Gold, like diamonds, holds a fascination much greater than its simple financial value. It is malleable, resistant to tarnishing, highly conductive and a fantastic metal to work with (in a previous life i completed a jewellery making course and came to appreciate just how easy gold is as a medium). In some countries, the open display of gold establishes your social standing.

Yet gold has another purpose. For millenia it has been a medium of exchange – money. Not that long ago, physical gold was the security behind the issue of a nations’ currency. In the 20th century, most countries moved to ‘fiat currency’, which made the gold holdings redundant, so central banks began to sell down their hoards of gold, resulting in an extended period of declining prices.

Cycle forward to the 21st century and the aftermath of the Global Financial Crisis. Suddenly the finances of major countries looked far less stable. The security of currencies began to be questioned. When the United States and the United Kingdom began to print money as a way of reviving their economies, the value of those underlying currencies began to fall.

People were now buying gold as a hedge against the falling currencies. The demand was so great that the price escalated rapidly. For a few years now, the price of gold has reflected the level of uncertainty about the future for investment markets globally.

Some analysts and forecasters are predicting massive deflation (think of the Japanese economy, where the sharemarket and house prices are still substantially lower than they were in the 1990’s), while others are suggesting runaway inflation as an inevitable outcome of the US and UK eventually winding back their money-printing exercise. In both cases, physical gold is seen as offering some form of capital protection against such outcomes. Whether this is true or not is actually not all that important. What matters is that many thousands of people think that it is, and when they buy physical gold or the listed Exchange Traded Funds (ETF’s) that do it for them, the outcome is a spike in demand with the almost inevitable rise in price brought about by constrained supply.

And so the price of gold has risen dramatically over the past 10 years. Some call this a bubble, while others suggest the price can still rally further from here – and that this rally won’t stop until the money-presses in the US and UK stop.

It is worth remembering that a lot of the people who buy gold as an investment do so to achieve greater security. We will have a look at whether this outcome is actually achieved a little later in this post.

Gold prices have risen and risen again since the central bank sell-off. Interestingly, the Australian companies that mined the stuff did not see their share prices rise at the same rate as the physical gold price. This is unusual, as these companies will usually see their enterprise value rise or fall further than the change in gold price, as they are leveraged to such outcomes through production costs and often through an ability to choose ore grades. Eventually however, the leveraged impact of the gold price on the valuations of these businesses did begin to assert itself in the sharemarket prices for those gold companies.

We’ll start by looking at the gold index (XGD) and comparing it to the physical price (we’ll use the ETF GOLD).

In the very recent past, anecdotal evidence is emerging that suggests the possibility of more sustainable global economic growth than has been the case for some time now. The United States money-printing continues to push funds into markets, which is stimulating investment (with the ‘cross your fingers’ hope that employment in the US will also rise) and promoting a move to risk-taking. Hence, we are seeing some of the heat move out of the gold price.

You can see the massive surge in price that occurred back in April 2010, primarily as a result of the ‘Euro Crisis’ and the uncertainty surrounding Greece, Ireland, Spain and Portugal. If you bought gold as a protection against this uncertainty, how have you fared?

• 28 January 2010 – 8 June 2010. The gold price lifted around 26%.
• 8 June 2010 – 28 July 2010. The gold price fell around 13.8%.
• 28 July 2010 to 1 December 2010. The gold price rallied 11.4%.
• 1 December 2010 to 28 January 2011. The gold price has fallen 8.8% so far.

If your aim was to gain greater security then this would only have worked if your timing was fairly perfect. You could just as easily have piled into gold with everyone else at the peak, only to see the value fall by 12% as at todays price.

How would you have gone if you’d simply purchased the ‘entire market’, as measured by the S&P/ASX 200 Index – the most common measurement of the Australian sharemarket performance. Remember that you would have been earning dividends from a share based investment, so let’s use the ‘accumulation index’ which accounts for the reinvestment of any dividends paid out by the top 200 companies.

Here is your pathway through the year just gone :

• 28 January 2010 to 15 April 2010. The market lifted 8.4%.
• 15 April 2010 to 5th July 2010. The market fell 15%.
• 5 July 2010 to 19 January 2011. The market rose 17.1%.
• 28 January 2010 to 28 January 2011. The market lifted by 7.2% overall.

From this you can see that buying gold for security didn’t really work. A cash deposit in an internet based term deposit would have earned around 6% over that period, so the volatility taken with gold prices was paid back with a higher return (9.2% for gold over the year). However, the volatility would certainly not have made anyone feel more secure.

The long term prospects for the gold price are heavily connected with the long term outlook for the major global economies. If a more stable growth pattern emerges then it is most likely that the gold price would not lift by all that much, and possibly even fall. The supply/demand of gold for other than investment purposes is quite solid but the massive wave of investment money is the key driver to prices currently, it would seem.

Here is a quick look at some gold company prices of late.

And, as usual, we should always look at the broader group representative of gold companies in Australia – the XGD gold index.

It will be interesting to see where the gold price moves from here…

Disclaimer – As usual, please remember the great rule of this website – nothing in this post or site is to be considered personal advice. You must not and cannot use it as a basis for making investment decisions, as personal advice can only be provided when it is in the context of your overall financial situation, objectives and preferences. These are simply ponderings, musings and reflections of a person whose average day is spent exposed to the tumult of the investment world.