How is Gold Priced?

[jason]

I am confused about how the price of gold is determined.  On the one hand, gold is priced twice a day by the "London Gold Fix", as described here: http://en.wikipedia.org/wiki/Gold_fixing
But gold is also traded on exchanges as physical gold and futures, and the price changes constantly throughout the day. 
So, what it is interplay between the price of gold determined by the Gold Fix and the price of gold determined on gold exchanges?  For example, if gold is trading at $1250/oz on exchanges just before the afternoon Gold Fix, and then the Gold Fix determines the price is $1350/oz, will the price instantly shoot up to $1350/oz on the exchanges?
Are there any articles out there about this?  A google search didn't turn up anything for me.

[Gosso]

Gold is priced by how many times Peter Schiff, Marc Faber, Jim Rogers, and Eric Sprott appear on TV in a given month. 

Try Googling the "silver fix", since there were some rumblings about it when one aspect of it was shutdown a few months back.  I don't think it has much impact for guys like you and me, but seems to apply more towards contracts based on a specific closing price at a given time.

[mortalpawn]

The short answer is that the "spot price" is set in the futures market.  Basically you take the "future" price for gold and discount it by the "risk free" rate (which happens to be near zero at the moment) to come up with today's price.  Since gold is traded around the clock worldwide, you can determine a live "spot" price 24 hours a day for gold and silver.  A bullion dealer will charge you a premium above this price when you purchase Eagles, Maples or other coins online or from a shop.

The long answer is more complicated.  If you want to drive yourself insane, read "Gold Wars" by Kelly Mitchell.  It covers just about everything having to do with the paper gold market which drives the spot price for physical gold.  It also explains how gold holdings are leased, loaned, swapped and made into derivatives to make "more gold" and then multiplied again on the futures exchange.  It covers how the futures market for gold and silver operates under rules that are entirely different than any other commodity (like uncovered shorts). I'm not much of a conspiracy theorist, but it is clear that the gold market follows rules like no other market.

He also walks through how you can statistically observe the price of gold falling when western markets are open (consistently they move in one direction over limited periods), but behave more like a free market when Western markets are closed.  He also covers certain periods when market interventions apparently occurred.  The "gold and silver" fixes are a reflection of this.  Its hard to tell how much of his speculation is true, and who might be behind the market moves but they make for interesting reading.

Ignoring the "price manipulation" theories for a moment, the bottom line is that the spot price for gold is determined by the futures market, which can be a very volatile place.  Metal futures have become a speculative vehicle on their own, quite separate from the original intent as a hedge for miners and producers, and the rise of huge Gold and Silver ETFs have only made things worse.  These ETFs often move large amounts of gold futures around on a daily basis, and the big banks are also huge players often writing naked shorts on gold and silver (which would not be allowed for any other commodities) effectively shorting gold that they don't actually hold.  Both drive prices.

This so called "paper gold" market has increasingly diverged from the physical gold market, which is why we are recently seeing gold go down despite huge demand for physical metals. The "paper gold" market also dwarfs the "physical gold" volume of sales.  In 2011, the "paper gold" futures markets cleared transactions of about 50 billion ounces, which is 10 times the amount of physical gold that exists above ground on the entire planet!

  So while your gold supplier may be out of bullion Eagles (as my local store was recently), that is really not driving the price.  Its the ETFs, big banks and those placing big bets in the futures market that determine your gold price.  Physical gold sales are miniscule by comparison.  Sad but true.

[barrett]

This so called "paper gold" market has increasingly diverged from the physical gold market, which is why we are recently seeing gold go down despite huge demand for physical metals. The "paper gold" market also dwarfs the "physical gold" volume of sales.  In 2011, the "paper gold" futures markets cleared transactions of about 50 billion ounces, which is 10 times the amount of physical gold that exists above ground on the entire planet!

  So while your gold supplier may be out of bullion Eagles (as my local store was recently), that is really not driving the price.  Its the ETFs, big banks and those placing big bets in the futures market that determine your gold price.  Physical gold sales are miniscule by comparison.  Sad but true.

OK, so I don't really want to read another book on gold (I am not saying I won't actually rush out and get 'Gold Wars').

My question for mortalpawn and others would be a simple one. Can physical gold or IAU - pick your ETF, that is the one I hold - be counted on over time to find a higher price in times of higher inflation (or low real rates), or does all this derivative crap mess things up so much that we really don't know what the hell is going to happen with the price of gold given certain economic conditions?

For me this then gets back to the basic question in a couple of other threads recently where people question whether or not Harry Browne would be tweaking his 4X25 allocation under current conditions.

[mortalpawn]

This is just my opinion (which is worth what you paid for it), but I believe there are a few key points with gold that remain unchanged over the last few thousand years:
  - Gold is a good store of value - it may not grow much but it does maintains its value over time
  - Gold is not well correlated with stocks or bonds which makes it a good addition to the PP, as it is often negatively correlated with these other assets
  - Gold is the ultimate insurance against financial malpractice and fiat currency failure (which many argue is going on now)

Note I did not include inflation above - gold is surprisingly not well correlated with inflation over the last 40 years.  It has done well in periods of low inflation, and also done poorly during some periods of moderate to high inflation.

Of the three points above, I think it is the last two (lack of correlation and the ultimate insurance) that make it an attractive part of the PP for me.  Yes, you can tweak the percentage of gold down and perhaps get some marginal gains in returns, especially given the 5+ year bull market stocks and 10 year bond rally we have had, but some of us see a significant bubble forming in the bond and stock markets due to QE-infinity and zero interest rates that may eventually pop. 

When it does pop, gold could do very well - especially as the Fed has painted themselves into a corner where they are doomed if they raise rates, and also doomed if they don't.  They don't have much dry powder left to deal with another financial crisis, and we're already seeing increasing volatility in the markets now.

As for me - I took the opportunity a few weeks ago to rebalance and bring my percentages back to 25% (stocks and bonds were previously high).

[barrett]

Note I did not include inflation above - gold is surprisingly not well correlated with inflation over the last 40 years.  It has done well in periods of low inflation, and also done poorly during some periods of moderate to high inflation.

As for me - I took the opportunity a few weeks ago to rebalance and bring my percentages back to 25% (stocks and bonds were previously high).

Thanks, mortalpawn. I also did a mini-rebalance within the last couple of weeks to bring everything back to 25%.

My understanding of HB's position on gold versus inflation is that he was talking about relatively severe inflation in the 5-6% range or above. I heard this in one of his podcasts which I should really dig up. Just looked up this chart for what it's worth:

http://www.aboutinflation.com/inflation ... ical-chart

My take is that gold has never really been fairly tested against "relatively severe" inflation since HB came up with his 4X25 allocation. I think we have to at least partially discount gold's performance during the high-inflation 1970s because it didn't start from a free-market price level.

Sounds like you hold gold for some but not all of the reasons outlined in Craig & MT's book.

[buddtholomew]

If we cannot depend on gold as an inflation hedge, then what is the alternative? Gold should rise when the future of the worlds reserve currency is of concern. This generally occurs in a time of high inflation, right?

[mortalpawn]

If we cannot depend on gold as an inflation hedge, then what is the alternative? Gold should rise when the future of the worlds reserve currency is of concern. This generally occurs in a time of high inflation, right?

I don't know what a better inflation hedge would be.  One interesting exercise I tried was substituting some other possibilities for gold and backtesting - for example using silver, oil, REITs, and other traditional inflation hedges.  None really performed better than gold.  One interesting characteristic of gold is that it seems to move independently of stocks and bonds over the long term, which is of course exactly what you want in a truly diversified portfolio.  Uncorrelated assets are the holy grail for reducing risk.

So yes, despite our love-hate relationship with the shiny stuff it does actually fit in well with the PP, and seems to work best.

As a side note - in times of very high inflation, most real assets will (by definition) rise in price as the currency declines in value.  While long term bonds don't keep up (they lose value as interest rates go up), stocks, gold and even short term bonds (rising interest rates) should rise in "relative" price.  Even during the Weimar republic, some people made a killing on stocks. After all the declining value of the Mark made exports very cheap to neighboring countries.
    http://www.economicpolicyjournal.com/20 ... eimar.html

However, your actual mileage during inflation may vary - because governments always get involved and they distort markets.  For example Argentina/2001 saw an initial stock market boom as people used the stock market to circumvent currency controls and effectively convert holdings and profits to dollars.  However in early 2002, the government closed this little loophole, meaning profits could no longer be repatriated, and stocks subsequently crashed.  In 2012 Argentina even banned most gold sales.

[barrett]

Gold should rise when the future of the worlds reserve currency is of concern. This generally occurs in a time of high inflation, right?

Well, the dramatic run up from 2001 to 2011 was not accompanied by high inflation. I think Harry Browne would have attributed that rise to a general lack of confidence in the US Dollar, but I obviously don't know that.

Mortalpawn is clearly right about gold's lack of correlation with bonds and stocks. That chart that Gosso posted on another thread in the last couple of days showed an amazing moderating of volatility when gold is added to a stock & bond mix.

[rickb]

My question for mortalpawn and others would be a simple one. Can physical gold or IAU - pick your ETF, that is the one I hold - be counted on over time to find a higher price in times of higher inflation (or low real rates), or does all this derivative crap mess things up so much that we really don't know what the hell is going to happen with the price of gold given certain economic conditions?

Physical gold and IAU (or any other ETF) are completely different animals.

IMO, physical gold can more or less be counted on to maintain its value - regardless of what's going on around you.  An oz of gold is an oz of gold.  Its value is intrinsically related to to how much effort it requires to extract an oz of gold out of the ground.  Machinery has, over time, made it easier - but gold has correspondingly become harder to find.  In the limit, I suspect the actual value of an oz of gold is a function of how much gold there is within a mile or two of the earth's surface (clearly some finite number) multiplied by some percentage of the earth's population (which will grow exponentially until it collapses).  The supply is finite, but the number of people wanting to own it grows - so the value increases proportionally to the population.  This relationship has essentially nothing to do with the amount of paper currency any government chooses to print.

On the other hand, the value of IAU (and the other ETFs) depends on the ability of authorized participants to exchange shares for gold at a specific exchange rate, and vice versa.  This ability has no intrinsic aspect to it (whatsoever), so could feasibly be broken in any number of ways.  I'm not saying it's likely, but the US government could (for example) freeze the assets of IAU (or GLD or ...) and "buy" their gold at some fixed price ($1000/oz, $20,000/oz, basically whatever they'd like) - completely disconnecting the price of these ETFs from the actual price of gold.  The point is that shares of IAU (or GLD or whatever) are a paper contract that the government can force you to surrender for paper money, which they can print in unlimited amounts. 

As xkcd is fond of saying, scenarios involving the words "unlimited" or "infinite" generally don't end well.

[jason]

The short answer is that the "spot price" is set in the futures market.  Basically you take the "future" price for gold and discount it by the "risk free" rate (which happens to be near zero at the moment) to come up with today's price.  Since gold is traded around the clock worldwide, you can determine a live "spot" price 24 hours a day for gold and silver.  A bullion dealer will charge you a premium above this price when you purchase Eagles, Maples or other coins online or from a shop.

The long answer is more complicated.  If you want to drive yourself insane, read "Gold Wars" by Kelly Mitchell.  It covers just about everything having to do with the paper gold market which drives the spot price for physical gold.  It also explains how gold holdings are leased, loaned, swapped and made into derivatives to make "more gold" and then multiplied again on the futures exchange.  It covers how the futures market for gold and silver operates under rules that are entirely different than any other commodity (like uncovered shorts). I'm not much of a conspiracy theorist, but it is clear that the gold market follows rules like no other market.

He also walks through how you can statistically observe the price of gold falling when western markets are open (consistently they move in one direction over limited periods), but behave more like a free market when Western markets are closed.  He also covers certain periods when market interventions apparently occurred.  The "gold and silver" fixes are a reflection of this.  Its hard to tell how much of his speculation is true, and who might be behind the market moves but they make for interesting reading.

Ignoring the "price manipulation" theories for a moment, the bottom line is that the spot price for gold is determined by the futures market, which can be a very volatile place.  Metal futures have become a speculative vehicle on their own, quite separate from the original intent as a hedge for miners and producers, and the rise of huge Gold and Silver ETFs have only made things worse.  These ETFs often move large amounts of gold futures around on a daily basis, and the big banks are also huge players often writing naked shorts on gold and silver (which would not be allowed for any other commodities) effectively shorting gold that they don't actually hold.  Both drive prices.

This so called "paper gold" market has increasingly diverged from the physical gold market, which is why we are recently seeing gold go down despite huge demand for physical metals. The "paper gold" market also dwarfs the "physical gold" volume of sales.  In 2011, the "paper gold" futures markets cleared transactions of about 50 billion ounces, which is 10 times the amount of physical gold that exists above ground on the entire planet!

  So while your gold supplier may be out of bullion Eagles (as my local store was recently), that is really not driving the price.  Its the ETFs, big banks and those placing big bets in the futures market that determine your gold price.  Physical gold sales are miniscule by comparison.  Sad but true.

Thank you for the detailed explanation.  I now understand that the spot price of gold is set in the futures markets.  But I'm still not clear on the relationship between the gold spot price and the London Gold Fix that takes place twice per day.  When the London Gold Fix sets a gold price, does this immediately affect the spot price of gold?  I guess I'm not even clear on why a London Gold Fix is needed if the spot price is set in the futures markets.