The Golden Dilemma

Duke University – Fuqua School of Business; National Bureau of Economic Research (NBER)

May 4, 2013

Abstract:

First Posted to SSRN: June 6, 2012.

Gold objects have existed for thousands of years but for many investors gold has only recently become a tradable investment opportunity. Gold has been described as an inflation hedge, a “golden constant”, with a long run real return of zero. Yet over 1, 5, 10, 15 and 20 year investment horizons the variation in the nominal and real returns of gold has not been driven by realized inflation. The real price of gold is currently high compared to history. In the past, when the real price of gold was above average, subsequent real gold returns have been below average. Given this situation is it time to explore “this time is different” rationalizations? We show that new mined supply is surprisingly unresponsive to prices. In addition, authoritative estimates suggest that about three quarters of the achievable world supply of gold has already been mined. On the demand side, we focus on the official gold holdings of many countries. If prominent emerging markets increase their gold holdings to average per capita or per GDP holdings of developed countries, the real price of gold may rise even further from today’s elevated levels. As a result investors in gold face a daunting dilemma: 1) embrace a view that “those who cannot remember the past are condemned to repeat it”, there is a “golden constant” and the purchasing power of gold is likely to fall or 2) embrace a view that “this time is different” and the “golden constant” is dead.

This research sets the stage for our most recent paper, Erb and Harvey (2012a), An Impressionistic View of the ‘Real’ Price of Gold Around the World.

The Golden Dilemma – Introduction

The global equity and fixed income markets have a combined market value of about $90 trillion.1 Institutional and individual investors own most of the outstanding supply of stocks and bonds. At current prices, the world stock of gold is worth about $9 trillion. Yet investors own only about 20%, or less than $2 trillion, of the outstanding supply of gold. A move by institutional and individual investors to “market weight” gold holdings would require them to offer the already existing gold owners a price attractive enough to incent them to part with their gold, probably sending nominal and real prices of gold much higher. Should investors target a gold “market weight”? Could they achieve a gold “market weight” even if they wanted to?
The goal of our paper is to better understand how we should treat gold in asset allocation. We start by examining a number of popular stories that are used to justify some allocation to gold, such as inflation hedging, currency hedging, and disaster protection. We then examine basic supply and demand factors. Remarkably, the new supply of gold that comes to the market each year hasn’t substantially increased over the past decade even though the nominal price of gold has risen fivefold. We also look at the distribution of gold ownership in developed countries and emerging market countries and estimate the impact on gold demand if key emerging market countries follow the same patterns of central bank gold ownership in important developed countries.

Gold has had an amazing recent run. From December 1999 to March 2012 the U.S. dollar price of gold rose more than 15.4% per annum, the U.S. Consumer Price Index increased by 2.5% per annum, while U.S. stock and bond markets registered annual gains of 1.5% and 6.4%, respectively. Indeed, Saad (2012) notes a recent Gallup poll found that about 30% of respondents considered gold to be the best long-term investment, making gold a more popular investment than real estate, stocks, and bonds.

Though some might use historical returns to estimate long-run forward-looking expected returns, it is implausible that the expected long-run real rate of return on gold is about 13% per year (15.4% nominal minus an assumed 2.5% annual inflation). Yet, it is essential to have some sense of gold’s expected return for asset allocation. Current views are sharply divergent. On one side is Buffett (2012) who compares the current value of gold to three famous bubbles: Tulips, dotcom, and the recent housing bust. Buffett writes:

What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As “bandwagon” investors join any party, they create their own truth – for a while.” Berkshire Hathaway 2011 Shareholder Letter, p. 18.

On the other side is Ray Dalio, who argued in a Barron’s interview (see Ward 2011) that U.S. Treasury bills are no longer a safe asset and that there will be an ugly contest to depreciate the three main currencies (dollar, Yen and Euro) as countries print money to pay off debt:

Gold is a very underowned asset, even though gold has become much more popular. If you ask any central bank, any sovereign wealth fund, any individual what percentage of their portfolio is in gold in relationship to financial assets, you’ll find it to be a very small percentage. It’s an imprudently small percentage, particularly at a time when we’re losing a currency regime.