Complex Made Simple

Gold, is it over priced?

If we look at the past price history of gold it looks like it is on an exponential curve. Every time we think gold has plateaued it simply continues its march upwards, with gold futures reaching new highs in recent weeks, topping out at $1816.60 on the 9th August. The underlying principle behind gold prices was thought to be a simple demand-and-supply equation with supply limited only by total unmined reserves.

By Chris Tedder

Forex.com

The problem with this argument is that most of the world’s gold sits in bank vaults, contracting supply even further. So this would lead us to think that a price bubble may be forming. Yet, in these turbulent times gold has taken on a not-so-new role by becoming the ‘ultimate’ safe haven and the quintessential hedge against risk and inflation. Additionally, investors do not run the risk of central banks intervening and manipulating the price.

Keep in mind that we have still seen traditional safe haven currencies like the Swiss Franc rise against other currencies during the recent market turmoil. It seems that investors will cling to any perceived safety net when viable alternatives are scarce. But gold is standing out as the ultimate harbour in a storm. This perception has become even more prominent in recent months with fear fuelling gold prices, whilst investors are focused on Europe’s sovereign debt problems and the US’ apparently unsustainable debt levels.

Without this perception, gold does not really look like an attractive investment. It has no earnings, pays no dividends and has little economic use. Furthermore, its price does not always conform to the laws of supply and demand. This combination of factors could drive investors to cash generating assets in a more ‘predictable’ market.

1980s Gold revaluation

During the early 1980’s gold was a victim of overvaluation, which subsequently saw the price half in two years. A common argument amongst gold sceptics is that this could happen again with parallels easily drawn between the state of the markets then and now. We could see a re-balancing of portfolios out of gold into other assets. Evidence of this can already been seen with some very savvy investors significantly reducing their stakes in gold, including George Soros and Eric Mindich.

So, will gold be a victim of its own success? In other words, does gold right now represent a bubble that is going to burst? We can certainly hear a few warning bells in the distance, with some significant players shorting gold.

Yet, they are insignificant when positioned against the current market environment, represented by fear and a flood to safe havens. Additionally, central banks from Thailand, South Korea, Kazakhstan, Mexico and Russia are also significantly increasing their gold holdings (a total of 198 tons of gold was bought by central banks during the year) in an attempt to act as a hedge against depreciating foreign-currency reserves. This resulted in a buying spree amongst institutional and retail investors; which, some might argue, could be expanding the hypothetical bubble.

However, the fact remains that the general perception is that gold will continue to rise in the short term. According to Bloomberg, about 60% of clients surveyed by UBS remain bullish on gold, with a target price above $1,800 before the end of the year. Gold has proven that is it unnaturally resilient to factors attempting to halt its rise. This was evident when the CME increased margin requirements for gold futures contracts by 22% on 11th August, resulting in only a marginal decline in the price of gold futures.

But he question remains: What will happen when markets rebound, will gold be set for a catastrophic fall or will this record run continue? If the markets do calm then we would expect to see a retracement in the gold price. However, it is not as clear cut since gold is not a pure risk/ risk off bet and historically gold also rises during bull markets.

So the future trajectory for the gold price is uncertain. Yet, in the short-to-medium term, the markets are still in harm’s way, there is still significant concern over the global growth outlook, especially with no workable solution to the current issues plaguing Europe and the US. Given this concern and gold’s safe haven status, it may be premature to short the yellow metal while markets remain plagued by uncertainty.