The Long View: Your guess is as good as mining By Philip Coggan

The Long View: Your guess is as good as mining
By Philip Coggan, Investment Editor
Published: April 21 2006 17:18 | Last updated: April 21 2006 17:18. Copyright by The Financial Times

There is no more controversial financial asset than gold. To its enthusiasts, gold is the only true store of value and the asset that comes into its own when all others are crumbling.

Many believe its moment has arrived. Marc Faber, investor and author of the Gloom, Boom and Doom report, points out that the Dow has risen less fast than gold since 2000. In his eyes, that means it is in a bear market in gold terms.

According to Paul Mylchreest of Chevreux, the ratio of the Dow to gold has averaged 12.5 since the collapse of the Bretton Woods exchange rate system in 1971. At its peak, in 2000, the Dow was 40 times the gold price, but in 1980 (with gold at $850), the two numbers were virtually the same.

Currently, the Dow is trading at around 17.5 times the gold price. If the ratio were to fall to the post-1971 average, gold would rise to nearly $900 an ounce (assuming the Dow stays where it is).

Another interesting ratio is that of gold to oil. The long-term average of this ratio is around 16, according to Mylchreest, but the ratio is currently only 9. A return to the average 16 level would take gold past $1,000.

Now I am not sure that these ratios are theoretically sound. For example, oil and gold have different discovery rates, different supplier structures, different economic users and different ownership structures (a lot of gold is owned by central banks).

But gold enthusiasts tend to think along these lines which is why they are unabashed at current trading levels and optimistic about the scope for potential gains.

There is (at the risk of receiving some rude e-mails) a distinctly apocalyptic tone to some of the gold bugs. They see paper money as a fraud on the public and view official inflation statistics as distorted. They believe the dollar will eventually collapse, thanks to irresponsible monetary and fiscal policy.

Some believe the central banks have in the past conspired to drive down the gold price (although the only official agreement between banks, which limits sales, is a conspiracy to keep the price up).

Nevertheless, one has to admit there is some force to their arguments and that the repeated interventions by central banks to prop up financial markets (for example, in 1998 and 2001) may have stored up inflationary pressures for the long term.

There has been no sign of that inflation at the consumer price level to date because the emergence of Asian manufacturers has borne down heavily on the prices of electronic goods and clothing. Falls in those prices have offset the increases in fuel and some foodstuffs.

But arguably there has been inflation in asset markets, particularly in housing and in share prices.

However, the same liquidity surge that has pushed up house prices is also having an impact on the commodity markets, including gold.

Institutional investors have discovered commodities as an asset class, using them as a means to diversify from bonds and equities. The momentum behind commodity prices has attracted hedge funds and speculative money.

Retail money is now being brought in; one of the reasons behind the recent sharp rise in silver has been the plans for an exchange traded fund in the metal, which will make it much easier for private investors to trade.

It is very hard to disentangle cause and effect at this stage. To what extent is the surge in the price of oil past $70 a barrel a sign of buoyant global demand or a sign that investors are fearing disruptions to supply, in the light of US-Iran tensions? And to what extent will higher prices be self-correcting by reducing the demand for energy?

What one can say is that, in some markets, price movements look very aggressive. Commenting on the silver price, Chip Hanlon of Delta Equity, says that “I don’t care what the asset is, when a chart starts to look parabolic, I get nervous.”

The recent arrival on my desk of a book on commodity investing (The Next Big Investment Boom) and the appearance of articles on the trend in the press are other factors that should cause concern.

We may be seeing a minor repeat of the technology craze of the late 1990s. Then as now, there are good reasons for belief in the underlying asset; business has been transformed by the internet; commodity supply has been restricted for many years and will be slow to respond to increased demand.

The difficulty is spotting the point at which price movements part company with the underlying fundamentals and reflect a Gadarene rush into the asset class by investors. I confess to being way too early in calling the top in the case of technology stocks, but that is the price one pays for being prudent.

Many commodity markets are quite small relative to the government bond and equity markets, and thus a limited amount of extra capital can push prices up a long way.

Nevertheless, while it seems right for investors to have some exposure to this area for the long term, this does not look like the best time to be piling in.

The volatility of the commodity markets was amply demonstrated on Thursday, when gold hit a 25-year peak of $645 an ounce before sliding back to $613. Nor was silver immune, as it plunged dramatically.

If you believe in the commodity story, it is worth waiting for markets to settle down a little before investing, and then only with a limited proportion of your portfolio.

philip.coggan@ft.com