February 24, 2011

Equities Will Outperform Gold In 2011
As always, we focus on the fundamentals to judge whether the gold price is overvalued. In this article, we challenge the common views on gold demand and prove that the recent gold rally lacks fundamental support. For mutual fund investors, gold is probably not the best bet as compared to equities.

by iFAST Research Team

Untitled Document
Chart 1
Chart 2: SPDR Gold Trust Gold Holdings Metric Tons
Chart 3
Chart 4

Key Points

  • The jewellery demand (by tonnes) is on course for a recovery, but it is still far from being robust
  • ETF demand dropped significantly in the fourth quarter of 2010
  • The SPDR Gold Trust’s gold holdings have struggled to climb further since October 2010
  • There are only few central banks joining the gold rush to increase their gold reserves in 2010
  • The LBMA annual clearing turnover also dropped in 2010
  • It is seemingly absurd to invest into an asset that one does not know the real demand and is thereby unable to estimate its fair value
  • We are more bullish on equities rather than gold for 2011

"You could take all the gold that's ever been mined, and it would fill a cube 67 feet in each direction. For what that's worth at current gold prices, you could buy all -- not some -- all of the farmland in the United States. Plus, you could buy 10 Exxon Mobils, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?" - Warren Buffett

Warren Buffett’s views on gold have been widely discussed, especially after an interview with Forbes in October 2010 when he was asked whether gold is in a classic bubble. Let’s take a closer look at the above sentences.. Buffett compares the relative value of gold versus all farmland in the United States and Exxon Mobils. From this investment perspective, gold price is definitely overvalued and gold is likely to be in a "classic bubble". For those who do not agree with the world’s richest investor, please infer further from his answer. If the current gold price is reasonable, it indicates that the price of all the farmland in the US and Exxon Mobils is unreasonably undervalued. In other words, the upside potential for farmland would be greater than gold.

Buffett’s views have been challenged by a great number of articles titled “Reasons why Buffett is wrong on gold” since the interview took place. Most of their arguments are based on how Buffett neglects the strong demand for gold from consumers and central banks around the world, and how gold can play an important role as an "alternative currency".

Deja-Vu? Yes, as we have seen a similar situation in the early 2000s when Buffett was once heavily criticised for his "stubborn" attitude towards tech stocks. Some dot-comers even said that value investing was becoming obsolete. After the bubble burst, all his critics were silenced. In our view, value investing can work well under market depression or exuberance. As always, we focus on the fundamentals to judge whether the gold price is overvalued. In this article, we challenge the common views on gold demand and prove that the recent gold rally lacks fundamental support.

The Global Total Identifiable Demand Cannot Justify The Gold Rally

Does the robust jewellery demand from emerging markets support the gold rally?
Indeed, the jewellery demand (by tonnes) is on course for a recovery but it is still far from being robust.

We have seen that India and Greater China, the two largest consumers for gold jewellery in volume terms, are leading the recovery of the global bullion market. In the fourth quarter of 2010, jewellery demand in India and Greater China rose 52.8% year-on-year and 31.9% year-on-year respectively. They are the only two countries in which the 4Q jewellery demand is higher than the average quarterly demand from 1Q 2006 to 4Q 2010. On the other hand, the recovery of gold jewellery demand in the rest of the world is relatively slow and remains fragile especially in the developed countries. High unemployment, negative income growth and climbing family debt in developed countries suppressed the consumer demand for gold.

Table 1: Demand in Major Jewellery Consuming Countries (Tonnes)
Jewellery Demand (tones) Q4 2009 Q3 2010 Q4 2010 Five-year Quarterly Average (from Q1 06 to Q4 10) Y-o-Y % change Q-o-Q % change
India 137.8 184.5 210.5 139.3 52.8% 14.1%
Greater China 93.3 107.9 123.1 88.9 31.9% 14.1%
Middles East 46.8 21.7 38.6 67.0 -17.5% 77.9%
Turkey 8 31.4 8.5 35.7 6.3% -72.9%
Russia 15.4 17.7 19.6 18.3 27.3% 10.7%
US 56 37 47 53.0 -16.1% 27.0%
World Total 490 530 575.2 534.5 12.8% 8.5%
Source: World Gold Council and iFAST Compilations

Overall, the global jewellery demand rose 12.8% quarter-on-quarter or 8.5% year-on-year to 575.2 tonnes in the fourth quarter of 2010 (see Chart 1). It marked the strongest demand since the third quarter of 2008. The fourth-quarter demand was only slightly higher than the average quarterly demand of 534.5 tonnes from the first quarter of 2006 to the fourth quarter of 2010. It shows that the world total jewellery demand has started to normalise but it is still far from being robust. In particular, global jewellery demand in the second quarter of 2010 even recorded a negative growth on quarterly and yearly basis, highlighting the recovery is still fragile.

Economic growth is a leading indicator of jewellery demand. Historically, it gives a picture of where the jewellery demand is heading to in the next two to three quarters. Thus, it would not be a surprise to see demand for real physical gold to pick up in 2010. In fact, even if the jewellery demand starts to recover, it could not justify the high gold price which has surged rapidly over the past two years.

Will ETF demand be the new driver of gold demand?
ETF demand dropped significantly in the third quarter and the fourth quarter of 2010.

Excluding exceptional results in the first quarter of 2009 and the second quarter of 2010, the average quarterly ETF demand is only 57.6 tonnes from 1Q 2006 to 4Q 2010. Historically, ETF constitutes only a small portion of the total demand (less than 10% of the total global demand). Over the past eight quarters (4Q 09 to 3Q 10, excluding the exceptional gain in the 1Q 09 and 2Q 2010), this portion even dropped to 3.5% even though people always claim that ETF will play a more important role in gold demand. Jewellery, which consistently accounts for over 60% of the total gold demand, is still a key component underpinning the overall demand for gold.

In addition, the gold holdings of the world’s largest gold-backed ETF, the SPDR Gold Trust, has hit the record high of 1305.69 tonnes in 28 September 2010. However, the trust’s gold holdings have struggled to climb further since October 2010. It has dropped by 76 tonnes from its peak to 1229.58 tonnes as of 26 January 2011 (see Chart 2), implying the potential upside for gold is limited.

Is the Gold Rally Well-supported By Central Banks?
No. They are not the major force influencing the gold market.

Table 2: Major changes in reported central bank gold reserves (tonnes) in the second half of 2010
Country Comments Jul Aug Sept Oct Nov
Bangladesh Purchase of 10 tonnes from the IMF took place in September - - +10 - -
Germany Sales under CBGA2 -4.3 - -0.7 - -
Mexico Long-term sales programme and periodic additions to reserves -0.1 -0.1 -0.1 -0.1 -0.2
Philippines Buys locally-produced gold; may sell or retain in reserves +4.0 +0.2 -0.2 -19.5 -
Russia Mainly purchases gold in the domestic market & other changes +16.2 +9.3 +20.7 +19.2 +9.0
Sri Lanka Additions to reserves +6.9 -6.7 - - -
Thailand Purchase +15.6 - - - -
Venezuela Purchase of locally-produced gold - - - +1.9 -
Source: World Gold Council and iFAST Compilations

According to the figures from the World Gold Council, there are only few central banks joining the gold rush to increase their gold reserves in 2010 (see Table 2). The total net purchase from central bank in the third quarter was just 71 tonnes, coming mainly from Russia. Relative to the world’s total gold demand of 922 tonnes in the third quarter of 2010, the purchase volume was insignificant. The total net purchase by central banks was only 28.8 tonnes in the second quarter after excluding the adjustment of Saudi Arabian Monetary Agency’s gold accounts which recorded an increase of 180 tonnes in June 2010.

In the article Gold Bubble Set To Burst In 2010, we have argued that diversification of foreign reserves is a long-term process. Central banks need to consider the long-term benefits when deciding what to use as reserves. Thus, it is unrealistic to expect central banks to keep buying gold for diversification especially when the gold price has been too high, without any support from fundamentals.

Is The Gold Rally Driven By Unidentifiable Demand?
Probably, and this makes gold investment even more risky!

It has been reported that the jewellery demand in emerging markets including India and China remains strong. However, the global jewellery demand has dropped in majority years of the past decade (from 2000 to 2003; from 2004 to 2006 and from 2007 to 2009). In addition, the total demand of gold remains stable at 3500 to 3800 tonnes. Central banks around the world have not aggressively increased their gold reserves. It means that the gold rally could be driven by the demand which is not identified by the World Gold Council.

We examine another source about the gold demand from the London Bullion Market Association (LBMA), a trade association that represents the wholesale gold market in London where it is the international Over-the-Counter market for gold. From Chart 3, we can see that the amount of annual gold metal transferred was in a downtrend from 2000 to 2004 but the annual average gold price rose moderately during the period. From 2004 to 2008, the increase in the gold price accelerated while the annual gold transferred rebounded. However, the amount transferred dropped from the 149387 tonnes in 2008 to 122936 tonnes in 2010, or a 17.7% drop. Even the LBMA annual clearing turnover cannot explain the gold rally.

Thus, we cannot rule out that there have been considerable amount of "unidentifiable" sources of demand. It is believed that this unidentifiable demand comes mostly from the secret buy from investment banks and rich investors who are able to do deal in a significant amount of physical gold. However, it is seemingly absurd to invest into an asset that one does not know the real demand and is thereby unable to estimate its fair value. Investors who bet on gold are actually anticipating the unidentifiable demand will keep increasing. It is very risky because the investment is based on something that investors do not fully understand.

"Forget Gold, Buy Stocks!"

We evaluate potential investment opportunities in equity markets by indentifying attractive expected returns determined by earnings and valuation. The ultimate key determinant of stock prices is corporate earnings, which is concrete, observable and identifiable. Unlike equities, it is hard to quantity the fair value for gold because there are no underlying cash flows (in fact, the cash flow could be negative if we account for storage and security costs). We look at the fundamentals to judge whether the rally of gold price is reasonable, but the sluggish identifiable demand over the past years cannot justify the gold’s bull run. Instead, the unidentifiable speculating demand could be the driver of the rally.

We think investors’ sentiment (risk aversion) and the speculation will continue to be the primary factor that drives gold price. In particular, US Commodity Futures Trading Commission (CFTC) data shows that a massive amount of speculative capital has entered into the gold future market. The long position on gold futures contracts has been dominated by the speculative demand (money management) since 2009 as shown in Chart 4.

We are more bullish on equities rather than gold. It should be noted that the global economy has just started to recover. Earnings for most countries have been growing nicely. Several markets have already seen record high earnings this year (US, Tech sector, Greater China, Korea, Indonesia) while many others are likely to see record high earnings in 2012 (Russia, Singapore and Australia). Once investors’ fear cools down, they will reconsider gold’s fundamentals and look for other assets like equities. Thus, investors should be more cautious about the potential downside risk of gold price.

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