Gold : Set for another glittering decade?

In 1998, Warren Buffett said the following about Gold

It gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.

From December 1999 to December 2009, gold has given a return of 277% as compared to a negative return of 23% on the S&P 500 index. During the same period, Warren Buffet's firm, Berkshire Hathaway Inc. has given a return of 83% (excluding dividends).

I am not suggesting here that Warren Buffett is not a great investor. He is and will remain one of the greatest investors of all times. All I wish to emphasize is that investment themes change often (in line with various economic, geopolitical and social factors) and one needs to be flexible in their choice of asset classes rather then forming a rigid opinion about any asset class.

Thus, after a decade of outperformance by gold, it is important to analyze if its still a good investment for the future or investors can shift from gold to other asset classes where returns can be superior.

In my opinion, gold is still a great investment option (especially for investors in the Western world) and it will continue to outperform over the next decade as well. I have discussed below some of the major reasons for this opinion.

Bearish outlook on the Dollar

The Dollar has lost over 90% of its value since the Federal Reserve was formed in 1913. In my opinion, the Dollar will continue to trend down in the long term primairly due to significant Government deficits which is projected to go up further in the next decade. Moreover, artificially low interest rates and money supply explosion would also be the contributing factors towards a decline in the Dollar. Since the Dollar and gold share a negative correlation, it would make sense to buy gold if one is bearish on the Dollar.

Negative Correlation of Gold and Dollar

Source: usfunds.com

This view can be made more clear from chart below from Kitco.com. It shows the increase in price of gold  in the last decade in Dollar terms and increase in prices in terms of currencies that make up the Dollar index (Euro - 57.6%, Japanese Yen - 13.6%, UK Pound - 11.9%, Canadian Dollar - 9.1%, Swedish Krona - 4.2% and Swiss Franc -3.6%).

Chart Source: Kitco.com

As evident from the chart, gold has gone up 238.5% in Dollar terms in the last decade. However, gold is up only 136.2% in terms of the currencies that make up the Dollar index. It is clear from these numbers that a large part of the rally in gold can be attributed to the weakness in the Dollar.

Since a further weakening of the Dollar is a very likely outcome in the future, exposure to gold will continue to give above average returns.

Bearish Outlook on paper money in general

Paper money has contributed largely to the erosion in purchasing power of individuals. This trend has become even more dominant after the current financial crisis. Countries are trying their best to devalue their currency in order to remain competitive in global trade. Thus, the Dollar might be trending down, but other currencies are also not any better off when compared to honest money (gold).

Increasingly, individuals are looking at gold more as a currency then just as an investment or ornament. Gold still retains one of the most important functions of money - That it is a store of value. Paper money these days is no longer a store of value.

It is also very clear that the supply of gold cannot be increased at the same pace as the supply of paper money. This implies that the value each unit of paper money will diminish as compared to gold over time. This factor will keep the demand for gold high in the future as well.

Demand for gold from Asian Central Banks

Asia (including Japan) holds 70% of the $7 trillion of world reserves. However, only 2% of the reserves in Asia are in the form of gold. Most of the Asian reserves are in the form of Dollar whose value is slowly getting eroded. The natural course of action for the Asian Central banks would be to try and diversify into other relatively stable currencies and gold.

The Indian Central bank purchased 200 tonnes of gold from the IMF and this is just an example of the slow diversification the Central banks are looking to make in order to preserve the value of their reserves. It is very probable that China would also buy gold in bulk in the near future.

This very likely course of action by the Asian Central banks would keep the demand for the precious metal strong.

Geopolitical tensions could be gold price supportive

A lot of countries in the world are in a state of war. Wars in Iraq, Afghanistan and to a large extent Pakistan are an example of the same. Military action against Iran also looks to be a probability.

On top of this, we have a declining superpower (the United States) and a rising superpower (China). This also would lead to a lot of tensions as China will increasingly have a greater say in global political affairs.

Commodities and precious metals do well in times of war. Gold could outperform in times of geopolitical tensions as investors and countries try to protect their wealth by keeping it in the form of hard assets like gold. Moreover, Governments resort to excessive money printing in times of war. This is also gold price supportive.

I am not suggesting that we are going to have a major global conflict in the next 3-5 years. But in general, things don't look great globally in terms of relations between countries and it is better to be safe then sorry.

Conclusion

There are several factors which should keep the demand for the precious metal strong in the future as well. I have outlined some of the most important ones above. In my opinion, gold will trend upwards in the next decade with phases of strong correction (typical of a bull market rally).

Therefore, gold is set for another glittering decade. I also think that gold has strong support at $1000 levels where it has a long phase of consolidation. Thus, if gold nears the $1000 level, then its a good opportunity for long term investors to consider exposure to the precious metal.

Gold - Technical View

Disclosure: Long on Gold through exposure to gold coins.

Permenent Link To This Post


Go Back To Home Page