Headline in the Gulf News, United Arab Emirates for August 6, 2011: "Gold vending machines multiply." If ever there was a sign of a bubble, this was it. A company called GOLD to go had placed six vending machines in luxury hotels and shopping centers to dispense gold coins and bars. Meanwhile, TV airwaves were filled with ads warning of impending economic collapse and imploring smart investors to convert their IRA accounts into gold. To contrarians, these were classic warning signs to look out below.
Exactly one month later, gold reached its all-time record high of $1,923 per ounce. The Financial Times reported that the London Bullion Market Association released a price prediction of $2,019 within a year. The publication also noted that the association's forecasts were typically overcautious.
Oops.
Gold closed Tuesday at $1,094.50 per ounce, down more than 43 percent from that lofty 2011 peak. The precipitous decline has vexed fans of the precious metal given their faith in its role as a bulwark against future inflation and global uncertainty. This misconception persists despite overwhelming evidence to the contrary. In fact, gold prices display very little systematic relation either to inflation or to international turmoil.
While it may once have been true, the evolution of a modern, highly liquid foreign exchange system of global currencies that are no longer linked to gold has negated its "safe haven" properties.
To begin with, many people overestimate the significance of gold as an asset class. Estimates of the amount in existence above ground today range from $5 to $10 trillion. That amount represents about two percent of the value of all investable assets in the world (stocks, bonds, cash and real estate).
But most of that gold is not circulating in investment portfolios. According to the World Gold Council, 63 percent of global gold production is used in jewelry, electronics and industrial production. Another 11 percent sits in the vaults of central banks and other institutions (becoming increasingly irrelevant by the day). Only one fourth of annual production finds its way into investors' portfolios. Prices, it turns out, depend much more upon the vagaries of Chinese and Indian tastes in physical adornment.
Gold has not proven to be a hedge against inflation, except over the very long run (millennia). Numerous academic studies have demonstrated nearly zero correlation between gold prices and either expected or realized inflation over significant time periods. But see for yourself.
The six-fold increase in gold prices between 2001 and 2011 occurred during one of the most stable periods in postwar history with respect to inflation. The annual price index hovered near or below 3 percent for the entire decade in question, and expectations for future inflation remained remarkably quiescent.
If indeed the shiny metal did provide a haven from rising prices, one would expect a reasonably constant ratio of gold to inflation over time. This has been far from true. The ratio of gold prices to the CPI has averaged 3.2 during the modern era. It peaked in at 8.7 in 1980 when inflation ran to 13 percent. Today, with inflation well below 2 percent, the ratio is back above 8. So much for the inflation argument.
Gold will continue to retain an intrinsic value as long as people continue to admire, own and exchange it. But today it no longer undergirds any major currencies and trades freely in global markets according to the laws of supply and demand. Therefore it offers no more protection than cattle, salt or cowrie shells, all of which once served as money due to their rarity and universal appeal. Buy gold because it's pretty.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga.