3 Things To Consider When Trading & Investing In Gold

This article originally appeared in FutureSource’s Fast Break Newsletter, where Craig Turner is a regular contributor on various futures trading topics.

Of all the precious metals, Gold is the most popular as an investment and to trade.  The value of gold is one of the most widely debated topics in the commodity and futures markets.  Before you trade or invest in gold, there are a few things you should consider and recognize concerning the value of gold.  These three topics are important yet not talked about enough by gold investors and traders.

Gold is a Store of Value

Any asset that can be accurately priced and universally accepted for cash can be considered a store of value.  Gold is one of the best known, and sought after, store of value assets.  However, one must go a step further and ask, what value is gold a store of?

The answer is Gold is a store of global wealth.  Gold is worth the same price in New York, London, Tokyo and any other place with a functioning economy.  They may be priced in different currencies, but after the currency conversion Gold is the same price all over the world.

This means gold is a universal store of wealth.  The most important thing to realize is that if the total wealth of the world increases, so should the price of gold.  If the total wealth of the world decreases, so should the price of gold.  Why?  Imagine there are only 100 ounces of gold in the world and the total wealth in existence totals $1,000.  If gold represents global wealth, then Global Wealth ($1000) divided by Total Gold Ounces (100) = $1000/100oz = $10/oz.  Let’s say the global economies and equity markets crash by 50%.  Total global wealth is now only $500 (down 50% from $1000).  What is the value of gold?  $500/100oz = $5/oz.  Gold has decreased in value as a store of wealth.

You might be saying to yourself “Wait a second; I thought if the stock market collapses then gold should rally.  Isn’t gold a hedge to economic collapse?” If it is one country failing, then yes, Gold is a hedge to for economic collapse.  If only the US markets were falling compared to the rest of the world, and there is weakness in the economy and the dollar, then gold should be moving higher.

However, if the entire global economy and equity markets are falling apart, gold will go down also.  Take a look at this chart during the worst period of the 2008 financial crisis.  Gold was trading over $1030/oz in the middle of 2008.  Many economists and analysts think we hit rock bottom shortly after the fall of Lehman Brothers.  Gold was trading down to $680 in October of 2008.

Continuous Monthly Gold Chart 2008

Gold is a Psychological Market

Gold, unlike many commodities, has little real world production value.  It is a soft metal with very few industrial uses.  Gold is used most as a form of jewelry and a store of value.  Crude Oil’s value comes from the need for energy.  Grain values are derived from the demand for food.  Gold on the other hand has little functional use.  We need the crude so we can keep the economy moving.  We need grains so we can feed the world.  We don’t need gold for anything except jewelry and that the investment community places a premium on that particular metal.

It is for these reasons why we call gold a “psychological market”.  One of the reasons the investment community places such a high value on gold, is because we have deemed gold a preferred vehicle for storing wealth.  When investors are looking for safe havens for their money, gold is a popular choice.  When risk and uncertainty become too great, investors choose gold over riskier asset classes.  Gold will typically outperform riskier assets in times of crisis, as investors feel the need for security, perceived or real.  Even in our above example, when Gold went down over 30% from high to low in 2008, the stock market went down over 50% from the 2008 highs to the lows after the failure of Lehman Brothers.  Gold declined during the liquidity crisis of 2008, but it performed better than most asset classes in that time frame.

Gold is Currency for Governments & Central Banks Only

While you can make the case that Gold is Money, real world applications do not work out so well.  Try going to your local convenience store and buying bread, milk and batteries with gold bullion.  I’ve never tried it but you can bet your bottom dollar it would be a disaster for everyone involved.

Gold is a currency at the international level.  Governments and Central Banks can use Gold as Money due to the transaction size and their financial sophistication.  It is very unlikely that gold will ever be a currency in every day life.  Even if the gold standard was brought back, we would still be handling paper money backed by gold.

The Value of Gold

So what is the value of gold?  Gold prices are determined as a function of supply and demand.  The supply is growing each year, as once gold is mined, it does not expire, rot, or get “used up” for industrial purposes.  Demand for gold will always depend on the economic outlook.  Inflation is the most well known driver in gold prices, as is weakness in the US economy and stock market.  However, investors and traders need to know if the weakness is in the global economy, gold could decrease because global wealth is decreasing.

During the last great financial crisis in 2008, only the US Dollar, US Treasuries and the Japanese Yen appreciated as the ultimate flight to safety assets, while gold traded all the way down to $680/oz, down from over $1030/oz.  Just because there are US Dollar inflation and US national debt concerns, or if there is economic weakness in the US economy that does not mean gold has to go up.  Traders need to consider things like deflation risks, global economic conditions, and the physiological make up of the markets.