Gold and Its Mechanics

Everyone has an opinion about the shiny metal, with its allure and its investment value. Gold serves as a currency and a store of value, albeit more out of convention than anything else. However, gold is used by the central banks as a reserve asset, and so long as they don't abandon it (which they have no reason to), gold would remain the ultimate safe haven currency. 

More than just shine

Here's an article covering the mechanics of gold, what it is, how it is traded and what determines its price. Surprisingly though, during periods of crisis, "in the wake of the September 11^th attacks and the 2008 financial crisis, gold remained flat or fell in tandem with the stock market. “When such an event takes place, most people want to be long cash,” he said. That includes selling their investments across assets – including, gold." 

If you click read more, there is another article based on some research I did on the topic. I had considered using an option to bet against gold, but decided against it for the meantime. Find out why.

Gold

23 Oct 10

P=1327.7/ounce

For an asset that gives no cash flow and has very little industrial usage, Gold is fundamentally hard to value. Its primary function is as a store of value. Store of value implies 2 things, 1) hedge against inflation (the same way any n on-cash asset is a hedge against inflation, including cash-denominated securities, since inflation is a measure of the value of money, and money is the same as cash), and 2) safe haven against crisis.

The value of gold arises through scarcity and convention. Scarcity – there is only a fixed amount of gold in the world, estimated to fill only 2 olympic size swimming pools [source: National Geographic Jan09: The Real Price of Gold]. Convention – gold was a choice made to be the underlying asset backing currency in the Gold Standard monetary system adopted in the late 19^th century until WW1, where a run on gold made it unsustainable for the bank of England to exchange its printed notes for gold. [source: Wikipedia].

Gold is chemically inert and hence does not tarnish and become debased. It retains its gleam because of its chemical lack of reactivity and is about double the density of gold.

2 main risks exist for gold in general. One is that if chemistry allows gold to be produced cheaply as opposed to having to be mined, as had been the dream of alchemy (even Isaac Newton was a practitioner), gold will then be completely destroyed as a valued asset, especially because it is fungible. Another is that it goes out of convention, which is unlikely since all major central banks including the IMF hold it and is a traditional source of reference for value.

Gold trading has risen become a source of commodity speculation which has been widely blamed as a major reason for the run up in its price. "At the moment, more than 50 percent of gold is going into investment demand," says Morningstar's Mat Hodge, an expert on Australia's gold mining stocks. According to World Gold Council figures, in 2010's second quarter, investment accounted for 52 percent of demand for gold, and demand among gold ETFs and gold trusts rose by 414 percent compared with the same quarter in 2009. [source: http://sg.finance.yahoo.com/news/Gold-May-Rise-But-Is-It-usnews-394308882.html?x=0]

Examining the historical chart of gold above, it moved in a range of $250-750 in nominal dollar terms from 1978-2007. In fact, from about 1981 to 2005, it moved in an even tighter band of 250-500usd, closing 2005 at $513. But clearly after that, it spiked up and today is trading at 1327.7 [source: Kitco], or 2.6x higher. So, the claim as a hedge against inflation is dubious since it has not risen in such a way as to consider the effects of inflation.

Saying it another way, for 24 years, it went nowhere trading in a tight range and then went up 160% in 5 years or 9.8% on a compounded basis. So, what happened in 2005? I haven’t a clue what happened that was particularly remarkable, we didn't have a crisis or anything like that in that year.

But let’s examine trading volume for gold. Since gold can be traded in quite a few forms, including physical, paper, futures and other derivatives form, and as an ETF quite recently, it can be hard to quantify trading volume. But looking at one of the easily traded instruments today, the SPDR Gold Trust, which is an ETF for spot gold launched in Nov 04, the trading volume has risen from almost nothing to 100-190 million shares per week [chart source: Google finance]. Its price is approximately 1/10^th of spot and the ETF actually holds physical gold bullion. That is, approximately 10 trillion dollars of gold is traded weekly on the ETF alone. In contrast, 4 trillion dollars of forex is traded daily [source: Chedet.com, Mahathir’s blog, he attributed the info to Star business news].

Credit: National Mining Authority,

 

USA

Going back further in time, the price of gold remained remarkably stable for long periods of time. For example, Sir Isaac Newton, as master of the U.K. Mint, set the gold price at L3.17s. 10d. per troy ounce in 1717, and it remained effectively the same for two hundred years until 1914. The only exception was during the Napoleonic wars from 1797 to 1821. The official U.S. Government gold price has changed only four times from 1792 to the present. Starting at $19.75 per troy ounce, raised to $20.67 in 1834, and $35 in 1934. In 1972, the price was raised to $38 and then to $42.22 in 1973. A two-tiered pricing system was created in 1968, and the market price for gold has been free to fluctuate since then as the table [right] shows

There was practically a price explosion for gold once it was allowed to trade freely, but the game ended in 1980-1981 when prices then subsided and ended up in its tight 250-500 usd band for the next 24 years as earlier noted. Something not so different happened to cause the current massive run. Gold had a renaissance of trading once again. Not that gold couldn’t be traded before, but there is now a massive wave of speculative pressure, which has given this rather unremarkable metal its massive run. I would think of it as a little financial alchemy that has happened to encourage this massive trading. In fact, the word bubble might be ascribed to it despite the problem that you can never know when a bubble ends until it pops. Why do I consider it a bubble? I had begun the article noting that gold has no fundamentals since it has no cash flows. And since that is the case, the cost of gold, can as a first estimate, be the cost it takes to get it out of the ground and then the cost of selling it. And since gold doesn’t get “used up”, it doesn't become increasingly rare, rare as it may be. We don’t run out of it.

Another reason for the massive rise is the rush to safety and the devaluation of USD as a result of the financial debacle of 2008. However, I would postulate that gold would collapse once the economic recovery takes traction. A leading indicator is stock market price rising, which has already happened. Employment is a key on the run indicator in my opinion for the wider economy.

Conclusion: I would go so far as to prescribe that gold should really be trading in its band of 250-500 usd. And would even call an average of 375 (averaging between the max and min of the range). To take advantage of a bubble popping, I might even institute buying a put option expiring about 5 years from now, at a strike of 500, in a small amount just to have a position if I am proven right. I would need to do the investigation for this price.

8Mar11: After just doing some reading about gold being a bubble, I think my conclusion is, even if it is a bubble, bubbles can go on for a long time, and besides, what are the catalyst factors that need to drive gold down? To be short something, you need a stronger reason than that one should not be long that something. You need reasons other than, it is overpriced. There must be catalysts driving it down. And what these are is completely uncertain. Even if interest rate rises, gold might dip but it certainly might not implode. Nonetheless, saying this, a USD1000 bet on a long put option on GLD expiring in Jan 13 with a 100 strike can give a payoff 700x if GLD falls to 70 USD levels (currently 140 levels. GLD to actual spot gold is about 1:10x).

Expected value calculation:

EV=0=-1000+probability*700,000=> probability=14%.

To get a 700x payout, there needs to be a 14% probability of it happening, exactly as I stated it, gold needs to half. The last time gold was at 700/ounce was in 2007, and that was also the point when gold went stratospheric. It needs to happen within 20 months from now. Is there a chance of it happening and what is this chance? Is this chance greater than 14%?