For gold to rise, this needs to happen

You buy stocks for good times, and gold for bad times.

No one could have said it better.

And perhaps no one other than us Indians have planned better for bad times.

We have been hoarding gold for generations. And to ensure we do not go astray it has been woven into our culture. So, no matter who you are…you are always hoarding gold.

For your wife. You want her to wear solid stuff. Social status and all.

For your daughter. You want to give her a fair share of your wealth in metal that has stood the test of times. Only the best will do.

For bad times. You can easily convert gold to cash and meet short term needs.

Our desire to hoard gold at its very core was perhaps driven by a need for wealth preservation.

What may have come as a surprise to us Indians is that Gold as an asset class has actually delivered a solid return over a long period of time.

See this chart prepared by FundsIndia (yellow highlights are mine).

While most are fascinated by the potential of returns that stocks can generate, an asset like Gold, without much fanfare, has comparatively done phenomenally well.

Over a five-year period, basis the FundsIndia data, Gold did as well as the Nifty 50 TRI. Over 15 years too it matched up to the far more riskier stocks.

Also, gold outperformed debt and real estate over all time periods.

If one goes purely by this chart, the real winner is gold.

Yet, I believe, gold’s place in the asset allocation of an individual is limited. Perhaps to the extent of 5% to 10%, generally speaking. (At times it may justify having even more money in Gold. All depends on your individual circumstances.)

Why so? In spite of these wonderful numbers.

For one, these numbers are perhaps a function of luck to some extent. Rather, something you probably never factored in when buying gold.

You see, the price of gold in India is determined by two factors (other than some core fundamental reasons that drive long term price of gold).

First, the exchange rate between the Indian rupee and US dollar.

Second, the price of gold that is set in international markets, in US Dollars.

So, while there is no doubt that over the last 20 years gold has done well in US dollar terms, it has done even better in India.

That’s because the value of the rupee has depreciated over this time. And this matters a lot as India imports most of its requirement of gold.

The weaker the Indian rupee gets, the higher the landed price of gold. In other words, the more valuable your holdings of gold, all else remaining the same.

If we take the 12% return over 20 years from the FundsIndia chart, of that a little under 3% has come from this second factor i.e. if the rupee had not weakened, your returns would have been limited to about 9% pa over 20 years. Worse, if the rupee had appreciated, your returns would have been lower.

So, my point here is that a very large allocation to gold in a portfolio involves making a call on the value of the rupee over the long term. If you have got that figured out, go ahead and make a big bet. If not, then you look at gold only from the “gold for bad times" perspective.

Now, let’s deal with what’s driving the price of gold in the international markets.

You see holding physical gold does not generate any cash flows. No interest, no dividends. You only get cash when you sell your gold.

And hence there’s what is called an opportunity cost of holding gold. i.e. if instead of putting money in gold, one had invested in say a government bond, there would be a guaranteed interest inflow, which is missing in the case of gold. So effectively, the cost of gold in this case is the interest forgone. (for sake of simplicity we ignore the movement in price of bonds, and gold).

And drawing from this, one can easily deduce that the higher the opportunity cost i.e. interest rates, the lower will be the interest in gold, and, therefore, lower prices in the immediate future.

And this is exactly what has happened with gold in the past year or so.

You see, even though the world is in peril, gold has not done as well as most had expected. In fact it would be fair to say it’s been a disappointment. And the reason for that is perhaps largely that the opportunity cost of gold has increased dramatically.

The federal funds rate, at the time of writing this, is at 5.33%. At the start of 2021, it was just 0.08% (source: Macrotrends.net). That’s quite a move.

In recent months, gold has oscillated more sharply than it generally does. And not surprisingly it’s because estimates of this opportunity cost have varied a lot.

Every time there’s news that the Federal Reserve may no longer need to raise rates, gold rallies. And whenever there is stronger than expected economic data, fuelling fears of further rate hikes, gold prices take a knock.

So, if you are thinking near term, this is how you could think of gold prices…

An economist may balk at the simplicity of this chart. But this simple framework should hold up well over short periods of time.

If you go by the chart, the ideal scenario is that US interest rates cool off…and the rupee weakens or remains stable. (This is in itself a contradiction, but then it’s possible because the rupee is not a freely tradeable currency).

So, for gold to rise, we know what needs to happen. Just check the US interest rates and you could get a fair understanding of how prices could move in the near term.

Translating them to your local market, you will need to factor in the rupee-dollar exchange rate.

One recent example of how this has played out is that in US dollar terms, gold peaked in 2020. It has since moved around a bit, but it’s still lower than the high hit in 2020. Not much of a move, right?

In rupee terms, however, gold is way past the 2020 levels. Significantly higher, in fact. The reason? The rupee has depreciated vis-à-vis the US dollar by about 15% since then.

And that’s effectively the return you have made. (The actual Indian price of gold may be higher than that but that’s because of taxes levied).

So you can see how the exchange rate can be the primary driver of returns on your holdings of gold.

The larger point I am making here is that the price of gold is influenced by a whole host of factors, that for most may be difficult to comprehend (interest rates, inflation, exchange rates among others).

If you do not understand these well, and have a good reading on how these could move, you don’t want to think of gold as an investment opportunity, where you hope to make a solid return.

You want to think of gold as something meant for personal use, and a safety net – “gold for bad times".

And yes, if like in the past, the returns pour in anyway, grab them with both hands.

Rahul Goel is the former CEO of Equitymaster. You can tweet him @rahulgoel477.

You should always consult your personal investment advisor/wealth manager before making any decisions.