Gold possesses the rare distinction of being both next to useless and highly valuable.Getty Images/iStockphoto
Before you buy into the current fad and start purchasing gold, you should stop and ask what the market's new darling is worth – and why.
It's a fascinating question to tackle, because gold possesses the rare distinction of being both next to useless and highly valuable.
The metal has few practical applications. Electronics, dentistry and industrial uses account for less than 8 per cent of global gold sales.
More frivolous, unpredictable sources of demand are the true drivers of the bullion market. Last year, for instance, jewellery buyers generated around 57 per cent of sales, while investors and central banks were responsible for about 35 per cent of demand.
The enthusiasm of these key buyers can fluctuate wildly, depending on everything from wedding seasons to perceptions of economic uncertainty. For all the talk about gold as a store of value, the market for the metal moves on gusts of emotion.
Investors, for instance, propelled the surge in demand during the first quarter of this year to near-record levels. Those investors bought 617.6 tonnes of the yellow metal, more than triple the amount they purchased in the final quarter of last year, according to the World Gold Council. Meanwhile, demand from jewellery buyers tumbled.
Confronted with this turbulence, how do you know if you're buying gold at a reasonable price or at the right time? Here are three indicators that might provide some insight.
Hey, copper
One way to assess the price of an ounce of gold is to compare it to the price of a pound of copper.
The two metals are opposites in many ways. Copper is utilitarian and practical. Its price booms during times of strong economic growth, when people are busily building things and need copper wiring, copper pipes and copper machine parts.
Gold, on the other hand, tends to produce unimpressive results when people are feeling confident about the future. Instead, it shines when economic uncertainty is high and people are seeking a safe harbour from global troubles.
Comparing the two metals provides a quick read on just how elevated investors' anxiety levels really are. Right now, the gold-to-copper ratio is higher than at any time since the financial crisis. It's also higher than it has typically been over the past 25 years.
One way to read this is to conclude that gold is looking rather expensive these days. A high level of anxiety is already built into its current price.
The raw truth
A more nuanced version of the above approach is to compare gold not just to copper, but to other raw material, as well.
Charlie Morris, a British fund manager and gold analyst who publishes the Atlas Pulse newsletter, likes to plot the path of the gold price against other commodities ranging from gas and cotton to copper and silver.
"The message from the commodity market is that gold was cheap in the late 1990s, yet today it stands on an 80-per-cent premium to its peers," he writes in his most recent newsletter.
You might conclude from this that gold is looking very expensive indeed. Mr. Morris, however, prefers an alternative explanation. He thinks gold is reasonably priced, for reasons we'll get to in just a bit. His point is that other commodities appear to offer even more compelling value.
A bond flick
One way to view gold is as a high-quality bond – but one that is linked to inflation and that pays no yield.
This is Mr. Morris's preferred perspective and hinges on his belief that gold is a long-term store of value. His model calculates how much such a bond would be worth under different combinations of two key factors – bond yields and inflation expectations.
Together those factors determine the outlook for real interest rates (that is, rates after inflation is subtracted). Gold prices typically shrivel when real rates go up; they swell when real rates head down.
The connection makes perfect sense: Real rates suggest how much return an investor can generate from alternative investments, such as bonds or bank accounts. The higher real rates get, the less attractive it becomes to hold a non-yielding asset like gold.
By Mr. Morris's numbers, gold looks fairly priced today at around $1,220 (U.S.) an ounce.
However, its value would be slashed if the U.S. Federal Reserve were to move quickly to tighten monetary policy and normalize real rates. Assuming inflation expectations were to remain steady, but 20-year bond yields were to rise to around 6 per cent, gold's value would fall in half.
Conversely, if the U.S. were to start to resemble Japan in terms of ultra-low or even negative interest rates, gold investors would prosper. Mr. Morris calculates that if 20-year bond rates were to fall to zero, while inflation expectations remained roughly where they are now, gold could hit $1,900 an ounce again.
Which scenario is more likely? That's a tough call, but anyone who is thinking of investing in gold right now should consult his or her crystal ball before making a purchase.
If, like many of us, you don't have a particular view about which way rates are going to head next, you may want to think twice about riding the current burst of enthusiasm for gold.
Ian McGugan