Features & Departments Why Gold May Not Glitter

Why Gold May Not Glitter
Gold bullion's traditional importance as a store of value has been challenged by several fundamental changes in the financial markets.
by Ben Amoako-Adu and Brian F. Smith

Beyond its use in jewelry, industrial applications and dentistry, gold has played an important role in the world's economy since the dawn of civilization. It has been a store of value and a hedge against a number of risks, including economic downturn, inflation, currency devaluation and political turmoil. For the last fifteen years, the role of gold bullion in the financial markets has been seriously challenged by five developments. First, in Canada's most recent economic downturn, gold bullion did not prove itself to be a hedge against recession. Traditionally, it has been argued that it maintains its value in difficult economic times. Second, central banks around the world became committed to working towards and maintaining low inflation. This reduces the inflation risk and the need for gold as a store of value. Furthermore, gold bullion has experienced a slight loss in its real value since 1976. Third, a number of derivative contracts have been developed which can be used to hedge against a loss in purchasing power and a variety of other financial risks, such as currency depreciation. Fourth, the fall of communism has reduced the likelihood of global political conflict. Thus, the need to hold gold bullion as a hedge against political risks is lessened. Finally, the establishment of the Euro currency promises to create a strong global currency that, in addition to the U.S. dollar, offers central banks an attractive reserve asset as an alternative to gold bullion. On the positive side, gold bullion offers portfolio risk reduction benefits to investors since it has only a small positive correlation with the stock market. In addition, an investment in gold stocks has provided a much higher return than has gold bullion.

The 1996 CRB Commodity Yearbook highlights how much the demand for gold is dependent on its investment appeal. World consumption of gold in jewelry, industrial and dental applications amounted to 3170 tons in 1996. This demand was met by an estimated 2280 tons of gold mine production, recycling of 650 tons of gold scrap and 250 net official gold sales. There are estimated to be approximately 100,000 tons of gold that are still in existence that have been mined over the centuries. Central banks hold 35,000 tons and the rest is in coins, jewelry and bullion. Thus, if gold lost its place as a store of value and central banks sold their gold reserves, gold mine production could close for over 16 years if consumption stayed at 1996 levels. Furthermore, the sale of coins and gold bullion from outside central banks would permit mines to close down for an even longer period. Thus, the role of gold in financial markets is critical to its valuation.

Bullion and Stocks as Investments

Gold bullion has had a mean annual real return of -0.85% over the period 1976 to 1997. The overall slightly negative return masks markedly different performances over two sub-periods. Over the period 1976 to 1984, the average real return for gold bullion was 3.29% versus -3.71% over the period 1985 to 1997. Thus, while gold bullion nearly maintained its real value over the 22-year period, there were extended sub-periods where significant value was lost.

On the other hand, gold stocks have provided investors with a much higher return than gold bullion. The average real annual return on gold shocks was 4.56% over the full time period and it was positive over both sub-periods. The higher return on gold stocks in an environment of stagnant gold prices is attributable to reductions in operating cost per ounce of gold mined for Canadian mining companies as well as favourable stock market conditions given historically low interest rates. The standard deviation of gold stock returns is also higher than that of gold bullion. This is because gold company profits are levered to the price of gold bullion in the presence of significant fixed operating costs.

Relationship of Gold Stocks to Bullion
There is a close relationship between the price of gold bullion and gold stock value. Table 2 shows the results of the regression of gold stock returns on gold bullion returns. The slope coefficient of this regression *1, is referred to as the gold beta of the stock. The slope coefficient value of approximately 1.14 for the full time period indicates that a 1% increase in the price of gold bullion is expected to lead to a 1.14% increase in the price of gold stocks.1 Table 3 tests how much the return on the TSE300 Index can explain the variation in gold stock returns. The returns on the TSE300 Total Return Index also have a significant positive relationship with gold stock returns. The percentage of variation of gold stock returns attributable to the change in gold bullion prices and the market return is 63%. Thus, the two factors explain almost two-thirds of monthly changes in gold stock prices.
Is Gold Bullion a Recession Hedge?

In periods of recession and depression, it is argued that gold bullion is a relatively attractive investment. For example, unlike deposits, there is no concern regarding default by deposit-taking institution during a period of poor economic performance with a gold investment. Furthermore, corporate bonds and stocks also tend to lose value if economic conditions significantly deteriorate. On the other hand, the value of gold bullion is not directly tied to the financial performance of corporations.

Proponents of gold bullion often cite the U.S. Great Depression as a period in which gold maintained its value and thus served as a hedge against economic decline. However, this was a period in which the U.S. dollar could be converted to gold bullion at a fixed price and thus the link between gold and the U.S. dollar was backed by the U.S. Federal Reserve.

Since the early 1970s, when the price of gold bullion began floating after the U.S. abandoned its gold standard, Canada has experienced two recessions. Between the second quarter of 1981 and the fourth quarter of 1982, Canada's real gross domestic product (GDP) dropped by 5%. Between the first quarter of 1990 to that of 1991, the real GDP likewise dropped by 4%. In the 1981-82 recession, the real gold bullion price increased by 2% but in the 1990-91 recession, real gold prices fell by 12%. Thus, the more recent experience would suggest that gold bullion does not provide a good hedge against the threat of economic downturn.

Is Gold Bullion an Inflation Hedge?

Figure 1 shows how U.S. inflation has been contained for the last fifteen years. The declining inflation rate has also been the pattern in other major economies as central banks around the world have made concerted efforts to ensure price stability. Thus, to the extent that investors have confidence in continued efforts by central banks to restrain inflation, there is less need for an inflation hedge. As the figure shows, gold bullion prices have declined concurrent with the reduction in inflation rates.

If gold bullion is to serve as a strong inflation hedge, then as inflation increases, gold value should also increase. The relationship between the nominal gold bullion price and inflation on a monthly basis is shown in Table 4. This table reports the results of ordinary least squares regression of the nominal return of gold as a function of the monthly inflation rate. Over the period 1976 to 1997,1 the coefficient of the inflation rate is positive and statistically significant at the 5% level. The coefficient of 2.57 indicates that a 1% increase in inflation is associated with a 2.57% increase in the nominal price of gold. However, as shown by the adjusted R2, only 5% of the variation in gold return is explained by changes in the inflation rate. Furthermore, over the two sub-periods, the relationship between inflation and the nominal return on gold bullion is not statistically significant. In summary, the link between nominal gold returns and inflation is weak and it is significant only over the long term.

Alternative Methods of Hedging Financial Risks

Since the 1970s, there has been a proliferation of very liquid derivative contracts used to hedge financial risks.2 For example, there has been rapid growth in the volume of U.S. Treasury bond futures contracts over a period when the gold price has stagnated. A short position in these futures contracts can be used to offset the risk of increases in government bond yields. To the extent that government yields compensate investors for inflation over the holding period, bond yields are highly correlated with inflation rates. Therefore, bond futures contracts can be used as a hedge against decreases in the real value of financial assets associated with rising inflation. Another financial instrument developed to handle inflation risk is the real return bond issued by British and Canadian governments.

It should be noted that derivative contracts have been developed to hedge other risks that an investment in gold bullion has traditionally been thought to help mitigate. Foreign exchange futures, forwards and option contracts are widely used to manage currency risk. Stock index derivative contracts are important for handling the risk of decreasing equity prices. Since both currency and stock market risk are highly correlated with political risk, gold's traditional and once dominant role as a safe haven in periods of economic and political turmoil is also being challenged.

The multitude of different derivative contracts now available means that management of financial risks can be much more carefully tailored than in the past. Furthermore, the increasing sophistication of individual investors and their advisors means that the derivative technology used to manage risk will be more widely adopted and the role for gold bullion further lessened.

Bullion as a Hedge Against Global Political Instability

Gold bullion has been viewed as a hedge against global political instability. It has been argued that gold bullion is a hedge against social, political or economic crises, as it can be traded worldwide at any time and its real value holds during such crises.3 For example, the peak of gold's price at over US$700 per ounce coincided with the Soviet invasion of Afghanistan and the taking of American hostages in 1979 by Iranian militants. These events demonstrated the link between gold bullion and major political crises.

However, since the breakdown of the USSR and the communist block, the threat of significant global political conflict has greatly diminished. The lessening of East/West tensions is mirrored in the reduction of US military spending as a percentage of GNP. During the late 1980s, U.S. military spending was approximately 6% of GNP. By 1994, such expenditures had decreased to about 4% of GNP. Furthermore, recent political crises such as the Gulf War, Russia's economic turmoil and Nato's air strikes inYugoslavia have not had as large an impact as earlier events would have predicted.

Impact of Strong World Currencies

As part of their reserves, central banks often hold strong global currencies such as the U.S. dollar rather than gold bullion. One of the factors behind the slide in gold prices over the past few years has been the attraction of US dollar denominated securities. This attractiveness was enhanced because of the significant real rate of return on government-backed debt securities. In contrast, the holder of gold bullion received no interest coupons and had to rely on an uncertain capital gain.

The creation of the Euro promises to establish another strong major currency in addition to the US dollar. Thus, investors have another alternative to gold bullion as a reserve asset. For the European central banks, the Euro eliminates currency risk within the monetary union and so lessens the need to hold gold bullion as a buffer against exchange rate risk.

A number of European countries including Switzerland, France and Germany have announced that, with the inception of the Euro currency, they will reduce their gold reserves to only 10% of current holdings. Given that Germany, France and Switzerland collectively hold 23% of the world's central bank reserves, it is not surprising that recent announcements from the European governments concerning these planned gold bullion sales have had a dampening impact on gold prices.

Gold Within a Portfolio

Despite the evidence outlined above that gold may not be attractive as a single investment, it is possible that gold may offer investor benefits within a portfolio. Most importantly, gold may reduce overall portfolio risk. This, of course, depends on the correlation of gold with the market. As shown in Table 5, gold bullion has a positive correlation of 0.27 with the market.4 This implies that gold bullion may substantially reduce portfolio risk. For portfolio diversification per se, it is worse to hold gold stocks because they have a higher correlation with the stock market compared to gold bullion. This is not surprising as gold stocks constitute a significant proportion of the TSE300 Index.

This paper has summarized how five factors are depressing the price of gold bullion. The return on gold bullion over the two most recent recessions in Canada suggests that gold no longer serves as a useful hedge against recession or depression. Central banks around the world are committed to working to keep inflation low. This reduces the inflation threat and as indicated from our empirical results, gold bullion is not a highly effective inflation hedge.Third, there are a growing number of financial derivatives that can be used to hedge risks associated with inflation and currency devaluation. These are more precise tools than gold for managing financial risks. Fourth, the fall of communism has reduced the threat of global political instability. Fifth, the strength of the U.S. dollar and the recently created Euro currency offer alternative reserve assets to gold bullion for the world's central banks. However, gold bullion offers portfolio risk reduction benefits. Furthermore, gold stocks provide much higher returns than gold bullion.


1. Tufano (1998) finds that the average gold beta of US and Canadian stocks over the period January 1990 to March 1994 is approximately 2.0.

2. The Wharton-Chase Derivatives Survey (1995) reports that over 70 percent of firms use derivatives to hedge commitments.

3. The traditional role of gold as a hedge against global crises is discussed in greater in Solnik (1991), International Investments, Addison-Wesley Publishing Company, Chapter 11.

4. The correlation of gold bullion with the TSE300 Index may overstate the correlation of gold with equities given the significant component of the TSE300 in gold stocks.


Jaffe, J., 1989, "Gold and Gold Stocks as Investments for Institutional Portfolios", Financial Analysts Journal, 45, 53-59.

Solnik, B., 1999, International Investments, Second Edition, Reading, MA: Addison-Wesley Publishing.

Tufano, P., 1996, "Who Manages Risk? An Empirical Analysis of Risk Management Practices in the Gold Mining Industry", Journal of Finance, 51, 1092-1138.

Tufano, P. and J. Serbin, 1998, "The Determinants of Stock Price Exposure: Financial Engineering and the Gold Mining Industry", Journal of Finance, 53, 1015-1052.

The Wharton School and the Chase Manhattan Bank, N.A., February 1995, Survey of Derivatives Usage Among U.S. Non-Financial Firms, Executive Summary. Ben Amoako-Adu and Brian F. Smith are professors of finance, The Mutual Group Financial Services Research Centre, School of Business and Economics, Wilfrid Laurier University in Waterloo.

Transcontinental Media G.P.