“What makes gold work as an investment and when does it become a portfolio disaster?”
When Does Gold DECLINE?
Let’s handle the “bad news” first. I said in my update of last week’s blog post: “Gold is not a good trading idea if the economy is indeed going to improve dramatically.”
If the economy is booming, stocks are rising rapidly, interest rates are rising ahead of inflation keeping real rates positive, and the U.S. dollar is strong, gold does horribly. You don’t need dollar insurance when the dollar is rising, and you don’t need to protect yourself against a decline in stocks when the economy booms for years in a row. That’s why gold was a horrible investment in the 1990’s. There was a huge economic boom, despite the bust to follow. Gold tanked.
When Does Gold SHINE?
In economic terms, there are three “secret” ingredients needed for gold (GLD; gold ETF) to shine. These are secret if you don’t know them!
First, gold does best with negative real interest rates, which means inflation above the rate of return of interest bearing instruments like bonds (10 Year Treasury Note (TNX), 30 Year Treasury Bond (TYX), corporate bonds (LQD) etc.). The rate of change of real interest rates can accelerate a move in gold prices as the market perceives that as a threat to price stability.
Second, gold also does well when the currency it’s measured against goes down, not up. When the economy is weak, the Federal Reserve lowers rates and longer rates fall as well, which can lead to negative real interest rates. Those negative real rates drive down the dollar. A weak U.S. dollar (expressed as the US dollar index) makes gold more valuable to U.S. citizens, because it then takes more dollars to buy it. A trend in this direction increases demand, speaking of which…
Third, gold goes up when it’s in demand worldwide. Demand means total trading demand worldwide, so gold naturally does best when it is rising in market timing terms in multiple important currencies worldwide than when it is just performing well in one currency. If gold is rising in multiple major currencies including the U.S. dollar, the Euro, the Yen, and the British pound, for example, gold often continues to do well.
This means that the trend itself is important, and to that extent, you need to do market timing of your investments in gold. Yes, gold often goes up, because it’s going up over a period of time that convinces the market that gains will continue. This means it can be overdone to the upside at times, and corrections ensue for example, as real interest rates change, or demand falls due to greater worldwide financial stability.
It is theoretically possible for influences like advertising to cause gold prices to rise. A big systemic shift in what financial advisors say about gold’s value as insurance or as an investment would help or hurt the price of gold.
A currency-driven financial panic can have a big effect on gold prices as we saw when the Euro seemed in peril. In that situation, the U.S. dollar AND gold can do well. They are both in high demand during a panic out of Euros.
So the ideal environment for owning gold (GLD) is: 1. Negative real rates of return 2. A weak dollar. 3. Sufficient demand worldwide vs. supply with rising prices in multiple major currencies.
Supply is not a big issue with gold, because the supply is constrained by its rarity. It could have an influence if there were a lot of gold selling all at once as it is always in the end supply vs. demand as with anything else that is bought and sold.
Gold has been weak because “1” (see above) has been lacking with rising real interest rates, “2” is missing, i.e., the dollar has not been weak enough, and “3” the world is not in panic mode, so demand for gold has fallen. The weak dollar has been the main force preventing lower lows in the gold price. Gold is a hold as “insurance” in our long term view of gold as U.S. dollar insurance, and we have no trading position currently.
For now, if the economy remains sluggish, gold will do fine IF rates resume their fall and IF negative real rates prevail, while the dollar does not strengthen dramatically, which it should not if rates are falling, and the world is not in “Euro panic” mode.
If you read this at a later date, just apply the principles the same way we are doing here with the current facts. They will help you make a better decision on whether to buy or sell gold.
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