So, I have been very interested in buying some gold for investment purposes since the last year. Gold has been rallying like a crazy bull for the past year, with no correction in sight. Partly, this has been because the US dollar has been devaluing, mostly because speculators worldwide are involved in the dollar carry trade, replacing the yen carry trade. However, despite this, the price of gold has been going on up in currencies which are not pegged to the dollar, for example, the euro and the yen. Only the Australian dollar has appreciated in value respective to gold, but this is primarily because the US dollar carry trade is happening with Australian dollars (the Australians are leading the recovery and have had to increase their interest rates).
The chart below shows the price of gold in US dollars. The period before 1967 is not of interest, as the dollar was on the gold standard, thus the price of gold didn’t fluctuate much. In fact, the price of gold remained constant from 1893 to 1918 (world war I).
The real question, of course, is whether this is a good time to invest in gold. I am not looking for a short-term play, but my motivation is primarily to protect myself and the family savings from another round of redistribution of wealth that will be brought upon by another round of recession, inflation or devaluation of the currency. So, I decided to compute the buying power of gold, and how that has changed in the last 30 years. For this, I compute the price of 1 lb of flour, needed to make bread. Computing the 1oz gold/1 lb flour ratio, we can see how many lbs of flour would be bought by 1 oz of gold. Luckily, we have this data for the last 30 years, but not much more. Of course, gold had surged in price following the stagflation of the 70s, so 1980 marks the highest point of this ratio, but we seem to be inching our way to those levels now. Thus, the real buying power of gold has gone up significantly, more than anything in the past 3 decades.
Credit: Gold prices from Kitco, and flour prices from FoodTimeline.org
This is a real pickle. On one hand, this signifies that we are going to see inflation, in which case, the price of flour will increase, but so will the price of gold in terms of US dollars. The other side of the coin is that gold is overpriced, as the gold/flour ratio should be relatively constant. However, examining the lows of the ratio in 2001 gives some sense of why gold has appreciated like a raging bull in the past decade. Another fact that is not captured in the graphs is the confidence of the rest of the world in US dollars. As confidence in the dollars increases, people prefer to hold dollars as opposed to gold. A reversal in that sentiment will drive the price of gold higher. This is the reason that we are seeing central banks in India and other emerging countries emptying the gold reserves of the IMF by selling their dollars and hoarding gold instead.
Typical investment strategy says that we should invest at least 10% in gold, to protect from devaluation of the paper currency. What do you think? I would love to know in the comments.