World as I Think

Its kinda becoming like a economics/ fianance blog still I thought it might help some people who are looking for cues to invest in gold.This is part of a mail which I mailed across to my friend penning my thoughts about investing in gold. I have tried to ascertain the direction of gold prices given my current perceptions and level of knowledge.

Below is the chart( click the image for a better view) of different asset classes compared with each other on the logarithmic scale.

1. Equity and Gold have moved in opposite direction since 1970 .
2. Commodities including Gold, Copper and Oil have moved similary ( the linear trend ) .
3. US dollar moves in the opposite direction to gold (negative correlation is lower) but gold has moved more steeper in the upward direction in the recent past against the dollar.
4. Peculiarly, all the asset classes have been in the uptrend barring the dollar after a large infusion of liquidity in the global markets since the Fed cut the rates to 100 bps in 2001 .

Investment Corrolaries

Gold is a hedge against the dollar, it is presumed that it is better to invest in gold as it yields a higher return compared to the US dollar assets which would yield negative or paltry return (Fed has been aggressively cutting rates and is expect to come to 100 bps mid this year).Lower interest rates result in the depreciation of a currency (investors sell the currency with the lower interest rate and buy currency with higher interest rates{the supply demand theory} hence spot rates of $ has been tumbling) and the Fed is not expected to increase the interest rate again before growth picks up in the US.US is expected to get into a recession and feel the brunt for at least the next four quarters. Thus a sharp reversal in $ trend is not expected until next year, assuming US gets into a recession now.

Fed is expected to cut rates; as a consequence, liquidity is expected to be at higher levels once the credit crisis subsides, this should logically fuel the prices of all asset classes. Now if US gets into recession the equity class would not perform and it is widely expected that S&P 500 would fall by 20% if US gets into a recession, so ideally going by past, gold should be bought as an alternative to equities.

Commodities are expected to outperform given the demand supply mismatch due to huge demand from developing countries (esp China & India) but the real question is whether slow down in US & developed world would reduce the demand and hence reduce the deficit and hence result in a cool off in commodity prices.

To invest in gold or not now ?

Gold & commodities in my view are at least 10-15% below their peaks, so ideally, they must correct or reverse the trend after it. The real state of US economy must be clear by Q3 2008, so ideally any new trend should happen then. If the US Equities correct by 10-15% by then and economy picks up, we can be almost sure that the trend is going to reverse. That is when Fed should ideally start increasing the rates and dollar must see any reasonable strength. This would bring back the confidence in the dollar and investors must flee gold.

The risks to the above conclusions are that the US might enter into a stagflation environment (the US GDP/prices falls even though there is a steep increase in inflation/ cost of input materials which cannot be passed on to the cosumers as there is a lack of consumer demand in a recessionary environment).The probable reasons should be that commodities demand supply gap is persistent and the prices do not come down. This is a good scenario for considering gold as an investment.

If US shows the middle finger to the recession scare and returns to throttle in another two quarters, then gold would correct sooner or later.

It all depends of when uncle Sam is expects to come back with a bang.

Labels: economics