Like any commodity or “real” asset, valuation of gold is straightforward. It’s purely supply and demand — nothing more. But commodities are different from most conventional investment assets. Stocks, bonds, or real estate give you cash flows worth something now and in the future when interest rates are factored in. Commodities just exist. They have no cash flows, so the price is only based on what others think they’re worth at a given time.
For instance, if a miner can pull gold out of the ground for $500 an ounce (in costs), he’ll keep producing as long as he can sell it for more than that. If the price of gold goes below $500, it’s not worth it for him to continue mining. He stops — and other miners probably do the same — and the dip in supply causes prices to eventually go up.
This is basic economics here. And let me add a bit of trivia, too. Did you know that all the gold that has ever been mined in the history of the world would only fill a soccer field about 6 or 7 feet high? We’re talking about a fairly small market here. But this only relates to the commodity production environment.
Demand is the driving factor. Gold has always traded as a currency rather than as a typical commodity (such as oil, wheat, or copper). It’s a fear trade. When global fear goes up, gold is a hedge against capital market negativity.
We’ve witnessed this over the last several years. When stocks, real estate, and other commodities rise, treasuries and gold fall, and vice versa. Investors turn to gold in risky times because of its “store of value.” They can’t lose with gold. But is that true?
Traditionally gold has been utilized as a hedge against inflation. Additionally, there has been a marked inverse relationship between the relative strength of the U.S. dollar and the price of gold recently. Should the Fed’s current monetary policies either increase the rate of inflation or weaken the dollar, gold price may increase further, already up by about 30 percent in 2010.
Jim Komadina, president of Colorado Resource Associates, a Colorado Springs based resource management expert, cites particularly strong Asian Central Central Bank and consumer demand in China for gold. “Supply and demand fundamentals alone would support an increasing gold price over the next several years,” he says.
As for the “cash for gold” phenomenon, the most important piece here is the haircut: what you get versus what your gold is actually worth. I don’t have any personal experience with this, but I would venture to say that gold being placed in the mail is unlikely to yield its true value. You pay a price for convenience. If you really want to sell your gold jewelry, take it to reputable dealers and collect several quotes to find out what it’s really worth before you complete a transaction.
Ultimately, you have to cut through the folklore when considering gold as an investment. Gold has a reputation of holding its value better than riskier capital market assets. But in truth, gold is a volatile market. It has gone through decades of flat to falling values in the recent past. Buying gold now is much riskier than it was several decades ago.
If you want to join the mad rush to get some gold exposure, it might be safer to invest through Exchange Traded Funds rather than buying bullion.