October 13 2008
From gold exchange-traded funds (ETFs) to gold stocks to buying physical gold,
investors now have several different options when it comes to investing in the
royal metal. But what exactly is the purpose of gold? And why should investors
even bother investing in the gold market? Indeed, these two questions have
divided gold investors for the last several decades. One school of thought
argues that gold is simply a barbaric relic that no longer holds the monitory
qualities of the past. In a modern economic environment, where paper currency
is the money of choice, gold's only benefit is the fact that it is a material
that is used in jewelry.
On the other end of the spectrum is a school of thought that asserts gold is an
asset with various intrinsic qualities that make it unique and necessary for
investors to hold in their portfolios. In this article, we will focus on the
purpose of gold in the modern era, why it still belongs in investors'
portfolios and the different ways that a person can invest in the gold market.
A Brief History on Gold
In order to fully understand the purpose of gold, one must look back at the
start of the gold market. While gold's history began in 3000 B.C, when the
ancient Egyptians started forming jewelry, it wasn't until 560 B.C. that gold
started to act as a currency. At that time, merchants wanted to create a
standardized and easily transferable form of money that would simplify trade.
Because gold jewelry was already widely accepted and recognized throughout
various corners of the earth, the creation of a gold coin stamped with a seal
seemed to be the answer.
Following the advent of gold as money, gold's importance continued to grow.
History has examples of gold's influence in various empires, like the Greek and
Roman empires. Great Britain developed its own metals based currency in 1066.
The British pound (symbolizing a pound of sterling silver), shillings and pence
were all based on the amount of gold (or silver) that it represented.
Eventually, gold symbolized wealth throughout Europe, Asia, Africa and the
Americas.
The United States government continued on with this gold tradition by
establishing a bimetallic standard in 1792. The bimetallic standard simply
stated that every monetary unit in the United States had to be backed by either
gold or silver. For example, one U.S. dollar was the equivalent of 24.75 grains
of gold. In other words, the coins that were used as money simply represented
the gold (or silver) that was presently deposited at the bank. (For more on
this, read The Gold Standard Revisited.)
But this gold standard did not last forever. During the 1900s, there were
several key events that eventually led to the transition of gold out of the
monetary system. In 1913, the Federal Reserve was created and started issuing
promissory notes (the present day version of our paper money) that guaranteed
the notes could be redeemed in gold on demand. The Gold Reserve Act of 1934
gave the U.S. government title to all the gold coins in circulation and put an
end to the minting of any new gold coins. In short, this act began establishing
the idea that gold or gold coins were no longer necessary in serving as money.
The United States abandoned the gold standard in 1971 when the U.S. currency
ceased to be backed by gold.
The Importance of Gold In the Modern Economy
Given the fact that gold no longer backs the U.S. dollar (or other worldwide
currencies for that matter) why is it still important today? The simple answer
is that while gold is no longer in the forefront of everyday transactions, it
is still important in the global economy. To validate this point, one need only
to look as far as the reserve balance sheets of central banks and other
financial organizations, such as the International Monetary Fund. Presently,
these organizations are responsible for holding approximately one-fifth of the
world's supply of above-ground gold. In addition, several central banks have
focused their efforts on adding to their present gold reserves.
Gold Preserves Wealth
The reasons for gold's importance in the modern economy centers on the fact
that it has successfully preserved wealth throughout thousands of generations.
The same, however, cannot be said about paper-denominated currencies. To put
things into perspective, consider the following example.
Example - Gold, Cash and Inflation
In the early 1970s, one ounce of gold equaled $35. Let's say that at that time,
you had a choice of either holding an ounce of gold or simply keeping the $35.
Both would buy you the same things at that, like a brand new business suit, for
example. If you had an ounce of gold today and converted it for today's prices,
it would still be enough to buy a brand new suit. The same, however, could not
be said for the $35. In short, you would have lost a substantial amount of your
wealth if you decided to hold the $35 and you would have preserved it if you
decided to hold on to the one ounce of gold because the value of gold has
increased, while the value of a dollar has been eroded by inflation. (For more
insight, read All About Inflation.)
Gold as a Hedge Against a Declining U.S. Dollar and Rising Inflation
The idea that gold preserves wealth is even more important in an economic
environment where investors are faced with a declining U.S. dollar and rising
inflation (due to rising commodity prices). Historically, gold has served as a
hedge against both of these scenarios. With rising inflation, gold typically
appreciates. When investors realize that their money is losing value, they will
start positioning their investments in a hard asset that has traditionally
maintained its value. The 1970s present a prime example of rising gold prices
in the midst of rising inflation. (For related reading, see What Is Wrong With
Gold?)
The reason gold benefits from a declining U.S. dollar is because gold is priced
in U.S. dollars globally. There are two reasons for this relationship. First,
investors who are looking at buying gold (like central banks) must sell their
U.S. dollars to make this transaction. This ultimately drives the U.S. dollar
lower as global investors seek to diversify out of the dollar. The second
reason has to do with the fact that a weakening dollar makes gold cheaper for
investors who hold other currencies. This results in greater demand from
investors who hold currencies that have appreciated relative to the U.S.
dollar.
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Gold as a Safe Haven
Whether it is the tensions in the Middle East, Africa or elsewhere, it is
becoming increasingly obvious that political and economic uncertainty is
another reality of our modern economic environment. For this reason, investors
typically look at gold as a safe haven during times of political and economic
uncertainty. Why is this? Well, history is full of collapsing empires,
political coups, and the collapse of currencies. During such times, investors
who held onto gold were able to successfully protect their wealth and, in some
cases, even use gold to escape from all of the turmoil. Consequently, whenever
there are news events that hint at some type of uncertainty, investors will
often buy gold as a safe haven.
Gold as a Diversifying Investment
The sum of all the above reasons to own gold is that gold is a diversifying
investment. Regardless of whether you are worried about inflation, a declining
U.S. dollar, or even protecting your wealth, it is clear that gold has
historically served as an investment that can add a diversifying component to
your portfolio. At the end of the day, if your focus is simply diversification,
gold is not correlated to stocks, bonds and real estate. (For more insight,
read The Importance Of Diversification.)
Different Ways of Owning Gold
One of the main differences between investing in gold several hundred years ago
and investing in gold today is that there are many more options to
participating in the intrinsic qualities that gold offers. Today, investors can
invest in gold by buying:
Gold Futures (For more on this investment type, see Trading Gold And Silver
Futures Contracts.)
Gold Coins
Gold Companies
Gold ETFs
Gold Mutual Funds
Gold Bullion
Gold jewelry
Conclusion
There are advantages to every investment. If you are more concerned with
holding the physical gold, buying shares in a gold mining company might not be
the answer. Instead, you might want to consider investing in gold coins, gold
bullion, or jewelry. If your primary interest is in using leverage to profit
from rising gold prices, the futures market might be your answer. (For more,
see A Holistic Approach To Trading Gold.)
A Holistic Approach To Trading Gold
October 20 2008
Since the beginning of time, gold has had a special place in history. It has
been used to build religious idols, settle political differences, honor
monarchs, demonstrate affection, serve as currency and, more recently, has been
used for commercial processes. Until 1971, gold backed the U.S. dollar and is
still held by central banks around the world for use in times of emergency. It
also holds promise for traders - if they can find the trend in this often
volatile commodity. (For more on gold, see The Gold Standard Revisited and What
Is Wrong With Gold?)
Background
From the Roosevelt administration during the Great Depression in the 1930s
until President Nixon took the country off the gold standard in 1971, the price
of an ounce of gold had been fixed at $35/ounce.
Following the removal of the gold standard for currencies, gold prices
skyrocketed 2,200% in U.S. dollar terms over the next nine years, peaking
briefly above $800 in 1980. It then spent the next 19 years in a bear market,
dropping as low as $260 in 1999 before starting its next long-term rally. But
thanks to an easing of currency restrictions following the last recession, the
Fed is facing increasing challenges. The effective Fed funds rate was above 6%
in early January 2001 but by early 2004, the rate had fallen more than 80% to
1% and the Fed did not start increasing the rate again until June 2004, more
than a year after the rally had begun. The Fed has taken a much more
accommodative stance on rates, which continued through 2007, and a weak dollar
and rocketing commodity prices during this year are the evidence of this: Gold
again surpassed $800 in 2007. Although we'll never know how high a new peak
will be until it's behind us, increasing volatility appears to be the modern
gold reality.
A Method for Trading Gold
As you can see in Figure 1, one strategy is to watch for situations where the
relative strength index (RSI) shows an extreme level that often marks market
tops. It is also common to watch for extreme lows because this often signals a
market bottom (shown by red circles). In this case, each RSI signal is not
acted upon unless it is confirmed by a moving average crossover. Each trade is
marked with a letter. In this chart, we are using nine-day (purple line) and
18-day (blue line) simple moving averages (SMAs). (For more on these
indicators, read the Moving Averages tutorial.)
Another powerful trading tool, known as divergence, involves looking for
situations when the price of an asset and an indicator move in opposite
directions. As you can see from the chart below, the numbers 1 through 3 signal
areas with positive divergences (in green) and negative divergences (in red).
Another good way of further confirming signal strength is to look for support
or breach of trendlines (dashed blue lines).
Figure 1
The challenge for the short-term trader as well as the buy-and-hold gold bug is
finding tools to help determine when to buy and sell.
Let's take a look at a few other technical and fundamental ideas to help
prevent you from getting overwhelmed by the emotions that accompany this highly
volatile precious metal. (For more on trading gold, see Using Technical
Analysis In The Gold Markets and Trading Gold And Silver Futures Contracts.)
Technical Tips
One of the simplest technical tools is also among the most useful, and that is
the trendline. Trendlines are also a great way to confirm other trading signals
such as those generated by the relative strength index or a moving average
crossover. Whenever possible, it is best to wait until the trendline has been
breached before executing a trade. As you will see from the charts below,
rising trendlines are created by simply connecting a series of rising bottoms
to gauge where the stock will potentially find levels of support. On the other
hand, downward sloping trendlines are created by connecting a series of lower
highs. This simple tool is an optimal method for traders to use for determining
an asset's direction. (For a basic overview of this concept, see Track Stock
Prices With Trendlines.)
Moving averages have become a popular trading tool because they are simple to
use and easy to generate in most charting programs. The idea is to buy when the
shorter term, faster moving average crosses above the slower one and to sell
when the faster average crosses below the slower average. This works great in a
trending market but not so well in range-bound markets. The trick is in knowing
what type of market you're in. Because markets trend about one-third of the
time on average, relying on moving averages as your primary tool can become
quite costly. This is where trendlines can help.
RSI is an oscillator that measures price momentum. It is also very useful in
showing divergences with price. As Figure 1 shows, the RSI often hits extreme
highs and lows at gold's price turning points. For example, with the first red
circle on the chart, the RSI hit an extreme as gold hit its 2006 peak around
$725.
Looking at the concept of divergence in Figure 1 (above), note the differences
between the RSI and price. As the first green lines on both show, the second
low in the RSI was higher than the first low while the second price low was
lower than the first. This warns the trader that buying power is building. Sure
enough, a rally followed. Red lines at Point 2 show an example of negative
divergence.
Fundamental and Intermarket Considerations
Intermarket relationships can be helpful in trading gold. As such, it's
important to watch the euro and the U.S. dollar index as well as crude oil
prices for clues on gold's trending action; they are important outside markets
for the precious yellow metal.
It is important to note that gold prices have rallied nearly every time the
dollar has dropped (see Figure 3). And when gold rallies, oil usually rallies
along with it.
Figure 2: Long-term chart of gold showing a three-year uptrend followed by
choppy trends after the 2006 top.
Figure 3: Daily chart of the U.S. Dollar Index that shows it moving in the
opposite direction of gold (as seen in Figure 2).
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Economic strength and interest rates are two other important fundamental/
intermarket considerations. A strong economy engenders confidence in domestic
markets, increasing their attractiveness to foreigners who need to purchase
U.S. dollars to buy stocks or other American assets. That is good for the
strength of the dollar. Rising interest rates have a similar impact. The higher
the interest rate earned by a Treasury or corporate bond, the more investors
these instruments will attract and the better it is for the dollar.
Putting It All Together
Let's walk through the trades shown in Figure 1, putting our analysis together
following the 2006 peak. First, we get an extreme peak in the RSI, after which
it turns down and then crosses the 70 RSI threshold (the first red dashed
line). Next, the nine-day SMA crosses below the 18-day SMA (Point A). The
long-term trendline was not broken but, given the parabolic rise in gold
leading up to its peak, it is always a good idea to draw short-term trendlines.
This short-term trendline on Figure 1 was broken around the same time as the
RSI sell signal occurred.
When you compare Figures 2 and 3, the U.S. dollar had also started to rally
just before gold peaked in 2006, and the Fed funds rate had risen from a low of
1% to 5.25%, which would be good for the dollar and bad for gold. As a result,
traders were left with three good technical and two fundamental/intermarket
reasons to sell gold.
Next, the RSI dropped to an extreme low before recovering, warning of a
possible trend change. This was confirmed by a moving average crossover buy
signal (Figure 1, Point B). A short-term trendline was also broken (not shown).
Looking at Figures 2 and 3, the dollar had hit a peak and was dropping again -
a good sign for stronger gold prices.
Finding Confirmation
Divergence between the RSI and price provides useful trade confirmation as
well. By waiting for confirmation in each trade, confidence is increased. And
the more confirmation from non-related tools, the better. Confirmation should
come from indicators that have a low correlation with each other, which is why
using technical and fundamental inputs to confirm price direction are so
valuable; they use completely different data sets.
Conclusion
Gold charts, whether short-term or decade-long, tend to include a lot of noise.
Because the hardest part of any trade is developing a plan and sticking with
it, combining technicals and fundamentals is important to prevent you from
being shaken out of your trade by the volatility.
As long as gold fundamentals are intact and intermarket relationships are
strong, stay the course. But here is the beauty in this approach: If these
factors change significantly, it will often be accompanied by a technical sell
signal such as a trendline break. As you get better at the gold trading game,
you will develop a feel for the process so that you'll be ready to execute when
the time comes.