Should you buy gold now?

When stock prices tumble, most investors are tempted to sell their shares and stash the money somewhere safer. But the recent meltdown in gold prices has drawn quite a different reaction from most people: ‘Great! Can I go out and buy gold, now that it is finally cheaper?’

The short answer is: Yes, you can. But do so after you understand the factors that are set to drive gold prices.

Fundamentals will rule

Any asset that rockets up for 12 straight years and gains eightfold in that time, as gold did, is setting itself up for a correction. This correction in the global gold markets is likely to be sharp and messy as speculators who were betting on quick gains react to this fall and worsen it by retreating en masse (see accompanying article). But once the froth goes out of the market, it is gold’s fundamentals as a commodity that will set the long-term direction for prices. We think three key factors will decide the global gold price outlook over the next two-three years.

Central bank buying

One key trigger for the recent gold price meltdown was the fear that troubled European central banks, tired of printing money, would now liquidate their gold reserves to raise cash.

First there were reports that Cyprus’ government was planning a sale of its gold holdings to fund its bailout package. After much hand-wringing, it came to light that Cyprus’ gold reserves, at 14 tonnes, are too small to cause a ripple in the global market (According to the World Gold Council or WGC, 4,400 tonnes of gold were bought last year). Then the bears pointed out that the worry, really, was about other troubled European nations following suit — particularly Portugal, Ireland, Greece and Spain.

With a combined war-chest of 3,100 tonnes of gold, there is no doubt that concerted selling by these four could cause the bottom to drop out of the gold market. But a lot depends on how much gold the banks decide to sell and how they structure the sales.

Central banks are fully aware that selling big chunks of gold into the relatively illiquid spot market can cause prices to nosedive. Indeed, this was why, when the IMF and the developed nations decided to reduce their gold reserves between 1999 and 2009, they agreed on annual quotas for these sales. Euro Zone banks too, if they decide to sell gold today, will probably offload their gold in measured doses spanning many years.

But will they find ready takers for all that gold? They may. Over the last five years, central banks from oil-rich and emerging nations, keen to diversify their foreign currency reserves, have displayed a prodigious appetite for gold. Russia, China, India, Saudi Arabia and others have bought 9,000 tonnes of gold from global markets in the last five years, show WGC data. This more than offset the 3,100 tonnes sold by the IMF and developed nations.

Trends in central bank gold reserves show that only 25 of the 125 nations tracked by the Council have reduced their gold holdings in the last five years. The rest have held on to or raised their gold hoard.

Boost to Jewellery

Another factor that has hastened gold’s recent fall is outflows from gold exchange traded funds or ETFs. So what will be the outlook for gold if investors beat a mass retreat from it?

Well, gold’s relentless rise in the past five years certainly owes a lot to newfound investor appetite for it. WGC data show that investment-related purchases of gold more than doubled between 2007 and 2012 as gold soundly trounced other investment avenues, on its way up. As prices rose, though, jewellery buyers and industrial users tightened their belts. While jewellery purchases shrank by 22 per cent, industry-related purchases fell by 11 per cent in the last five years.

Now, with a reversal in gold prices, there is every possibility that the tables will turn. Investors may desert gold for the flavour of the month — equities.

But as gold languishes at a price that is 20 per cent cheaper than it was just a few months ago, buyers in emerging markets such as India, who view it as an essential festival/wedding purchase, are likely to throng back to the shops.

This rebound in jewellery purchases can make up for a good portion of the diminished demand for ETFs, bars and coins.

Last year, jewellery buyers spent $103 billion on 1,900 tonnes of bullion, at average gold prices of $1669/ troy ounce. Even assuming consumers do not increase their gold budgets at all, they would still be able to buy 2,300 tonnes of gold at today’s prices. That’s a 400-tonne addition to annual gold demand and can offset a 30 per cent decline in gold investments.

Low prices to cut supply

A sustained bull run in any commodity normally tempts producers to churn out more of it. This ultimately leads to over-supply and a price correction.

But gold has proved quite an exception to this trend. The decade-old price rally hasn’t really prompted mining companies to open up a rash of new mines. Instead, rising production costs and labour troubles have made it difficult for smaller miners to sustain profitable operations in recent years.

That is why, while gold demand has climbed at a 7 per cent annual rate over five years, supply has crawled up at less than 3 per cent, despite stratospheric prices.

Gold price declines beyond a point will actually end up curtailing gold supply further. A recent estimate by Gold Fields Mineral Services suggests that it cost global gold miners about $1,150 on an average to turn out an ounce of gold in 2012, but many South African miners operate at much higher costs.

At gold prices of $1,300 or less, it is estimated that about 15 per cent of the global mines may have to shutter their operations.

This cost structure, in fact, suggests that $1,300 an ounce may be a good floor for the recent correction in gold prices. If at all prices do break below this floor, it will be at the cost of a further shrinkage in supplies. This is the level at which retail investors can step in to buy.

Do it in measured doses

Convinced that this is the right time to buy gold? Go ahead but keep the following caveats in mind:Gold isn’t an investment. It is portfolio insurance. The main argument for investing in gold is that it does well when other assets are in retreat.

Indians must invest in gold as a hedge against a tumbling equity market and a sliding rupee. But this also means that gold must not make up over 10 per cent of your portfolio. Would you shell out your entire salary towards insurance premium?

With gold’s fundamentals turning less rosy this year, keep your return expectations moderate. Gold may not repeat its five-year annual run rate of 15 per cent.

As gold offers no regular cash flows, there is no intrinsic value that we can assign to, say, a bar of gold. This means that gold prices can theoretically decline to any extent in a corrective phase. It would be a good idea to start buying now, but to phase out your purchases over 4-5 instalments to benefit from volatile prices.

If you are looking for safety, gold isn’t the best bet. Go for bank deposits instead; they offer an assured return.

If you are looking to buy jewellery, best to buy it when gold is cheap, like now. But jewellery isn’t an investment in gold. Gold ETFs are.