Bullion Markets (An Introduction)


Gold as an investment

Gold was in use as a form of money, in one form or another, at least from 560 BC until the end of the Bretton Woods system in 1971. It was used as a store of value both by individuals and countries for much of that period. Since the end of the Bretton Woods system in 1971, gold has largely lost its role as a form of currency. It is still considered by many as a store of value and a safe haven in times of crisis. Central banks retain large gold reserves.


Gold as a financial asset

Gold and other precious metals are assets that are both tangible and liquid (i.e. easily traded), unlike real estate which is tangible but not liquid, or company shares and bonds which are liquid but not tangible. Considering its high density and high value per unit mass, storing and transporting gold is very easy. Gold also does not corrode. Historically, it was also very easy to verify that an offered coin had the density of gold through the use of Archimedes' principle. Today, however, some metals are denser than gold yet cheaper. While some think gold deserves special treatment based on its cultural value and use as money, others consider gold a commodity, like copper or lead.


Buying physical gold

Some people, sometimes referred to as gold bugs, buy gold which they retain in their physical possession in the belief that should the monetary and financial system collapse, gold would still be considered valuable. Other reasons for doing so include the ease of hiding the gold from others, such as family members or tax authorities.


Buying gold for the gold price

Some people buy gold not in their physical possession, but stored for them by a bank, through a gold exchange-traded fund, or in the form of a gold certificate; their motivations also apply to those who hold gold physically. Some asset allocation strategies use exposure to gold as a form of diversification, though the inclusion of gold in portfolios has largely been abandoned since the 1980s. Gold may be included in portfolios as an insurance against unforeseen calamities which may affect the price of other investments negatively.

Gold is sometimes treated as the fifth world currency, along with the US dollar, euro, Japanese yen, and the British pound. It is therefore bought in a process analogous to currency speculation: when it is expected that the dollar will soon decline against other currencies, for an investor who receives his salary in dollars, buying gold or other currency before the decline and selling it afterwards could realize a profit. Additionally speculators attempt to make a profit by predicting the gold price, detecting market trends they believe will show them the future price direction.

For centuries gold has remained a store of value. Some people believe that by buying gold, they will be most likely to maintain their wealth in the long term, protecting them against inflation and decline in the value of fiat money. These individuals believe that certain events (e.g. war or economic crisis), may have a negative influence on the value of their other investments, but the opposite effect on the value of gold.

Types of gold investor

Investors may buy gold as an investment because they are either one of, or a combination of, the following:

Asset allocator

Traditional asset allocation strategists used to recommend exposure to gold on the grounds of diversification. Although the inclusion of gold in portfolios has largely been abandoned since the 1980s, it is once again being considered by some asset allocators.


Cacheur

Physical gold can be anonymous. Gold is a very soft metal, meaning that (assuming the gold is in the physical possession of the owner) the bar's serial number can be altered or obliterated with a hammer and chisel. If the bullion's ownership is not recorded anywhere the gold can become untraceable. Cacheurs seek to hide part of their wealth from their spouse, family, tax authorities, creditors, thieves, invaders or others. The density of gold allows them to store a large value in a very small space, without fear of depreciation or erosion over a long period of time. A metric tonne of gold (1,000 kg or 2204.6 pounds) would be equivalent to a cube of side 37.27cm (1 ft 2⅔ in), or roughly the size of a basketball. This small cube would contain 32,150 troy ounces, and be worth about $19,200,000 (June 29th, 2006).


Currency speculator

Since the main gold market is priced in US dollars, speculators who believe the dollar will decline may buy gold. They think that if the dollar declines, the gold price will remain constant in other currencies, thus rising in terms of the U.S. dollar. Gold may also be bought if they feel that a different currency will decline, since they expect the dollar price to be stable, but the foreign currency price to rise. Many currency traders treat gold as the fifth world currency, after the US dollar, European euro, Japanese yen and British pound.


Gold bug

Gold bugs, in the traditional sense, believe in, fear, or even hope for the Second Great Depression or Armageddon, and believe that by holding gold they will survive and prosper. 

 
Hoarder

Some investors respect gold as a long-term store of value, and seek no profit, other than to maintain their purchasing power. By buying gold and hanging on for the long term, they believe they can keep their wealth intact.


Inflation hedger

For centuries gold has remained a store of value. It has performed this function best in times of high inflation. Investors thus buy gold to protect themselves against a rise in inflation and a decline in the value of fiat money.


Libertarian

Libertarians may use privately issued digital gold currency, in preference to fiat currency, for reasons such as lack of trust in fractional-reserve banking or monetary policy.


Portfolio hedger

Similar to asset allocators, except the purpose of the investment is as an insurance against unforeseen calamities which may affect the price of other investments negatively. Portfolios that contain gold are better able to withstand market surprises than those that do not. Some recent independent studies have suggested that traditional diversifiers, such as bonds, property and hedge funds, often fail to stand up to market stress and may sell off with equities in times of uncertainty. Even a small allocation of gold to a portfolio significantly improves its performance during unstable periods. These individuals believe that certain events, if they occur (e.g. war or economic crisis), may have a negative influence on the value of their other investments, but the opposite effect on the value of their gold.


Speculator

Speculators attempt to make a profit by predicting the gold price. They may think that macroeconomics are affecting the demand for gold, or believe they have detected a market trend showing them the future price direction.

Gold price

The usual benchmark for the price of gold is known as the London Gold Fixing, a twice-daily (telephone) meeting of representatives from five bullion-trading firms. Furthermore, there is active gold trading based on the intra-day spot price, derived from gold-trading markets around the world as they open and close throughout the day.

Factors influencing the gold price

Today, like all investments and commodities, the price of gold is ultimately driven by supply and demand, including hoarding and dis-hoarding. Unlike most other commodities, the hoarding and dis-hoarding plays a much bigger role in affecting the price, since almost all the gold ever mined still exists and is potentially able to come on to the market at the right price. Given the huge quantity of above ground hoarded gold, compared to the annual production, the price of gold is mainly affected by changes in sentiment, rather than changes in annual production or gold jewelry demand.

Central banks and the International Monetary Fund play an important role in the gold price. At the end of 2004 central banks and official organisations held 19 percent of all above ground gold as official gold reserves. European central banks, such as the Bank of England and Swiss National Bank, have been selling a total of approximately 500 tonnes of gold a year from the late 1990s until 2005.

In November 2005, Russia, Argentina and South Africa expressed interest in increasing their gold holdings. Other than Russia, these are not viewed as significant central banks, but any move by Japan, China or South Korea to do the same would be seen as significant. Currently the USA has 75% of its foreign reserves in gold, whereas China holds approximately 1% in gold.

Although central banks do not generally announce gold purchases in advance, some such as Russia have expressed interest in growing their gold reserves again as of late 2005. In early 2006, China, who only holds 1.2% of its reserves in gold, announced that it was looking for ways to improve the returns on its official reserves. Many bulls took this as a thinly veiled signal that gold would play a larger role in China's reserves, which they hope will push up the price of gold. It would however be impossible for China to increase its gold reserves by anything other than a small percentage, since there is simply insufficient gold available in the market.

Inflation fears have also been influential in the past. Inflation is once again rising. The October 2005 consumer price index level of 199.2 (1982-84=100) was 4.3 percent higher than in October 2004. During the first ten months of 2005, the CPI-U rose at a 4.9 percent seasonally adjusted annual rate (SAAR). This compares with an increase of 3.3 percent for all of 2004.

Sentiment

It used to be said that "Gold is the world's frightened bunny". Whenever crisis threatened, the demand for physical gold increased.


Bank failures

When dollars were fully convertible into gold, both were regarded as money. However, most people preferred to carry around the paper dollars issued by their bank rather than the somewhat heavier and less divisible gold coins. If people feared their bank would fail, a bank run might have been the result. This is what happened in the USA during the Great Depression of the 1930s, leading President Roosevelt to impose a national emergency and to outlaw the holding of gold by US citizens.


Inflation

Paper currencies pose a risk of being inflated, possibly to the point of hyperinflation. Historically, currencies have lost their value in this way over time. In times of inflation, people seek to protect their savings by purchasing liquid, tangible assets that are valued for some other purpose. Gold is in this respect a good candidate, and producing more is far more difficult than issuing new fiat currency, and does not rely on any particular government's health.


War, invasion, looting

In times of national crisis, people fear that their assets may be seized, and the currency may become worthless. They see gold as a solid asset which will always buy bread or transportation. Thus in times of great uncertainty, particularly when war is feared, the demand for gold rises.


Production

According to the World Gold Council, annual gold production over the last few years has been close to 2,500 tonnes. However, the effects of official gold sales (500 tonnes), scrap sales (850 tonnes), and producer hedging activities take the annual gold supply to around 3,500 tonnes.


Demand

About 3,000 tonnes goes into jewelry or industrial/dental production, and around 500 tonnes goes to retail investors and exchange traded gold funds. For the last few years, the official sector sales of around 500 tonnes have been taken up by retail investors and gold funds.


Supply and Demand

Some investors consider that supply and demand factors are less relevant than with other commodities since most of the gold ever mined is still above ground and available for sale at a price. However, supply and demand do play a role. According to the World Gold Council, gold demand rose 29% in the first half of 2005. The increase came mainly from the launch of a gold exchange-traded fund, but also from jewelry. Gold demand was at an all time record. Demand from the electronics industry is rising by 11% a year, jewelry by 19%, and industrial and dental by 21%.

Methods of investing in gold

Investment in gold can be done directly through ownership, or indirectly through certificates, accounts, shares, futures etc. Most investors would not recommend storing gold oneself (e.g. in one's home or buried in the garden) but to use a bank or dealer. Other than storing gold in one's own safe deposit box at a bank, gold can also be placed in allocated (also known as non-fungible), or unallocated (fungible or pooled) storage with a bank or dealer. In the case of the latter going bankrupt, the client will be unable to claim the gold and would become a general creditor, whereas gold held in allocated storage should be returned to the client in full. However even with gold held in allocated storage, many gold bugs would still choose their storage provider carefully, making sure of high net worth, with some preferring an offshore bank or storage facility.

Bullion

The most traditional way of investing in gold is by buying bullion gold bars. In some countries, like Austria, Liechtenstein and Switzerland, these can easily be bought or sold "over the counter" of the major banks. Alternatively, there are bullion dealers which provide the same service. Bars are available in various sizes, for example in Europe these would typically be in 12.5kg or 1kg bars (1kg = 32.15072 Troy ounces), although many other weights exist, such as the Tael, the 10oz or 1oz bar.

 
Coins

Buying gold coins is a popular way of holding gold. Typically bullion coins are priced according to their weight, with little or no premium above the gold price. Amongst the most popular bullion gold coins are the South African Krugerrand, the Canadian Gold Maple Leaf, and the Australian Gold Nugget, all of which contain exactly one troy ounce of gold each. Other popular one ounce bullion coins include the American Gold Eagle, the Chinese Panda, and the Austrian Philharmonic. Gold coins which are used as bullion coins include the British gold sovereign and the Swiss Vreneli, but these are much lighter than one ounce. Again the large Swiss and Liechtenstein banks will buy and sell these coins over the counter. Also available is the gold dinar which has Islamic significance.

Gold certificates

A certificate of ownership can be held by gold investors, instead of storing the actual gold bullion. Gold certificates allow investors to buy and sell the security without the hassles associated with the transfer of actual physical gold. The Perth Mint Certificate Program (PMCP) is the only government guaranteed gold certificate program in the world. Some argue that it is not the same as owning the real thing, as a certificate is just a piece of paper, especially in a war, crisis, or credit collapse.

Gold accounts

Most Swiss banks offer gold accounts where gold can be instantly bought or sold just like any foreign currency. Digital gold currency accounts and the BullionVault gold exchange work on a similar principle. Gold accounts are typically backed through unallocated or allocated gold storage. Different accounts impose varying levels of intermediation between the client and their gold, for example through bailment or within a trust. Bailment is the legal action of a client entrusting their physical property to another party for safekeeping, and paying for the service.

Gold exchange-traded funds

Gold exchange-traded funds (or GETFs) are traded on the major stock exchanges including London, New York and Sydney. The first gold ETF, Gold Bullion Securities (ticker symbol "GOLD"), was launched in March 2003 on the Australian Stock Exchange, and originally represented exactly one-tenth of an ounce of gold. Due to costs, the amount of gold in each certificate is now slightly less. They are fully backed by gold which is both deposited and insured. The inventory of gold is managed by buying and selling gold on the open market.

Gold ETFs represent an easy way to gain exposure to the gold price, without the hassle of buying gold directly. Typically a small commission is charged for trading in gold ETFs and a small annual storage fee is charged. The annual expenses of the fund such as storage, insurance, and management fees are charged by selling a small amount of gold represented by each certificate, so the amount of gold in each certificate will gradually decline over time. In some countries, gold ETFs represent a way to avoid the sales tax or the VAT which would apply to physical gold coins and bars.

In May 2006, gold ETFs held 491 tonnes of gold in total.

Gold shares

These do not represent gold at all, but rather are shares in gold mining companies. If the gold price rises, the profits of the gold mining company could be expected to rise and as a result the share price may rise. However, there are many factors to take into account and it is not always the case that a share price will rise when the gold price increases. Some of the following questions might be relevant before investing in the shares of a gold mining company: Has the company hedged the gold price i.e. already sold part of its future gold production through forward sales? Is the company already producing gold, or is it mainly exploring for gold? Does the company make a profit? How many years of ore reserves are left in the mines before they have to be closed down? What PE ratio and dividend yield does the company have now and in the following years? Are the mines subject to political or economic risks?

Unlike gold bullion, which is regarded as a safe haven asset, gold shares or funds are regarded as high risk and extremely volatile. This volatility is due to the inherent leverage in the mining sector. For example, if you own a share in a gold mine where the costs of production are $300 per ounce and the price of gold is $600, the mine's profit margin will be $300. A 10% increase in the gold price to $660 per ounce will push that margin up to $360, which actually represents a 20% increase in the mine's profitability, and potentially a 20% increase in the share price. Conversely, a 10% fall in the gold price to $540 will decrease that margin to $240, which actually represents a 20% fall in the mine's profitability, and potentially a 20% decrease in the share price. The amplification of gold mining profits during periods of rising prices can cause a gold rush.

In order to reduce this volatility many gold mining companies hedge the gold price up to 18 months in advance. This provides the mining company and investor with less exposure to short term gold price fluctuations, but reduces potential returns when the gold price is rising. The AMEX Gold BUGS Index (ticker symbol "HUI") is comprised of the largest unhedged gold stocks listed on AMEX (BUGS - Basket of Unhedged Gold Stocks). As of May 2006, the two largest stocks listed in the index were Newmont Mining and Gold Fields.

Unhedged gold stocks, AMEX Gold BUGS Index ("HUI"), have outperformed general gold mining stocks, represented by the Philadelphia Gold and Silver Index ("XAU"), over recent years.

Instead of personally selecting individual shares, some investors prefer spreading their risk by investing in gold mining mutual funds such as the Gold & General Fund by Merrill Lynch, or exchange-traded funds such as the Market Vectors Gold Miners ETF (NYSE: GDX) by Van Eck Global which tracks the Amex Gold Miners Index ("GDM").

Spread betting

Firms such as Cantor Index and IG Index, both from the UK, offer the ability to take a bet on the price of gold through what is known as a spread bet. Say the price of December gold was quoted at $475.10 to $476.10 per troy ounce. An investor who thought the price would go down would "sell" at $475.10. The minimum bet is $2 per point, (i.e. equivalent to 200 ounces). If the price of gold finished at $480.10 when the seller closed their bet, the loss would be 500 points multiplied by the bet of $2 making a loss of $1000 in total. No commissions or taxes are levied in the UK on spread betting.

Derivatives

Derivatives, such as gold futures and options, currently trade on various exchanges around the world. In the U.S., gold futures are primarily traded on COMEX (Commodity Exchange) which is a subsidiary of the New York Mercantile Exchange. Speculation about the future price of gold and other commodities takes place at COMEX.

Investment strategies

Fundamental analysis

Investors may base their investment decisions on fundamental analysis. These investors analyze the macroeconomic situation, which includes international economic indicators, such as GDP growth rates, inflation, interest rates, productivity, and energy prices. They would also analyze the total global gold supply versus demand. Over 2005 the World Gold Council estimated total global gold supply to be 3,859 tonnes and demand to be 3,754 tonnes, giving a surplus of 105 tonnes.

Technical analysis

Investors may base their investment decisions solely on, or partly on, technical analysis. Typically this involves analyzing past price patterns and market trends, in order to speculate on the future price. Some investors try to predict the future gold price by tracking the ratio between the Dow Jones 30 and the gold price. The Dow/gold ratio has fluctuated from a low of 1.0 in 1980 (i.e. the Dow and gold price were the same) to a high of 43.7 in 1999 (i.e. the Dow was 43.7 times the gold price).

Using leverage

Bullish investors may choose to leverage their position by borrowing money against their existing gold assets and then purchasing more gold on account with the loaned funds. In order to keep the cost of debt to a minimum, these individuals would normally seek a loan in the currency with the lowest LIBOR, which as of April 2006 was the Japanese yen. This technique is referred to as a "yen-gold carry trade". Leverage is also an integral part of buying gold derivatives. Leverage may increase investment gains but also increases risk, as if the gold price decreases the investor may be subject to a margin call.

Gold's value versus money supply

Historically increases in the supply of paper money or fiat currency through increased money supply would cause the demand for gold to increase. There was a time when gold was money and vice versa. If citizens felt that there may be insufficient gold to cover the paper money in circulation, they would queue up at the bank to change their paper currency back into gold.

However, since the gold standard was ended on August 15, 1971, governments have been free to print as much money as they choose, without fear that their populations will come knocking on the central bank's door demanding to change their paper money back into gold.

In January 1959 US M3 money supply was $288.8 billion, and the official gold reserves of the United States was then 17,335.1 tonnes, or 557,336,000 ounces (there are 32,150.7 troy ounces in a tonne). That means that in 1959, there were $518 in circulation for every ounce of gold reserves held by the USA. Although the theoretical price should then have been $518 per ounce, the actual price, as fixed under the gold standard was only $35 an ounce.

By August 2005, the US M3 money supply had risen to $9,873.9 billion, whilst at the same time the Official Gold Holdings of the United States had fallen to just 8,133.5 tonnes, or 261.50 million Troy Ounces. This means that today, in 2005, there are $37,831 in circulation for every troy ounce of gold held by the United States.

However, this increase of 75 times in the ratio of central bank gold holdings to debt does not allow for the fact that the gold standard was abandoned in 1971 and gold holdings have been deliberately and considerably reduced. Another far less dramatic way of looking at the same figures is this: In 1959 US government debt valued in gold was 8 billion Troy ounces, in 2005 US government debt was 20 billion oz gold - an increase of only 2.5 times.

The above numbers show the falling influence of gold in the monetary system of the world today. Gold bugs believe, or even hope, that one day gold's importance will return as the printing of paper money gets out of control and we end in a hyper-inflationary fiat money collapse.

They sometimes cite the huge United States public debt, budget deficit and trade deficits as additional evidence that things are getting out of control. For example, in 1959 US public debt was $290,797,771,717 ($290 billion), whereas by February 2006 it had reached $8,205,376,724,587 ($8.2 trillion). The U.S. budget deficits are the largest in history and according to the U.S. Government's own published plans, the budget will not be balanced in the foreseeable future.

The United States Federal Reserve ceased publishing M3 data on 23 March 2006, with the last published data indicating a year-on-year growth rate of 8.23%.

Central banks may see this as a reason to limit further increases in their reserves of dollars, and thus alternatives such as gold or the euro might be considered.

Supply

In 2001, it was estimated that all the gold ever mined totaled 145,000 tonnes, which would form a sphere slightly less than 25 metres in diameter. Global gold production is between 2,500 to 3,000 tonnes per year, which would mean that about 155,000 tonnes of gold would have been mined as of 2006, with a total value of $3.2 trillion at June 2006 prices.

Bulls versus bears

Many argue that gold's role in the world's monetary system has ended, and that it will never again represent the store of value that it once was. John Maynard Keynes, the influential economist, as early as 1924, described the gold standard as a "barbarous relic". Many central banks, especially in Europe, seem to agree, and have been selling off their gold reserves at the rate of around 500 tonnes a year. The gold price peaked at around $850/oz t ($27,300,000 per tonne) in 1980, and in real terms is still well below that. However, since April 2001 the gold price has more than doubled in value against the US dollar (as seen here), prompting speculation that this long secular bear market (or the Great Commodities Depression) has ended and a bull market has returned.

Taxation

Gold maintains a special position in the market with many tax regimes. For example, in the European Union the trading of recognised gold coins and bullion products is free of VAT. Silver, and other precious metals or commodities, do not have the same allowance. Other taxes such as capital gains tax may still apply for individuals, according to their jurisdiction. There is no capital gains tax in Switzerland.