Investing in gold was one of the safest things to do under volatile economic conditions. But all that changed when gold took a plunge last month. Now, people are aware that even gold is subject to volatility. It is like the stock market where there are highs and lows; it will not remain bullish all the time.
For the past 10 years, gold was generally upbeat. Those who traded in gold never experienced a major crash. This gave a sense of false security that gold is a risk-less investment. But now, things have changed and people will think twice before investing in gold. While there are benefits of investing in gold, there are disadvantages as well. Therefore, it is best to identify the pros and cons of investing in gold in order to determine the best time to buy and the best time to sell. Just like trading, proper timing is important to maximize gain.
Some people see gold not only as an investment, but a hedge fund. It is where investors go when all else fails. For many people, gold used to be a retirement insurance policy that provided long-term financial security. For the past decade, gold was even better than an insurance policy since the potential gains were much higher than the insurance earnings.
The securitization of gold started a new era in the market. The SPDR Gold Trust ETF (NYSEMKT:GLD) became one of the most popular investment choices among gold investors. The ETF, which seeks to replicate the performance of the price of gold bullion was soaring at the beginning of this year. John Paulson is well-known for his large stake in the ETF. JPMorgan Funds also invested more than $1.5 billion in the ETF. However, the participation of hedge funds in the gold market through ETFs initiated a new era in the market.
Pros of investing in Gold
If the global economy suffers inflation, gold strengthens amid the falling value of paper currency. People will resort to another form of currency, which is gold. Therefore, inflation is one of the signals for the ups and downs of gold.
In contrast, if money strengthens under a deflationary economy, the value of gold will decrease. Money can buy goods, but gold can’t. So, if the value of money strengthens, it gains higher capacity to buy more goods and services. In this case, some people will sell their gold and convert them into currency in order to enjoy the benefits of lowered prices of goods and services.
This is why there is a correlation between gold and the consumer price index [CPI]. The CPI is one of the measures to evaluate if an economy is undergoing inflation or deflation. The CPI is a measure that monitors the changes in the prices of common household goods. This is sometimes controlled by the government.
A high CPI indicates that the prices of goods and services are increasing and inflation is rising. The value of gold will potentially increase if the CPI is high due to rising inflation. So, gold’s value will increase if the CPI is high.
Other than the CPI, the purchasing power index [PPI] is another tool that determines the inflation and deflation of economy. Unlike the CPI that measures the economy from the consumers’ point of view, PPI is from the producers’ perspective. Nonetheless, gold strengthens when the economy experiences inflation.
There will always be demand for gold, and the demand is rising year over year. Supply, on the other hand, is getting scarcer and the costs of mining are continuously increasing. This is a sign that the value of gold, despite falling sometimes, will continue to increase. This makes it a good investment with better chances of appreciation in the future.
According to some analysts, about 10% of the demand for gold comes from the industrial sector. Gold is used in some manufacturing processes. It is used in electronic devices since it is an excellent conductor of electricity that is devoid of corrosion.
In fact, there is gold in some brands and models of mobile phones, calculators, television sets, and other home appliances. Practically, in almost all highly sophisticated electronic devices, there is gold. It is integrated in connecting wires and strips, in soldered joints, and in relay contacts and switches.
Majority of the demand for gold is in jewelry, which accounts for about 45%. China and India are among the major gold users for jewelry. This is why the economy of China and India can affect, to some extent, the prices of gold. The recent fall of gold is partly attributed to the slowdown of the Chinese economy.
Moreover, gold is used in other areas outside of the manufacturing industry. It is used in dentistry, in medicines, and in aerospace, as well. The point is, gold will always be in demand in various sectors. The problem lies in the supply. Time will come when the supply will no longer be able to cope with the rising demand. In such a case, the value of gold will skyrocket to new high level.
Cons of investing in Gold
Just like stocks, gold is volatile. The value of gold is greatly affected by several factors. One of them is the Federal Reserve’s policy changes. The U.S. economy can also affect the value of gold. While the economies of other nations like China have influence on gold’s value, the impact of the U.S. economy is heavier.
When news was out that China missed its targets of economic growth, many believed that the U.S. economy will follow. Speculations on a declining U.S. economy led, in part, to the fall of gold. Aside from that, the futures market also caused gold to plunge. So, it is highly vulnerable to speculative plays, causing short-term fluctuations of gold price.
In addition, the value of the dollar is inversely correlated with gold. The U.S. dollar trades in a highly volatile currency market. This makes gold somewhat volatile, as well. The U.S. dollar is the preferred reserve currency because it was the only currency from 1931 to 1971 that was backed by gold. At that time, it was equated with gold, or used as a substitute for gold. If the U.S. dollar strengthens, gold weakens.
The low interest rates and expansionary monetary policies greatly benefited the gold and bond holders in the past decade. iShares Barclays 20+ Year Treasury Bond Fund ETF (has gained about 50% in the last five years. The ETF, which seeks to replicate the price and yield performance of Barclays U.S. 20+ Year Treasury Bond Index, reached a market cap of almost $4 billion. Its yield is currently 2.67%.
But, as interest rates reached an absolute bottom of ‘0 boundary’, they have nowhere to go but up. The effect of higher interest rates can be devastating on both gold investors as well as bond holders. In fact, bond holders are likely to suffer the worst from rising interest rates.
What about Goldcorp Inc. (USA) (NYSE:GG)?
Goldcorp Inc. (USA) (NYSE:GG) is the largest publicly traded gold company on the market. However, the recent plunge in gold prices hit the company very badly. Currently, it is trading at around $27, which is 40% below its 52-week high.
The company has strong financials. Its debt to equity is near zero. It is also cheap with a price to book value 0.95. I think the market over-reacted to the fall in gold prices. Goldcorp Inc. (USA) (NYSE:GG) is probably going to rebound to much higher levels if gold picks up.
No investment is devoid of risk. It normally comes with certain level of risk, and gold is no exception. However, the risk is probably lesser. Gold may even be a safer investment compared to some blue chip stocks in a low interest environment. While gold was battered recently, it might eventually bounce back. The rebound will be duly supported by rising demand amid limited supply. It may retreat sometimes along the way, but I think it will stabilize and move along with inflation.
The article Pros and Cons of Investing in Gold originally appeared on Fool.com.
Nur Tarkak has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Nur is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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