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Precious metals:the next money spinner?

As equity markets wrestle are in another bear market, it is perhaps time to turn our heads towards the likely bull market in precious metals. Precious metals have been in their own bear market since April 2011 but there is very high degree of probability that their bottoming out process has culminated.

International gold chart since 1973

International gold chart since 1973

This chart is even more longer term and adjusted for US inflation

This chart is even more longer term and adjusted for US inflation

Historical Gold Prices – 100 Year Chart

Why invest in a non interest bearing asset?

There are several reasons why investing in gold could be a good idea but the biggest is that gold is synonymous with wealth. While it no longer serves directly as money, it has done quite well as an asset class in terms of returns ever since the final abandonment of the gold standard in the 1970s. While it is debatable whether it serves as a hedge against inflation, it provides a long term hedge against wealth destruction. In times of hyperinflation, gold is the best store of wealth by far but such instances are rare and are not expected in India for many years.

However, the biggest reason to buy gold is that it can generate fantastic returns, even better than equity; this happened in the first 11 years of the new millennium.

The rise and the fall

The rise and the fall

Gold vs. silver
Gold has some use as jewellery and in electronics but most of its demand comes as a store of wealth. Silver on the other hand is a widely used industrial metal and increasingly it is losing its coupling to gold and behaving like a cyclical commodity. What this means is that in times of economic turmoil, silver cannot be relied upon to generate returns. Silver’s status as a precious metal is under threat as the gold to silver ratio has broken down severely. Before the twentieth Century, 16 ounces of silver bought an ounce of gold i.e. 16:1. For most of the twentieth Century, the ratio has been around 50. Currently with gold at $ 1250/oz and silver at $15.55/oz the ratio is 80: 1. In effect, silver is not being considered precious any more.

The extra edge gold has in India

While both gold and silver have seen multiple bull and bear market patterns in international markets, it has largely been a smooth upward trend in India. The exception is the recent period of past several years when gold has seen sharp ups and downs.

Why does gold fall only marginally, stay flat, or even go up in India even in time periods when international gold prices are falling? The answer lies in the USD/INR exchange rate. As gold prices are set in the dollar denominated international trading markets, a rising dollar makes gold costlier in terms of Indian rupees even if gold as an asset class does nothing. Thus gold acts a hedge against dollar appreciation for those who are likely to spend in dollars for education or foreign travel.

5 Year Gold Performance in India

5 Year Gold Performance in India-Note the milder price fall

Ok, got it, how do I invest

There are multiple options today and all have their pluses and minuses.

Buying jewellery is an option but making charges etc. may make it unwise from an investment perspective. Yet, if periodic buying of jewellery is common in your family, it is smart to time the market a bit and buy when prices seem low. Gold jewellery will always have value.

Buying direct gold as coins or biscuit variants too is an option if storage is not an issue. At present, an investor pays an extra 8% of the metal cost on account of taxes like VAT and duties. This is tangible and there is something to feeling the metal in your hand but selling gold in a hurry could be difficult in an illiquid market.

Gold Exchange Traded Funds (ETFs) are a smart option with the ease of electronic buying and selling of gold at the click of a button. The overhead costs are initially not as high as buying physical gold but with a catch. ETFs have administrative costs and the expense ratio is usually around 1%. Add brokerage costs and taxes and over a few years, ETFs could be a costlier method of purchasing gold. However, liquidity is rarely an issue with them which means that it is much easier to move with the market if one is in ETFs as against physical gold.

There is one key philosophical drawback with ETFs though. They do not confer the right to redeem the units for actual gold. This partly defeats the purpose of investing in gold as a permanent store of value even in times of crisis because the investment becomes coupled to the financial risk of the institution issuing the units of ETFs. If the institution goes under as might happen in a 2008 type situation, the virtual ETF units would vanish too.

The National Spot Exchange (NSEL) issued e-series units offering demat gold, silver and platinum a few years ago. The exchange offered easy conversion to physical form whenever the investor desired. For someone could buy and trade 20 grams of gold and when one wanted the metal, take physical delivery from the warehouse. It sounded too good to be true, and it was. The detection of fraud at the NSEL means that only gold ETFs offering investment via routine NAVs remain today.

Investing in silver

Bought cleverly, sliver too offers the opportunity to make good gains when global markets are doing well. It is much more volatile and spikes up faster than gold. However, silver is much tougher to buy. It can be bought physically as bullion from local traders but there is no electronic mode of investment except short-term futures. There is no silver ETF in India. Thus, for the retail investor, investing in silver is difficult. Investing indirectly by buying it as silverware or jewellery is an attractive option but buyers must beware of often steep premiums being charged on simple silver coins or statues by retailers. Buy bricks directly from wholesalers.

Silver price chart since 1985-note the volatility

Silver price chart since 1985-note the volatility

Endnote

While there is no guarantee that gold’s recent low of $1050/oz would hold, it was a 40%+ correction from the 2011 highs and with a long-term bottom forming process over multiple years. The international price levels are at levels where one could say that they were buying at multiyear lows. Gold has rebounded sharply from its lows to $ 1250/oz and has been one of the best performing asset classes of 2016. For silver, the bottom may not be in as it has not shown the same bounce back from lows. An investor could try to time his/her gold purchase at this time but must consider investing in this must-have alternative asset.

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Gold’s is the true bull run of the 21st Century

Ask Midas and he will tell you that gold is a class in itself. Gold is often called the barbaric relic and rightly so. It has bedeviled people for thousands of years as the ultimate store of wealth. Bappi Lahiri may be one of the best music composers of his generation but he is the most prudent investors too,literally wearing his love for gold on his sleeve.

Gold:The International Story

Gold has lived in tumultous times. It has been loved but it has also been reviled as responsible for financial crises and delays in economic recovery. After all, a gold standard prevents runaway monetary expansion. In 1973, the removing of gold backing of the dollar triggered the greatest boom in the history of gold with gold peaking at $ 850/oz in 1980,rising from $ 35/oz in 1973. Those were interesting times. Crude too had hit $ 100 a barrel only a short time earlier. Gold then saw a terrible bear market for the next twenty years that virtually killed confidence in gold as a store of value. Its obituaries were written and central banks, most notably the Bank of England unloaded the gold in their reserves.

Look at this chart from 1971-2005. You can see how the 20 year bear market in gold had lower tops and lower bottoms till 2000 when the trend suddenly changed spectacularly. It was almost as if it were echoing Jennifer Lopez in her millennium song ‘Waiting For Tonight’. At Y2K, gold launched itself into a bull run that has not ended yet.

Gold has seen big crests and troughs in its career

Note how gold took 25 years to get back to its previous peak but the actual upward movement took almost no time

 

The first chart covers gold’s trajectory till 2005, the year in which it recaptured 1979 highs once again. The other one covers the 2Ks till present. As you can see, it is a largely undisturbed trend except for except for brief periods of volatility in 2006, 2008 and 2011 (The latest one cannot actually be called a correction yet. It could also be the start of a bear market although I would bet against it).

The stellar run of gold in the new millennium

The stellar run of gold in the new millennium

Gold: the Indian Story

Indians have been gold bulls from the times of Alexander. We never had much of the precious metal naturally available in India but a long tradition of accepting virtually all our foreign trade payments only in gold and silver has led to Indians being the greatest hoarders of gold in the world.

The Indian belief in the value of gold has been vindicated time and again

The Indian belief in the value of gold has been vindicated time and again

However, let’s cut to the present.In the last 40 years, the experience of the Indian consumer has been very different. He has only seen rising prices. Gold imports were banned in the 1970s and thus smuggling was common.(Big B as Don was engaged in gold smuggling).This kept prices even higher than international prices. The graph below does not take that into account. There never have been bear markets except for two periods 80-86 and 96-01 when it dropped but not too significantly.Why is India so decoupled from the global markets?
The hero or villain depending on which side of the buy/sell equation you are is the INR/USD exchange rate.

The rupee weakens, then hangs onto a support, then weakens again

The rupee weakens, then hangs onto a support, then weakens again

It is rather obvious that the rupee has been on a long term downward trend and in spite of being less volatile in recent years, the current stabilization of the rupee at 48-50 instead of 42-44 is part of a larger structural weakness of the rupee. Even if gold prices fall internationally, a falling rupee takes it up.
This rather reinforces Bappida’s and the common Indian’s belief in the yellow metal. India consumes 900 tons of gold every year. Indians have between 20000-25000 tons of gold stored privately which is around 15% of the total gold mined in the word till date(165000 tons). The global gold output is around 2500 tons. Buying gold is no investment(except very recently)for Indians, it is sacred tradition. So we Indians actually drive the price of gold even if the prices in our spot markets do not reflect global trends.

The movers and shakers of gold:

Real interest rates:Gold acts inversely with real interest rates. This is a long term phenomenon that can actually be relied upon. In today’s low interest rate scenario, gold should rule the roost.

Liquidity: There has to be money to buy gold. Even if real interest rates are low and there is no confidence in the equity markets, gold would still collapse in the absence of liquidity. This happened in 2008 when a run on equity markets also led to a run on gold.

Dollar index: Being dollar denominated, gold moves inversely with gold. It is no coincidence that the gold lows of 1999 and 2000 coincided with lifetime highs of the dollar index.

Gold is Money: The non-stop printing of dollars by the US Fed is undermining the dollar.Central banks have turned net buyers in the last two-three years after decades of selling. There is no doubt that the world will have to rely less on the dollar in the future. Gold could very well be back as a reserve currency. Unlike paper currency, it is real and can be felt and touched and its writ is not determined by a government.

Hedge against hyperinflation: Yes, you read that right. In India, because of the depreciating rupee, gold does act as a hedge against inflation but it is not always bought when inflation goes up. Therelationship is more complicated than that. However, in a case of hyperinflation, there is no asset like gold. It is literally te only asset left standing. So if confidence in the fiat currency in which you hold your assets erodes or it devalues itself crazily, only precious metals can save you. Hyperinflation is a very rare event but it can never really be ruled out in an intrinsically flawed financial system.

China: China is also the world’s largest producer of gold but it exports none of it. Its central bank has also been buying gold externally and is rumoured to be building a gold war chest as a hedge against a falling dollar. China is likely to overtake us this year in terms of gold consumption.
Jewellery: In India as well as China, gold has its use as jewellery. In case the investment does not work out, physical gold could be converted into jewellery. Most families do need jewellery on occassions like marriage and so hedging the risk being forced to buy it at a much higher cost in the future is prudent. The physical asset or a gold ETF could be used for the purpose.

Naysayer arguments:

Useless Ponzi asset: Warren Buffett wrote this year that gold is an unproductive Ponzi asset that no use whatsover and is bought in the hope that it would someone would pay a higher price for it in the future. He is right but remember that Buffett held vast quantities of silver from 1997-2006 and mistimed his exit thus completely missing out on the bull run in the white metal.

Technicals: Gold has formed lower tops and lower bottoms after falling from its September peak of $1920/oz. It is currently at 1700. There is not a whole lot of strength in its movements. It has also been in a very long bull market and thus could fall a long way.

Too Many Bulls: There is no doubt that the number of people bullish on gold has increased greatly in 2011. The correction post September has reduced the number. Market peaks and bottoms are usually reached when the buyer seller ratio becomes extremely skewed. Saying this for gold is difficult because we do not see the average Joe giving advice on gold and buying it aggressively yet.

Do I buy it then?

The long term fundamentals for gold are very strong and specially for the Indian consumer, buying gold is never a bad decision. In the last few months, we have seen gold moving in a very narrow band between 27000-29000 per 10 grams while international prices have yo-yoed largely due to the rupee which has played the see-saw with international price movements and led to a cancellation of both factors.
An appreciation of the rupee could make gold cheaper but it is also equally true that if gold breaks out, 1920 is not too far. A close above those highs could take gold to any level. That could make gold completely unaffordable for those who need it for jewellery. Thus, if one does not have gold, accumulating it at present levels may not be a bad idea. Having said that, till it resumes its trend, it is as risky as equity. Do not treat it like a safe haven.