Does it make sense to buy or sell gold in current market?

28 Sept 2009

Renowned for its reputation as a safe haven, the yellow metal is nowadays giving sleepless nights to its prospective buyers and sellers. The problem is its valuation. While buyers don’t know what is the right price to buy, sellers are equally confused — unsure at what price should they let go of this precious metal. Gold prices are hovering around Rs 16,000 per 10 grams these days, up more than 30% from last year.

The shining metal’s historical correlation’s with oil and equity is showing strains in the short run, raising fears of a bubble building in this commodity. Industry body Assocham predicts that gold prices may climb up to Rs 18,000 per 10 gm in the festive season, on back of strong demand and low international production.
What the future holds for gold prices only time will tell, but here’s our take on this alternative asset class — does it make sense to buy or sell in the current market.

FIRST THINGS FIRST

Gold prices like any other commodities are decided by the demand-supply scale. While demand comes from fabrication, supply is driven from mining and scrap sale. Since India is an importer of gold, price is arrived at by converting the international gold price at prevailing foreign exchange rate to the Indian rupee and then adding the necessary duties and taxes such as customs, octroi, sales tax to it.
London Bullion Market Association releases gold prices twice a day (4 pm and 8.30 pm), which is usually used as a reference price. Jewellers further add a retail premium to this calculation to arrive at the retail price. That’s the reason why the US dollar price of gold in international markets and the currency conversion rate to the Indian rupee has the maximum influence on the retail gold prices in India.

Apart from the spot market, gold is also traded in form of futures, options and exchange traded funds. In India, Multi Commodity Exchange of India (MCX) and National Commodity and Derivative (NCDEX) offer gold futures and option contracts. India is the biggest consumer for gold especially in the form of jewellery.

PORTFOLIO INSURANCE

Even though this precious metal stands an uncertain course of action, personal finance experts say gold can still be a part of any investor’s portfolio as its ability to act as a portfolio diversification tool cannot be discounted. “It reduces the portfolio risk. In 2008, when Sensex was down more than 50%, it was gold that helped investors absorb shocks coming out of the equity markets. During that period, gold prices went up by almost 30%,” says Devendra Nevgi, an independent investment expert and former CEO of Quantum AMC.

What could make gold scale new highs in the coming months is the likely weakening of the US Dollar due to record budget deficits, rising public debts, relentless money printing by Federal Reserve and rising inflationary expectations. Gold, a traditional inflation hedge, has a very high negative correlation with the US Dollar. The demand supply matrix also remains tight and marginally surplus demand could lead prices to soar.

“If even 1% of US or Chinese household assets move into gold, the price will go through the roof,” says Nevgi. Other analysts too support the view. They say low interest rates in major currencies support the yellow metal as an alternative investment. “The rise in gold price is part of a bubble. However, this bubble could further intensify if liquidity continues to remain high in the market,” says Dharmesh Bhatia, technical analyst at Kotak Commodity Services. Analysts expect gold prices to move north above Rs 18,000 in the mid to long term.

TOO HOT

Gold may be prospering as an investment destination, but there also exist a section of analysts who feel that getting too near to this metal at this stage can also burn fingers. In case there is a sharp appreciation of Indian rupee vis-a-vis US Dollar, this could negate all the benefits of US Dollar price rise of gold in international markets. Also, if the real jewellery demand does not recover and scrap sales rise significantly, this can trigger a correction in the prices.
Interestingly, central banks globally also do their bit to cut the flab in gold prices. “Since it’s a proxy currency competing with the paper currency, these banks historically haven’t enjoyed a rise in price of gold and tried to defuse the upsurge by intervention,” says Nevgi.

According to him, gold is unlikely to move into the so called bubble territory. The rationale is in an asset bubble, there are abnormally high returns fuelled by excessive speculation, which is not evident as of now in this glittering metal. “Since 1975, gold in US Dollar has returned less than 5%, whereas the US stock markets have delivered (till 2008) almost twice the returns gold has delivered,” points out Nevgi.

As the case is, historical correlation often breaks down in the short run, especially in an abnormal situation of excess liquidity. Gold may shine bright or lose lustre in the coming days, yet its reputation as a safe-haven asset cannot be challenged in the long run, at least as of now.