Golden Rules Gone

Even before the tumble in the price at the end of last week, things were not looking good for gold. Before this year, the multi-year bull market (rising in dollar terms every year from 2001 to 2012) defied the credit crisis and the subsequent period of patchy global recovery and central bank quantitative easing. This increased the perception that gold could survive anything and the good times would continue. But it also created a false sense of security for gold bulls and that’s now increased, because the old rules have broken down and as yet, there’s nothing new to replace them.

Of course, unlike stocks or bonds, gold gives no income flow (coupon or dividend) and has limited use, so traditional approaches to security valuation (estimating and discounting these flows) can’t be applied. As such, many theories and views (some tame, some very crazy) fill this intellectual void to justify (mostly higher) valuations.

There have been many justifications of the rising gold price in recent years during the 2001 to 2012 period. During the early part, gold was painted as a dollar story, the rising gold price (in US dollars) the opposite side of the falling dollar story. During this time, gold’s correlation with the dollar was -0.55. On the same basis (rolling 3-month, measured weekly) it’s now in positive territory.

Gold Daily

There’s been a similar change in gold’s relationship with global real interest rates (global bond yields minus inflation). The relationship is a simple representation of the opportunity cost of the real return forgone by holding a non-yielding asset. If inflation adjusted returns are high in general, then it’s a bigger hurdle for investors to give up to invest in gold, with a larger capital appreciation needed to overcome the real rate lost. This held quite strongly in the credit crisis period (2008-12), an inverse correlation of 0.50. Currently it’s strongly positive at 0.65.

Even the advocates of money debasement via the expansion of central bank balance sheets are having a hard time of late. Over the past 6 months, global G4 central bank balance sheets have expanded by more than 12% (weighted change in assets), whilst the gold price has fallen by 16%.

The upshot is that the golden rules for gold, as much as there can be rules for such an asset, have floundered. For now, nothing has emerged to take their place. As such, expect the bulls to push a return to the old world order. Whilst the global gold price peaked 19 months ago, global holdings of gold in ETFs peak just 4 months ago. From this perspective, the lack of a rule-book could mean that there is more liquidation to come before any recovery can take place.