Supply and demand do NOT determine the gold price

Fsp Invest, 02 Sep. 2013

Tags: gold price, supply, demand, share price, gold, hedge your portfolio,

Contrary to popular belief, simple supply and demand doesn’t determine the price of gold. Because the real conundrum for investors lies in what determines supply and demand, of course. And the answer lies in the position gold plays in investors’ portfolios. Let’s take a closer look at what affects the gold price…

As a rule, investors require a minimum real return on their total investment portfolios, explains FSP Invest in How to Make Money from Gold.

Gold’s a store of real value over time. You can use it to insure against low anticipated returns on your other investments – such as shares or government bonds.

Expected returns on gold vary inversely to the yield required by other classes of investments. Gold prices will be low and expected returns high when share prices are high and their expected returns are low.

For example, in 1980, the earnings yield on global shares – the percentage returns which new investors would make through their stocks’ dividend payments – was high.

In other words, expectations were high. And the gold price was high, so expected returns on gold were low.

By 2000, the opposite was true.

The link between share prices and the gold price

At the start of the year, share prices were high and the gold price was low. Then the two moved in opposite directions – partly because the market’s expectations were right and partly because expected returns on shares had been rising for nearly 20 years.

But things are changing. Gold’s heading firmly upwards in a long-term trend.

The price of gold, effectively the inverse of stock prices, had to rise to reduce long-term expected returns. Since 1979, the earnings yield on global shares and global inflation alone explains 89% of the variation in real gold prices.

Shares aren’t the only investment that can be hedged using gold.

Gold prices have often been low when the rates of return from government bonds, especially index-linked gilts, have been low. This doesn’t provide a fool-proof forecast for gold price.

But it provides confidence that the gold price should continue to move in an opposite direction to the price of other investments.

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