The sharp fall in the price of gold in recent days took many investors and analysts by surprise. I’ll admit that the plunge in the prices for precious metals was surprising, and I didn’t think gold would fall so promptly.
Nonetheless, I thought the price of gold would have started its descent when the market adjusts to the Fed’s change in monetary policy (assuming it will change it in the near future). Based on the recent developments in the gold market, does this mean gold will keep falling from its current level? Is the golden era of gold behind us?
Gold as a safe haven
The notion of gold as a safe haven may have started after the Fed began its first quantitative easing plan back in 2008. Moreover, the weakness in the equity market (on account of the financial meltdown in 2008) and low long-term yields of U.S. Treasuries pushed investors toward gold.
I think another driving force may have been speculation of many investors that the U.S will eventually go back to the gold standard. In case you think this might be a good idea, just look at the Euro area – this region has the Euro as its own type of gold-standard currency.
Economist Paul Krugman made this comparison. Basically, the Euro-area countries aren’t able to print money (even though the ECB has this possibility). This puts Euro-area countries, such as Spain and Italy, in a situation where they can’t print money even if they need it to jump start their economies. This is a fair comparison that proves why going back to the gold standard is a bad idea.
Is there a reason for concern?
In the past few years, the U.S equity markets recovered; the Fed’s plan to cut long-term yields with its asset-purchase programs helped steer investors away from government bonds and into equities. U.S. inflation remained contained at less than 2%. This reduced the concerns investors might have had about a sharp rise in inflation even further.
The U.S dollar remained relatively strong against leading currencies, such as the euro, yen and Canadian dollar: the decision by the Bank of Japan to augment its asset-purchase program drove the yen sharply lower, which made the U.S. dollar strong. Meanwhile, the debt crisis in Europe kept the Euro weak against the U.S. dollar.
Even though the U.S economy has shown some signs of recovery, it’s still too soon to claim that the Fed’s asset-purchase program made any difference. Moreover, if the U.S government continues to cut its budget, U.S economic growth might change course and contract.
Gold as an investment
The main problem with gold is that it only has the potential to appreciate over time as a return. When gold prices aren’t rising, the metal becomes less attractive as an investment. The sharp fall in gold’s price by more than 12% since the beginning of the month also pulled down the ETF SPDR Gold Trust (ETF) (NYSEMKT:GLD) Shares. The ETF lost 16.3% of its value so far in April.
Moreover, the ETF keeps losing ground as its holdings continue to dwindle. Since the beginning of 2013, the ETF’s gold hoards fell by 16%. This ETF follows the price of gold, and thus if the price of gold will continue to dwindle, the ETF’s price will also decline.
Moreover, the linear correlation between the monthly changes in the SPDR Gold Trust (ETF) (NYSEMKT:GLD)’s gold holdings and the price of gold is mid-strong and positive, and stands at 0.52. This strong correlation isn’t surprising and means the direction of gold price affects demand in this ETF.
Other gold-related investments similarly took hits: shares of royalty company Royal Gold, Inc USA) (NASDAQ:RGLD) lost more than 36% in value since the beginning of the year. Shares of the gold producer Goldcorp Inc. (USA) (NYSE:GG) tumbled 24%.
Nonetheless, Royal Gold, Inc USA) (NASDAQ:RGLD) still has a very high profit margin because it doesn’t produce gold mines, only buys them and collects royalty payments for them. The company’s operating profitability was 60% in 2012.
This means that even after the price of gold lost 16% of its value, the company’s profit margin is likely to have remained in the black. But the recent drop in the price of gold might lead Royal Gold, Inc USA) (NASDAQ:RGLD) to cut back on its business developments or at least reevaluate them.
The situation is much different for Goldcorp Inc. (USA) (NYSE:GG). The company’s operating profitability is lower than that of Royal Gold, Inc USA) (NASDAQ:RGLD), and in 2012 reached 39%. The company’s total cost in cash (dollar per ounce) to produce gold sharply rose in 2012 by 34% compared to 2011 and reached $874 per ounce.
If the cost of production rises again to a range of $1,000 and $1,100 per ounce, the company’s profit margin will likely decline substantially considering the price of gold is currently trading at around $1,380 per ounce.
Perhaps the only silver lining for these companies is that the sharp drop in their stocks raised their dividend yield: Royal Gold, Inc USA) (NASDAQ:RGLD)’s current dividend yield is nearly 1.5%; Goldcorp Inc. (USA) (NYSE:GG)’s is around 2.2%. This is one of the few advantages these companies have over holding gold or investing in a gold SPDR Gold Trust (ETF) (NYSEMKT:GLD).
Another advantage is that both companies are expected to augment their operations in 2013. If gold doesn’t fall any further and these companies remain profitable, a rise in operations might offset the adverse effect the price of gold will have on corporate revenue during the year.
The bottom line
The golden era of gold might be behind us but some gold companies, such as Royal Gold, Inc USA) (NASDAQ:RGLD), will remain in business. These companies’ profit margins and revenue growth are likely to dwindle, but at least they will offer higher dividend yields. Alas, I don’t think the dividend yield will be enough to make these companies a worthy investment; especially if the demand for gold as an investment falls further, which will keep dragging gold price down.
The article Is the Golden Era of Gold Over? originally appeared on Fool.com is written by Lior Cohen.
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