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Has the Price of Gold Taken A Pause for Breath?

Recent patterns suggest that gold has, more or less by accident, become positively correlated with risk assets — but not consistently so.

The price of gold has just risen to a five-month high in response to fears about U.S. inflation, defying those gold skeptics who say that as a conventional investment, it falls at the first hurdle: Investors cannot agree on how to begin calculating its underlying value.

Estimates of gold’s fair value — the intrinsic value to which asset prices tend to revert — currently vary from a little over $400 to about $10,000 an ounce. Both are extremely far from Friday’s close of $1,685.

The price of $400 or so is arrived at by looking at the average price of gold, in 2012 dollars, since 1900 — multiplying the original price by inflation to arrive at the price in today’s terms. At the other end of the extreme, $10,000 is the very approximate price for gold if all U.S. dollars in circulation, physically or virtually, were backed by the amount of gold held in the vaults of the Federal Reserve, under the strictest of monetary regimes based on the gold standard. The figure is reached by dividing the value of the dollars by the number of ounces held.

It is not clear that a Republican administration would implement exactly this version of the gold standard, following presidential candidate Mitt Romney’s call for a gold commission. However, some investors see this as a good rule of thumb regardless of political developments, arguing that there has historically been a clear link between the size of the monetary base and the price of gold.

Most investors would nevertheless put the fair value of gold at somewhere between these two figures — if they agreed that a fair value could be established at all for an asset that, unlike equities or bonds, produces no income stream that can be used as a starting point for the task. One method of valuation that would put the price of gold not far from last week’s close would be the commonly quoted ratio between gold and oil, though the flaw in this method is that it can give a misleading signal about gold’s over- or undervaluation if short-term speculation has pushed the price of oil far off its fair value. Since 1900, an ounce of the yellow metal has on average bought about 13 barrels of the black gold. At the close of the week ending August 31, it would have bought almost 15 barrels of Brent crude oil.

Investors skeptical about fair value concentrate more on correlations, basing their buy or sell calls for gold on the historical tendency for it to rise at times of fear about the future of the global economy — particularly if that future may include high inflation — and to fall as those fears subside.

However, this alternative method has become distinctly unreliable.

Even after allowing for Friday’s lurch upwards as expectations rose that U.S. Federal Reserve chairman Ben Bernanke would soon follow his downbeat speech on the U.S. economy with a third, inflationary round of quantitative easing, gold has traded in a very narrow range since March. The front-month gold futures contract on Comex has failed to rise above $1,700 or fall below $1,500, despite some moments of heart-stoppingly worrying global economic drama — most notably talk of a possible break-up of the euro zone. Even after last week’s rise in the gold price, it is still 12 percent below its 2011 record nominal high of $1,912. Many gold bulls have been left perplexed and frustrated by this.

One possible explanation for gold’s rather bored response to news that in previous times would have moved the price more vigorously is the "pause for breath" argument: that after a breakneck advance in the three years to its 2011 peak, gold is consolidating its gains, prior to a likely move back upwards. “The rally has been long, and gold has paused not collapsed,” says HSBC Bank.

More worryingly, gold and stock markets have shown a recent tendency to fall sharply in unison, as they did in early to mid-May for example. Analysts say a possible explanation is that individual funds are buying an ever-wider range of assets, for several reasons that include a search for absolute return unconnected with the performance of a particular market. Sudden losses in one part of their portfolio, such as the equity tranche, force fire sales of other assets that can easily be liquidated, such as gold.

This suggests that gold has, more or less by accident, become positively correlated with risk assets but not consistently so. The pattern is instead rather asymmetrical, with gold showing no consistent tendency to rise during sudden jolts upwards in stock markets, despite its marked tendency to fall when stock markets do.

This irregular pattern is a serious potential weakness for gold, because, in the absence of any reliable way of measuring its intrinsic fair value regardless of broader asset markets, its appeal is based largely on how it behaves in relation to other assets. If investors can no longer rely on the gold market to act in a predictable way in response to different market conditions, it loses much of its luster.

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