Investors get increasingly bitten by the gold bug

In a hidden corner of major business broadsheets was a small news item that Soros Fund Management — which manages over $25 billion (Dh91.95 billion) — had gone out an increased its stake in gold holdings by over 152 per cent.

This comes along when other money managers of repute have been accumulating gold over the past year. These include David Einhorn, John Paulson, Paul Tudor Jones etc. All this must make one wonder and ask — what is going on?

The first and simplest answer is that there is an increasing sense that the alternate store of global wealth, the euro, is likely to depreciate substantially.

The crisis in Greece over the past six months has increasingly exposed structural deficiencies of the euro zone.

As had been alluded to in a previous column, inability to directly intervene with a bailout package and sky-high deficit spending patterns, in not just Greece but also in Spain, Portugal and now increasingly in the UK, have made markets increasingly wary of the euro's sustainability as an alternative currency store of wealth.

Concomitant to this wariness is the lack of long-term faith in the dollar's ability to hold steady against other assets. In essence, despite the rise of the dollar against the euro, the markets are unclear where to go for yield and predictability in the intermediate term.

The second and more complex explanation is that there is a rising level of noise trading. A rising number of funds and individuals are convinced that gold is headed for record highs.

From men like Jim Rogers who had called for gold to head towards $2,000 an ounce earlier in the year to the four largest exchange traded funds who have accumulated over 1,500 metric tonnes of gold.

For example, the SPDR Gold Trust holds more gold than China and Switzerland. There is an increased level of mushrooming effect. Traders are piling on positions because they anticipate others to pile on and every trading desk wants to get onto gold before the others get on.

Easy money

A more structural factor is the low interest rate regime across the markets. This results in all the right factors for the creation and sustenance of asset bubbles. However, for asset bubbles to emerge and flourish, one needs an institutional environment which sustains and rewards that behaviour.

In the 1990s there was the ‘newness' of technology, in the 2000s, there was the easy credit driven real estate boom. In both cases there was the structural incentive to convert one form of asset into another form, which presumably would relatively appreciate. In today's atmosphere of sustained uncertainty — politically, economically and from a political perspective — along with low cost of capital (courtesy low interest rates), the markets are in search of yield-multiplying asset.

There also remains the proverbial $64-million question of inflation. While the market tends to continue to assess which way the inflationary winds are blowing, the median estimate is that mild levels of inflation (around 2.1 per cent) is to be expected. To many the declining euro, uncertain dollar and inflationary fears are a combination guaranteed to raise gold prices.
 
Yet, there are sufficiently large numbers of participants who think gold is very expensive today. This despite the fact that compared historically, today's prices after inflation adjustment are only half of the all-time high reached in 1980.

What accentuates the fear that gold may be overbought is that gold has been increasing for the past 10 years and other commodities that have shown such secular ascent have often ended seeing a precipitous decline in price. For example, crude oil rose over 100 per cent in 12 months around 2008, only to suffer a serious decline (of over 75 per cent) in the subsequent six months.

That volatility, induced no doubt by the credit crisis, is what many analysts suspect gold might also display.

Yet, to confuse gold as just yet another commodity is to fail to understand the impact gold has on cultural norms.

Gold remains, in our opinion, the increasing refuge for global investors for real and speculative purposes. And one would be well advised to think of it as an active asset allocation strategy in a portfolio. Uncertainty can breed fear, but in this case it seems uncertainty also breeds greed.

The columnist works for a major European investment bank in New York City. You can follow his tweets at: http://twitter.com/ks1729