with developed countries. They are growing at a fast pace and are in the middle of industrialization and urbanization.

The 13% annual return on gold, while honourable, has been dwarfed by that of other commodities such as nickel (18%), copper (21%) or (the alchemists’ revenge) lead (28%). In fact, the return on gold has been lower than that of the overall commodity market as measured by the UBS Bloomberg constant maturity commodity index (16%).

This is because the industrial use for gold is thin compared to other metals, despite an increased demand for gold as a component in electronics.

The emerging market catch-up theme can only be used to explain the rise in gold if one can argue that demand for gold as a consumption good will increase in line with the additional wealth and income these countries may enjoy over the next few years. However, this type of relationship could not be empirically proven in recent years. Demand for jewelry and, to a larger extent, consumption (e.g. hoarding of gold coins and bars) has remained fairly stagnant.

 

Inflation and other fears

Gold usually performs well when there is uncertainty or even fear about the future.

In the past, geopolitical tensions have often boosted gold as a ‘safe-haven’ asset. Moreover, gold has the reputation of not losing purchasing power when inflation pressures or inflation expectations increase. It is also known for not losing purchasing power over the long run.

Gold appreciation during the last seven years can partly be explained by geopolitical fears. After a decade of relative calm following the end of the cold war, the general sentiment of geopolitical insecurity has increased due to 9/11 and the subsequent wars in Afghanistan and Iraq. But the main argument gold investors would use to explain their preference for this asset is the fear of accelerating inflation or even a period of stagflation.

 

Far from being a bubble yet

According to the late US economist and bubble expert Charles Kindleberger, “a bubble is characterized by any deviation in the price of an asset that cannot be explained in terms of ‘fundamentals’ and an upward price movement over an extended period of fifteen to forty months that then explodes.” The problem with this definition is that we only know we were in a bubble once it has burst.

Nevertheless, to shed more light on a possible bubble we asked UBS WMR’s chief technical analyst Peter Lee to compare the trend in the gold price over the last several years with what occurred in 1976-1980, which in retrospect can clearly be defined as a bubble.

From the August 1976 low to the January 1980 high, that rally produced gains of +764% in a relatively short period (nearly 3.3 years). In hindsight, an important technical signal warned investors of an impending major top in gold. At the peak of the cycle (January 1980) gold traded 238% above its 30-month moving average. This suggested widespread speculation and an unsustainable rally.

There appear to be noticeable differences between today’s gold rally and the earlier one, note UBS analysts. First, the magnitude of today’s rally (+196%) is considerably lower. Second, the duration is already twice as long as the earlier rally. Third, consolidation phases are occurring more frequently today than in the past; this may help to alleviate overbought or speculative conditions. Gold is now trading 27% above its 30-month moving average, which suggests that gold is moderately extended but not yet at a speculative level warning of a major top.

 

Should we buy gold?

None of the reasons mentioned above is truly convincing on its own, but put

together all three make the case that there is still some appreciation potential in the yellow metal. This holds true especially against the US dollar, which still seems at risk. Technically speaking, USD 830 and even USD 873-883 do not seem far-fetched potential price targets. On average, gold price should stay significantly above USD 700 in 2008, after an average USD 670 year-to-date.

That said, UBS analysts would not recommend buying gold alone. From a pure risk/return perspective, a broadly diversified commodity basket would certainly be more rewarding than just investing in gold. Despite all the myth and aura surrounding the “barbarous relict,” as John Maynard Keynes called gold, it remains a commodity, and not necessarily the most useful of them.