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What’s happening with gold?

April 23, 2013

Published in ‘New Europe’, online edition

GOLDThe recent drop in the price of gold has led to a number of articles and analyses that try to explain what determines the metal’s price fluctuations, its valuation, and its place in the modern financial world.

However, for the most part, these articles rather add to the existing confusion, than clarify the subject. Usually, each analyst considers only one aspect of the metal, or looks at only one set of variables, and ignores the rest.

But the starting point in order to understand what’ s happened to gold is to understand the very nature of this precious metal.

Gold is a strange ‘bird.’ It borrows characteristics from four different asset classes, and that is what obscures the analysis. Gold is a financial asset, but also a commodity, a monetary instrument, and an asset of the last resort.

As a financial asset, gold is traded in a de-materialized form, either spot (usually in unallocated metal accounts), or in form of futures, options, or certificates – much the same way as any other financial instrument, be it a currency, bond or stock. Gold has one peculiarity though: the lack of yield, in form of interest or dividends; the total absence of future cash flows renders its valuation by standard methods, as that of discounted cash flows, impossible and reinforces the adoption of subjective elements.

As a commodity, gold can be thought of as another industrial metal, such as copper or nickel, with an annual mining production and industrial consumption, mainly by jewelry, dentistry or electronics. But unlike the other metals, gold is indestructible so that the total amount mined since the origin of time is stocked and hoarded. Thus the annual figures of gold mining production and industrial uses (the ‘flow’ data) have a limited impact on the metal’s price formation, compared with the financial variables that influence the transactions on the huge ‘stock’ of gold held by private people, institutions, and central banks. We must always have in mind this ‘stock-flow’ aspect when interpreting gold price movements.

The third aspect is that of a monetary instrument, or more precisely of the relic of such an instrument, kept massively as a reserve of value or a war treasure, by central banks. Objectively, there is no reason for the central banks to keep gold stocks whatsoever, or at least to specifically keep gold bars rather than platinum, palladium, or diamonds. Keeping gold is certainly a relic of the past, when gold played a central role in monetary systems, under the various forms of Gold Standard. Currently, central banks sit on enormous stocks of 400-ounce gold bars and, for the most part, they just keep it. However, central bank action in the markets is broadly unknown, because when they carry out a transaction this is done through specialized dealers, in a confidential manner.

The fourth and last use of gold is that of an asset of the last resort, one everybody would want to own in extreme situations, such as in war or a collapse of the monetary system. This is what motivates people in many parts of the world, from Southeast Asia to Europe, who choose to place a usually small part of their wealth in physical gold, just in case…

All four of the above uses of the precious metal determine the actions of the participants in the gold market, and their combined influence form the movements in gold’s price. But what about the relation of gold and the other financial and political variables? A large number of studies (including mine) have tried to statistically relate the price of gold to factors such as the inflation rate, oil price, stock indexes, the dollar’s exchange rate, the price of other precious metals, fear indexes etc, or any combination of the above. The general finding is that there is no stable relation between gold and any of the above economic or political indices, over time. One can easily observe a statistically significant correlation over a specific period, but even so there is no way of using it in an operational way.

Another conclusion drawn when studying time series of gold prices, is that the metal’s market tends to produce large movements, more so than other financial instruments, a phenomenon known as ‘fat tails’ in financial theory. In practice, this means that when gold moves sharply, whether upwards or downwards, it does so by price jumps, usually without allowing the possibility of a transaction between two consecutive price levels.

So, what can be done in this market? Well, there’s no single answer to this question. If you intend to enter the market as a trader, aiming to benefit from short-term price movements, you’d better not. Leave this to professional traders with sufficient experience of this market and funding to face margin calls; occasional players only risk losing their money. If, on the other hand, you intend to take a position on the long term trend, then play with the fear sentiment: buy gold when the predominant perception of the monetary system’s stability becomes negative, and sell the metal when sentiment improves. As we live in interesting times, with monetary authorities around the globe that press hard on the printing press, interest rate bubbles, banking crises, and systemic instability, we’ll surely have plenty of opportunities for change in sentiment and position taking.

http://www.neurope.eu/article/what-s-happening-gold

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