Gold has now crossed $600 and gold bulls are hopeful that at this rate it will cross the old high of $850, made sometime in early 80s. Will it and if it does, what are the other implications? Is gold a good investment at the current levels? Remember, unlike other financial assets, gold does not pay interest or dividend. Besides, in inflation-adjusted terms gold has not been a great performer. During a period of economic prosperity, gold can go down quite a bit in a continuous fashion over years. Newspaper headlines are screaming now that gold prices have reached 20-year highs in dollar terms and so on. The fact is, it has grown just 10% in these 20 years. The real rise has happened after April 2001, when gold hit $256. But if you bought gold in April 1989, you would have paid $400. By 2001, 12 years later, the loss would have been 35%. Of course, this is a comparison in dollar terms.
With a steady devaluation of rupee, price of local gold would have stayed up. Like most other financial products, there is a time to own gold and there is a time to stay away from gold.
So, the key factors to consider while guessing the price of gold are (apart from the movement of rupee vis-à-vis dollar) estimate of inflation vis-à-vis interest rates and of course estimates of physical demand and supply of gold. Too many complex and global factors are embedded in the price of gold. Not only is it impossible for individual investors but even for teams of experts to get all these elements right to make any worthwhile bet on the direction and magnitude of gold prices. Most importantly, there is little transparency in the large physical demand and supply of gold involving central banks, hedgers and actual users. Gold rises on demand and supply factors such as central banks, hording lots of gold, deciding to sell, depressing prices. But as a thumb rule, it is the expectation of higher inflation worldwide that pushes up the price of gold.
If you want to buy gold for large returns, be careful what you wish for. You would be betting that the world is facing difficult times. When all other asset classes are doing badly, gold will be a top performer. When interest rates are higher than the inflation, gold is not preferred because gold pays no interest. But if interest rates are close to inflation or below, gold is a preferred asset. This is so because inflation eats up the actual earnings power of interest income and reduces the value of financial asset. Suddenly, gold becomes important in those times.
But if you believe that India is a growth economy you may well find yourself in the position of the US investor in 1980. In January of 1980, the Dow Jones Industrial Average was 850, and gold was at $850 an ounce. In 2006, Dow is at almost 12000 and gold is at $600. If India keeps growing and its currency remains stable, stocks will outperform most asset classes and gold will not do too well, whether we have a bull run in commodities or not.