Waiting for Gold Price Correction?

Posted On Wednesday, Nov 04, 2009

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Gold prices in Indian Rupees are currently trading at 15,000 per 10 grams. Though the price of gold is lower than the record price of Rs. 16,119 per 10 grams set on 24th February 2009, the price of gold is 54% higher than its 5-year historical average of Rs 9,765 per 10 grams.


The Indian marriage and festive season begins this month. Informal interactions with consumers and investors suggests that interest in gold still remains unchanged and remains in the priority list of ‘things to purchase’ for consumers. However, it seems that people are waiting for bargains - a price correction - before they grab the golden metal.


But, while it is true that the price of gold has risen from the Rs. 4,000 per 10 gram levels a few years ago to Rs. 15,000 levels currently, waiting for the price of gold to fall may not be a wise decision.


Gold: heading up - or down?


We do not have a crystal ball to predict the future. All we know, is that gold prices have been in an uptrend and global economic and financial conditions are supportive of a further price rise over the long term. In addition to the global factors, there is a seasonal, festival factor which influences gold prices in India.


An analysis of historical price trends (see Chart 1 below) tells us that - generally - prices tend to increase from August to December. This also means that waiting for the price to fall (we are in August already!) may prove unwise and one may be better off buying gold today.


Chart 1: Average monthly change in price of gold over an 8-year period, 2001 to 2008 (in USD):
Quantum Mutual Fund_Golden Truth_Waiting for a Correction
Source: Bloomberg


However, Chart 1 also suggests that prices tend to dip in October. Mathematically, though, since the fall in October is after steep rises in August and September, the price of gold in October has still been higher than in August.


Furthermore, the fall in average returns in October over the 8 year period covered in the chart is not a true picture of reality since this "average" is influenced by the steep fall in the price of gold in October 2008, an unusual event. Gold prices fell in October 2008 mainly on account of distress sales by investors in the developed world to recoup losses from a steep fall in value of other assets like stocks and real estate. If we remove the October 2008 loss of -16.8% from the average, then the price of gold yielded a positive average return of +0.5% for the month of October for the seven year period 2001-07.


There is a near term negative factor that could hurt the price of gold: there is a drought in India. With lower farm incomes, rural buying of gold may be affected. If the drought gets worse, could rural India turn into net sellers of gold? That could cause gold prices to decline.


So, while the past seasonal impact suggests that one should buy gold sooner rather than later, the rain gods may have an important say in where the price of gold may be headed over the next few months. In 2002, when India was last hit by drought, Indian demand fell by -20.8%. However, demand in the fourth quarter strengthened and increased by +39% as compared to the average of the first 3 quarters. On the same count, even the prices increased by +5.3% in the fourth quarter.


How exchange rate movements impact the price of your gold.


Over the longer term, the price of gold is influenced by international events: wars, economic crises, financial crises, and natural disasters.


But foreign exchange rates influence the price of gold and your returns.

The Indian gold price is a derived price: gold prices are set in international markets where they are priced in US Dollars. We multiply the international gold price in USD with Indian Rupee (INR) to derive at the Indian Gold price in INR.


Indian Gold price in INR= International Gold price in USD x INR/USD exchange rate

If there is no change in the currency rate between the USD and the INR, then an appreciation/increase in international gold price leads to an increase in Indian gold price and a deprecation/decline leads to a decline in gold price. A direct relationship.


Now, let’s assume that there is no change in the price of gold in the international markets but there is a change in the currency rates.

In this scenario, if the INR gets stronger against the US Dollar (this means that one rupee buys you more dollars) then the price of gold - when quoted in INR declines.


The opposite is true if the INR gets weaker against the US Dollar (this means that one rupee buys you less dollars). The depreciation of the INR leads to an increase in gold price when quoted in Indian Rupees.

So, there is an inverse or opposite relationship between the price of gold in USD and the price of gold in INR when currency rates are taken into account.
A strong rupee, means weak gold prices in INR terms.
A weak rupee, means strong gold prices in INR terms.


As Chart 2 indicates, since May 2009, a strong Indian Rupee has suppressed your returns in gold.

An analysis of the recent price trends of gold denominated in INR shows a range-bound movement in gold prices. There have been big fluctuations in the international gold prices denominated in dollars per ounce; which has gained about +6% in USD. But much of this gain in USD has been lost and the gain in Indian Rupees is only about +3.5%, because he Indian Rupee has gained by +3% against the USD. This explains why gold is trading in a narrow band of Rs.14, 500 -15,500 levels.

Chart 2: Gold price fluctuations (Rebased)
Gold price fluctuations (Rebased) chart - Quantum Mutual Fund
*Rebased to 100          Source: LBMA, RBI, QuantumAMC


The extreme effect of currency movements can be seen in the month of June 2009.

As seen in Chart 2 above, in the month of June, where international gold prices increased by +12%, Indian rupee appreciated by +6%. This led to Indian gold prices increasing by only +6%. This means that 50% of the gains in the international gold price were negated by the appreciating rupee.


So, buy now or buy later?


But, in the end, should investors buy gold now - or buy later?


The price of gold in US Dollars could decrease due to:

  1. lower global inflation fears (seems unlikely given the exponential growth in money supply).

  2. a drought in India, which results in lower demand or - if farmers begin to sell the gold they own - then a larger supply could see gold prices decline.

  3. a stronger dollar - as people dump gold and have faith in the US currency.


Conversely, the price of gold in Indian Rupees could increase due to:

  1. a stronger US Dollar - which will mean a weaker Indian Rupee

  2. a sharply weaker Indian Rupee due to fears that India’s economy will slow down due to the drought.

If you need to buy gold at the "best" price level, you could watch these different dynamics and make a decision.


But, since you cannot predict which of these forces will be more powerful in determining the price of gold, our view is that it is best to plan for your future requirement for gold and buy gold continuously over time by investing in the Quantum Gold ETF, just as you own a stock in your portfolio.

These continuous purchases will ensure that, when the time comes to buy the gold jewelry for your daughter’s wedding, you will be well prepared. The gold will already be there in your portfolio - ready for you to convert from our vault (where it is held in safe custody on your behalf) to a fine piece of jewelry for your daughter.


Meanwhile, owning the Quantum Gold ETF in your portfolio has another benefit: it allows you to smoothen your overall losses when stock markets take a beating - as they did in calendar year 2008 - and the price of gold increased by +27% in Indian Rupees.



Disclaimer:

The views expressed in this article are the personal views of the Fund Manager of Quantum Gold Fund. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. This information is meant for general reading purpose only and is not meant to serve as a professional guide/investment advice for the readers. This article has been prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable. Readers are advised to seek independent professional advice and arrive at an informed investment decision before making any investments. Please visit – www.quantumamc.com/disclaimer to read scheme specific risk factors.

Above article is authored by Quantum.

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