The following article was commissioned by Dynasty for our clients and compiled by our research partner, Analytics Consulting, as represented on our Investment Committee.
Notwithstanding the Decoder methodology outlined below, Dynasty considers other non-quantitative factors in determining an investment case for gold, which are currently supportive of this asset class/currency. These include an apparent weaponisation of the dollar in 2022 when the US froze the Russian central bank’s foreign exchange reserves, the prevailing increased purchase of gold by the Chinese Central Bank mentioned below, the retail price of gold in China trading at a premium of around $50/ounce to the listed gold price in London, concerns around the ever-increasing US debt – currently at about $34 trillion, and the announcement by Saudi Arabia in January 2023 that it is open to using currencies other than the US dollar in oil contracts.
Dynasty’s domestic multi-asset class house-view fund, namely the Dynasty Ci Preserver Fund, has 6.7% exposure to a Gold ETF. The Fund was ranked 2nd in its sector over the one year and 1st over two year years ended 31 March 2024, of the more than 150 funds in the sector, per Morningstar.
Please note that the fair value estimate is updated regularly and that this value may well have increased since 8 April the time of writing based on subsequent heightened geo-political tensions in the Middle East.
Gold’s Ancient History
The pages of history tell a story of how people became intoxicated, obsessed, haunted, humbled, and exalted over pieces of metal called gold. Gold has motivated entire societies, torn economies to shreds, determined the fate of kings and emperors, inspired the most beautiful works of art, provoked horrible acts of one group of people against another, and driven men to endure intense hardship in the hope of finding instant wealth and annihilating uncertainty.
Gold’s most mysterious incongruity is within the metal itself. It is so malleable that you can shape it in any way you wish, even the most primitive of people were able to create beautiful objects out of gold. Moreover, gold is imperishable. You can do anything you want with it, but you cannot make it disappear. By contrast, iron ore, cow’s milk, sand, and even computer blips are all convertible into something so different from their original state as to be unrecognisable. The gold in the earring, the gold applied to the halo of a fresco, and the gold bars hidden away in the United States’ official cookie jar at Fort Knox are all made of the same stuff.
Despite the complex obsessions it has created, gold is wonderfully simple in its essence. Its chemical symbol AU derives from aurora, which means “shining down”, but despite the glamorous suggestion of gold, it is chemically inert. Gold is extraordinarily dense: a cubic foot of it weighs half a ton. The density of gold means that even very small amounts can function as money of large denominations. Unlike any other element on earth, almost all of the gold ever mined is still around. About 244,000 metric tons of gold have been discovered to date (187,000 metric tons historically produced plus current underground reserves of 57,000 metric tons). All of the gold discovered so far would fit in a cube that is 23 meters wide on every side.
The previous role of gold in the international monetary system and the rise of the dollar
Gold served as the anchor for the international monetary system of exchange when it underpinned the Gold Standard. The Gold Standard is a fixed monetary regime under which a government’s currency is fixed and may be freely converted into gold. The so-called “classical gold standard era” began in England in 1819 and spread to France, Germany, Switzerland, Belgium, and the United States. Each government pegged its national currency to a fixed weight in gold. These parity rates were used to price international transactions. Other countries later joined to gain access to Western trade markets.
There were many interruptions in the gold standard, especially during wartime. Governments frequently spent more than their gold reserves could back, and suspensions of national gold standards were extremely common. Moreover, governments struggled to correctly peg the relationship between their national currencies and gold without creating distortions. The Gold Standard slowly eroded during the 20th century. This began in the US in 1933, when Franklin Delano Roosevelt, who was president between 1933 and 1945, signed an executive order criminalising the private possession of monetary gold. After WWII, the Bretton Woods Agreement forced Allied countries to accept the US dollar as a reserve rather than gold, and the US government pledged to keep enough gold to back its dollars. In 1971, the Nixon administration terminated the convertibility of US dollars to gold, creating a “fiat” – meaning a currency backed by an issuing government – currency regime. Gold had eventually lost its anchor role in the international monetary system and the US dollar spot index then became the international monetary system anchor from 1973 following the dismantling of the Bretton Woods system. The US dollar spot index started at a level of 100.
The importance of gold as a store of value and a hedge against crises
Gold remains an important store of value, serving as a hedge and retaining value during economic crises. In 2023, amid uncertainty about US interest rates and continued geopolitical risks, the metal once again demonstrated its importance by hitting a new record in December.
Most of the world’s gold is stored in various locations, including central bank vaults, private depositories, and jewelry holdings. Countries maintain gold reserves for various reasons. Firstly, gold serves as a stable and dependable store of value, enhancing confidence in a nation’s economic stability, especially during times of financial uncertainty. Additionally, despite the waning relevance of the Gold Standard, some countries still deem gold reserves crucial for maintaining currency stability. Moreover, gold’s tangibility enables countries to diversify their overall portfolio. Currently, almost one-fifth of all the gold ever mined is held by central banks. The US boasts the world’s largest gold reserves, with 8,133 metric tons stored in 12 Federal Reserve Banks across the country. Russia and China—arguably the United States’ top geopolitical rivals—have been the largest gold buyers over the last two decades. The People’s Bank of China was the biggest buyer of gold last year, purchasing 225 metric tons. Gold reserves also have a role in international trade and finance. Some countries use gold to settle trade imbalances or as collateral for loans. The presence of gold reserves can enhance a country’s creditworthiness and influence its standing in the global economic system. Moreover, gold serves as a hedge during crises. Its value often rises during economic downturns or geopolitical uncertainties, safeguarding against inflation and currency devaluation. There is also a widely held view that the appeal of gold is heightened by its inverse correlation with the US dollar. When the value of the dollar declines, gold tends to increase in value.
The perceived inverse correlation of the gold price to the dollar can disappoint
Empirical evidence suggests that this perceived inverse correlation with the US dollar may not always hold true. At the end of September 1975, the US dollar spot index was at a level of 104. Towards the end of March this year, the US dollar spot index was again at 104 (having been as high as 165 in February 1985 and as low as 71 in March 2008). Over this very long period of nearly 50 years, the price of an ounce of gold moved up from $141 to $2,184, increasing by a factor of 15.5. From January 2003 to August 2011, the US dollar spot index moved down by 26% while the gold price increased 5 times. From the end of August 2011 to the end of March this year, the US dollar spot index moved up by 40% while the gold price also moved up, but only by 20%. These observations suggest that the expectation of an inverse correlation will at times lead to disappointment, particularly over longer measurement periods.
Gold has also had significant periods in the doldrums. Towards the end of 1980, the gold price was at $620 per ounce, a price level only reached again in the third quarter of 2006, nearly 26 years later. The gold price peaked again in early September 2011 at $1,900, from where it tumbled until it reached $1,060 at the end of 2015, only returning to the 2011 peak at the beginning of 2021, nearly ten years later. The gold price has also had two significant periods of sustained strength. From a low point of $256 in August 1999, the gold price reached $1,900 in September 2011 as mentioned above, and from the low of $1,060 at the end of 2015, it had more than doubled to its price of $2,340 as at the time of writing.
The“ Analytics Decoder” methodology to establish fair value for the gold price
During these periods of time, there did not appear to be an anchor against which to weigh the prevailing gold price. At any point in time, the question as to whether to buy or sell gold was largely unanswered from a valuation perspective. The question as to whether gold at any time is cheap or expensive usually leads to debate rather than a convincing answer and the debate then often centres on whether gold is a currency or a commodity or a hybrid of the two.
Our research into estimating an equilibrium (or fair value) level for a currency pair has led to the development of the Analytics Currency Decoder that uses a unique, proprietary set of algorithms to decode (or mine) information-rich historical exchange rates to extract inherent, stable characteristics. This decoding process leads to an estimate of fair value at any point in time for an exchange rate. The Decoder is now our primary analysis tool for determining whether to buy, sell, or wait on trading a currency pair. This Decoder has now been used to study the gold price on the assumption that gold has sufficient currency-like characteristics. We have completed a number of historical case studies and the results have been interesting and informative.
For example, on 14 March 2008, the gold price reached a level of $1,003. The Decoder estimated fair value at $506 on that day, suggesting that gold was very expensive. By 12 November 2008, the gold price had fallen to $712 while fair value had moved up to $720 on the back of a strong US dollar. Gold was then very close to fair value. The gold price then moved up steadily until 5 September 2011 when it reached $1,900. The fair value estimate had also moved up over that period of time, but only to a level of $1,031. The Decoder suggested again that gold was very expensive. By 10 May 2013, the gold price had fallen to $1,449, moving down through fair value that was estimated at $1,455 on the day. The gold price continued to move down while fair value moved up and by 27 September 2018, the gold price was at $1,183 while fair value was much higher at $1,703, the latter being boosted by a strong US dollar. The Decoder now suggested that gold was cheap. The gold price then moved up again and by 02 July 2020, the price was at $1,775 with fair value having moved up marginally to the same level.
More recently, on 31 March 2022, the gold price was at $1,937, essentially at fair value that was estimated at $1,934. The gold price then fell to $1,622 by 26 September 2022, while fair value actually moved up to a level of $2,262 on the back of a strong US dollar. Gold was cheap again, according to the Analytics Currency Decoder. By 4 April 2023, the gold price had moved up to $2,020, very close to fair value that had moved down to $2,029 on the back of a weaker US dollar. The rally in the gold price continued and by 08 April 2024, the gold price was at a new high of $2,340 with a fair value estimated at $2,141
The most important observation from these historical case studies is that the gold price always returns to the estimate of fair value at some point in the future whenever there is a significant gap between the two. The fair value estimate does seem to provide a reliable forward directional signal for the gold price. These selected historical case studies suggest that there is a strong, positive directional correlation between the US dollar spot index and the fair value level of the gold price.
While the price of gold served as the external anchor for the international monetary system of exchange during the gold standard era, the Analytics Currency Decoder has uncovered a way to calculate a credible estimate of fair value for the price of gold, and this fair value level can now function as an internal anchor for the gold price itself.
This estimate of fair value for the gold price currently serves as a valuable piece of real-time information when deciding whether to buy, sell, or wait on the role of the precious metal within a portfolio of investments.
Sources: “The Power of Gold” by Peter Bernstein, Investopedia, US Geological Survey, Visual Capitalist, Forbes India
