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The Central Bank of India Tells How Low Gold Can Go
Monday January 14, 2013 09:46
Astute Investors Want Rigorous Analysis, but it is Hard to Come By
There is no argument that astute investors do not get wedded to one point of view. Astute investors continuously seek information from diverse sources. Since precious metals are international commodities, it is important to seek information from across the globe.
Unfortunately while opinions, innuendo and conjecture on precious metals are readily available, rigorous analytical analysis is hard to come by.
Why the Reserve Bank of India is a Credible Source
The central bank of India is called the Reserve Bank of India (RBI). By some estimates about 11% of the world’s gold resides in India. Growth in gold demand in India has been outpacing the gold demand increase in the rest of the world. The chart illustrates the point.
Traditionally India has been the largest importer of gold in the world. Despite large increases in gold prices over the recent years, the imports of gold by India have been rising at an unsustainable pace. The chart tells the story.
What happens to gold is extremely important to the Reserve Bank of India for two reasons. First large imports of gold at elevated prices are causing large trade deficits. The deterioration in current account deficit due to large gold imports has become a drag for the Indian economy.
Second, there has been tremendous increase in lending against gold in India. If gold prices were to fall a lot, it would wreak havoc on the Indian financial system similar to the havoc caused by collapsing house prices on the American financial system in 2008.
The chart shows about 700% increase in lending against gold in India since 2008.
Gold loans were provided by money lenders and pawn brokers for several centuries. In recent years the gold loan business has shifted from pawn brokers to financial institutions. There has been a big rise in the number of institutions lending against gold. In addition to the banks, nonbank financial companies (NBFCs) have become major players in lending against gold. To handle the large demand for loans against gold, NBFCs have increased borrowings from the banks on a massive scale.
Only Minuscule Probability of Greater than 30% Fall in Gold Price
RBI concluded sound forecasting of the volatility in gold prices to be technically infeasible. Our extensive research At the Arora Report has led us to the same conclusion. Independent of RBI, The Arora Report had started an analysis based on the historical patterns, now finishing the study is moot because the RBI has already published the results.
The RBI study concludes that there is only very small probability of gold price decline of 30% or more in the short-term. However, a 10-15% decline in gold prices has about a 15% probability during a six month period.
Here is the RBI’s methodology. The RBI identified episodes of price declines over periods of six months, three months, two months and one month basis and derived a frequency distribution from 30 years’ worth of data. From the frequency distribution, the probability of occurrence of major and minor declines is measured. Based on a CRISIL’s methodology, the Working Group also calculated the probability of gold price decline in four baskets (six-months, three-months, two-months and one month basis) using World Gold Council’s long-run daily price of gold in US Dollar from January 1979 to April 2012. It is evident from the analysis of the past data that there is no probability of a drop in gold price of more than 40% and even the possibility of 30% or more fall is very rare in all the four baskets. However, based on past episodes a likelihood of decline in gold price of 10% or above could be in the range of 14.6% to 3.3% over the time horizons considered. Similarly, the possibility of decline in gold price of more than 20% or above could be in the range of 0.4% to 3.0%
Gold Price Volatility
In case of gold price, the series exhibits periods of unusually high volatility followed by more tranquility.
The RBI also did a good job of analyzing the volatility as follows:
Simple plotting of the gold price data in differenced form demonstrates different sets of volatility, so the possibility of ARCH effect is quite high. The autoregressive conditional heteroskedasticity (ARCH) developed by Engle (1982) and the generalized ARCH (GARCH) developed by Bollerslev (1986) are two methods, the Group has followed for modeling volatility in gold price in Indian Rupee over the period 1979-2012 based on daily data (5-day week) from the World Gold Council.
What to Do Now?
The practical question for precious metals investors is what to do now.
It is important to note that the foregoing analysis is based on the past data and the world has changed. Our analysis at The Arora Report of the trading data from across the world has consistently shown that since 2011, gold has been controlled by the momo crowd.
Gold bugs and the gold momo crowd are often confused. The reality is the differences between the two groups as I have assessed from a large number of emails is stark. Gold bugs tend to be intelligent and well-steeped in economics, especially monetary policy. They understand the arguments against gold and silver. Gold bugs tend to be long-term-oriented and disciplined investors. As an example, last year I did not see gold bugs mortgaging their homes and buying silver on margin.
The gold momo crowd is another story. Gold momo crowd buys gold and silver simply because everyone else in their social circle is buying gold and silver, they think it is going up, and they are scared of monetary policy pursued by the Federal Reserve. The gold momo crowd keeps up the ruse that they understand inflation and history, but in reality, my experience is that unlike gold bugs, their knowledge is superficial.
Since there is no long-term historical data on the momo crowd, it is conceivable that this time during a decline gold may behave differently than it has done over the period of study, namely the last 30 year.
Our take is that gold and silver alternate between investable periods and trading periods. During the last investable period we recommended backing up the truck and buying silver, we allocated 20% of total assets to silver at an average price of $17.73. It is a matter or record that we sold all of our silver as it hit $50 and went short with a target of under $34, i.e., the point was to profit from declining silver prices.
It is also a matter of record that we aggressively accumulated gold in the $600 range, sold half of it at $1904 and the other half at $1757. Since then the Allocation Model of the ZYX Change Method has consistently shown that gold and silver are in a trading period and not in an investable period. Therefore, we have been only taking short-term trades in gold and silver and staying away from initiating new long-term investment positions.
The Quantitative Screen of the ZYX Change Method continues to show that the fair value of gold continues to be $1200 $1450 and fair value of silver is under $24. These values are consistent with RBI’s analysis.
For nimble astute investors who believe in probability based investing the best course of action is to stay alert to the start of another long-term investable period in gold and silver. Once such a period starts, our strategy will again be similar to the one successfully executed in the past, i.e., buying gold and silver with both hands within the limits imposed by our diversification criteria. Until then we will simply continue to capture low risk short-term opportunities as they arise.
Long-term investors may consider ignoring talking heads making predictions based on Indian wedding season, The Trillion Dollar Platinum Coin to pay off the U. S. debt, etc.; however such issues become important from a trading perspective. From a trading perspective it is best to maintain a balanced view. Jon Nadler’s columns are excellent examples of a balanced perspective.
By Nigam Arora
Chief Investment Officer
Courtesy of www.TheAroraReport.com
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