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Gold bars from melted gold jewellery and pure gold bars are seen at Express Gold in Toronto (Moe Doiron/Moe Doiron/The Globe and Mail)
Gold bars from melted gold jewellery and pure gold bars are seen at Express Gold in Toronto (Moe Doiron/Moe Doiron/The Globe and Mail)

The case against gold Add to ...

ETFs have given investors the opportunity to buy and sell gold at the touch of a button throughout the day, without having to worry about the inconvenience of storing and guarding the stuff. This democratizing development is lauded by some observers for bringing gold to the masses. Indeed, it is estimated that retail investors hold as much as 70 per cent of the outstanding units of the SPDR Gold Trust.

However, the popularity of these new investments raises a concern: If investors have piled into gold as the price has risen, what are these investors going to do if the price of gold declines or even stagnates? Some ETFs such as the SPDR Gold Trust, might be forced to sell their gold holdings to meet redemptions, creating a negative feedback loop that will pull down gold prices.

The market itself is expressing doubts about the long-term outlook for gold. Demand for gold stocks - that is, the companies that run the mines - is relatively weak next to gold itself.

The divergence factor

Pierre Lapointe, global macro strategist at Brockhouse Cooper, noted that the ratio of the gold price to the U.S. gold stock index is about 6.5, which is well above the ratio's historical average of 4.4 for data going back about 25 years. In other words, gold stocks haven't been keeping up with the price of gold, creating a confounding divergence.

"Such a divergence can be interpreted two ways. On the one hand, it could mean that gold stocks have yet to reflect the increase in the underlying commodity," Mr. Lapointe said. "On the other hand, it could mean that the commodity has overextended its rally and that stock investors do not believe the bullion rally has legs."

He leans toward the latter explanation, largely because gold stocks are nowhere near bargain levels. World gold stocks trade at nearly 20-times estimated earnings, compared to about 15-times earnings for the broader S&P Global 1200 composite index.

If gold stocks were to rise to the point where they closed the gap with the price of gold, then the P/E ratio for gold producers would come close to 29 times estimated earnings. Such lofty valuations are often followed by disappointment.

Addressing the long-term outlook for gold, Jeremy Grantham, the widely followed chairman of GMO LLC, the global asset management firm, recently offered a withering comparison.

"I would say that anything of which 75 per cent sits idly and expensively in bank vaults is, as a measure of value, only one step up from the Polynesian islands that attached value to certain well-known large rocks that were traded," he wrote in his monthly letter to clients.

Some fear that the gold market is repeating history. In 1980, gold shot up to $850 an ounce amid fears of war and inflation. Anyone who was late to the party, though, nursed losses for the next 28 years, as gold retreated to $500 an ounce just months after hitting its peak, and then fell to $300 by 1982.

It wouldn't take much to skewer the price of gold a second time. An improving global economy would send interest rates and bond yields higher, which would make the opportunity cost of holding gold - which pays no dividend - prohibitively expensive. Money would probably flow out of gold investments and into other assets, such as stocks and bonds.

"If you look at the Internet bubble or the housing bubble, it can go on longer than you think," Mr. McElvaine said. "But are the fundamentals for you or against you? With gold, they're against you. It doesn't mean it won't work out in the short run, but it will end badly."



1980: Gold peaks at $850 (U.S.) an ounce amid a surge in the price of oil following the 1979 Iranian revolution. At the same time, Federal Reserve chairman Paul Volcker confronts double-digit U.S. inflation by raising key interest rates as high as 20 per cent.

1999: Gold tumbles to a cyclical low of $252 an ounce during the height of the dot-com bubble and soon after the Nasdaq composite index peaks at more than 5,000. With low U.S. unemployment and a strong housing market, there was little for investors to fear.

2007: The price of oil rises above $80 a barrel for the first time amid concerns about rising Chinese energy demands. The gain feeds concerns that higher energy will translate into rising inflation, which sends the price of gold above $600 an ounce.

2008: The global financial crisis sends investors scurrying for shelter and into the U.S. dollar. The dollar's gains send gold down as low as $700 an ounce - down about 30 per cent from its high near the start of the year.

2009: The price of gold rises above $1,000 an ounce again to a new record high in nominal terms. Investors fret over the implications the Federal Reserve's monetary policy, which involves printing hundreds of billions of dollars to buy U.S. Treasury bonds.

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