Gold: an attractive long term investment at the current prices?

Recently gold prices have touched a new record, almost reaching 1200$ per ounce. As usual, when some kind of asset reaches record prices, be it stocks, bonds, real estates or commodities, it gets a lot of attention from the media and the investors community.

But why gold prices have risen so much in the last 8 years, rising to 1200$/ounce from 300$/ounce, an advance of 300%? Are fundamentals responsible for this advance or is there also some kind of speculation behind it? At today prices can we expect to get satisfable returns from gold as a long term investment?

I will try to give my answers to those questions.

Historically, gold has 2 distinct properties which distinguish it from all the other commodities and assets:

- It is an inflation hedge: it's nominal return mimicks the inflation rate over long periods of time

- It is perceived like an hedge against financial crisis and geopolitical instability, meaning that, at last teorically, gold will mantain it's value or even increase it even during an economic depression or wars.

Having avoided financial disaster in late 2008/early 2009 i believe that right now the second property matters little for the market.

The first one could be much more important in explaining the sharp rise in gold prices during 2009. The record amounts of fiscal and monetary stimulus that goverments injected in their economies to prevent a new depression and deflationary pressures could have unpleasant after effects, specifically in the form of high rates of inflation in the next years.

Let's take a look at a graph which shows gold prices in nominal and real terms from 1914 to these days:



By looking at this graph, you may understand why i think that the most important fundamental in explaining gold intrinsic value from a long term perspective is inflation. Of course supply and demand, particulary investment demand, affect gold prices, but they affect them more in the short-medium term than in the long term. In the long term what will affect the prices of gold is inflation, because gold performance will tend to mirror inflation. At last in an economy that works well over the long term like the US economy.

If gold performance mirrors inflation over very long periods of time, over a sufficently long period of time gold real yield must be 0% or at least be very close to 0%. Siegel in his work, "Stocks for the long run", shows that over a 200 years time span gold has had a real return near 0%. This strenghtens my thesis.

This doesn't mean that gold real return in the short-medium term can't be higher/lower that the historical mean which is near 0%. That's because gold prices, like the prices of all the other assets be them equities, bonds or real estate, are affected in the short-medium term by emotional and speculative forces which can push the asset away from it's intrinsic value to overvalued/undervalued valutations. But because these factors are only temporary, over a sufficiently long run period their effects disappear and there is a ruturn to the historical mean real yield.

We can see from the graph that gold is undervalued and can be a good long term investment when it's real return has been negative. Like in 1997-2001, because in the 1914-1997 period it had been underperforming inflation.

That's not the case right now. The bull market of the last 8 years has changed drammatically the situation: today gold nominal return has overperformed the inflation rate in the 1914-2009 period, and it's real return in that period has been much higher than 0%. Gold has been more expensive in real terms only the the period between the '70s and the '80s, when it seemed that the FED had lost it's control on inflation. After that period you can see that it's performance has been pretty disappointing.

This means that gold today is already discounting a sharp increase in the inflation in the next years and beacause of this by purchasing it at todat prices you may lose a substantial part of it's hedeging properties.

That's why i think that at the actual prices gold is overvalued.

Personally to protect myself from inflation i prefer goverment bonds which are indexed to the inflation rate. Differently from gold they also offer an income in the form of the coupons in addition to the hedging of the principal. Over a sufficiently long period of time this makes a substainstial difference.