Central banks are buying gold – is this a sign to sell?

Never, ever fall in love with an investment. No matter how much money it's made you.

If you had bought technology stocks in the early 1990s, then by the end of the decade you'd have made a fortune on paper. By that point, parting with those companies would have felt very painful. But if you had kept holding for just a little longer, you'd have seen your paper fortune evaporate.

The same thing happened with the property bubble in the early 00s. Lots of erstwhile real estate barons ended up bankrupt.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

So what about gold? Since the start of the century, it's been one of the best-performing assets on the planet. It's made early investors a lot of money, and it's an investment we've been very keen on.

But as anyone who bought in 1980 will know, while gold might be a good store of value over the very long run, it can endure some pretty awful bear markets too.

And while we think it's worth having a portion of your portfolio in gold consistently as insurance, you don't want to have the lion's share of your wealth invested in it when the next down-cycle comes.

Gold's suffered something of a lull in recent months. Combined with the fact that central banks - never great market timers - became net buyers last year for the first time in decades, it's worth asking if their interest in the yellow metal is a sign to the rest of us to get out.

Our central bankers have a poor investment record

Central bankers have generally made a hash of managing the global economy. Rather than reining in over-exuberance during the bubble years, they fuelled it, by cutting interest rates at the first hint of any slowdown.

This knack for doing the wrong thing at the wrong time extends to their investment decisions too. As Ronald-Peter Stoeferle of Erste Group Research puts it in one of his recent mammoth reports on gold, "central banks tend to be civil servants with an extremely pro-cyclical investment behaviour".

In other words, they're very good at buying at the top and selling at the bottom. They are a classic 'contrary indicator'. The obvious example is Britain's decision to sell gold in 1999.

Clearly this was driven by then-chancellor Gordon Brown, so it's not all down to the Bank of England. But in any case, the sale meant that the UK missed out on the gold bull of the next 13 years.

Indeed, the decision was so badly handled that it led to claims that Brown was acting to protect several major banks from a disastrous decision to short gold. GATA (the Gold Anti-Trust Action Committee) argue that this is still going on.

The Libor scandal means that we can't rule anything out. However, for now the evidence points to cock-up rather than conspiracy. Indeed, at the time, The Economist called the BoE's gold sale, "sensible portfolio diversification".

Moreover, The Economist also pointed out that "Britain's sales are not unusual; nor are the amounts particularly large. Canada, Belgium and the Netherlands have each sold more than the 415 tonnes Britain plans to dispose of." Even Switzerland began selling gold, a process that has led to their gold reserves falling by 60%.

In short, the BoE wasn't the only central bank to get its gold timing badly wrong.

Which central banks have been piling into the gold market?

So that raises the question: should we be worried now that central banks are starting to buy gold again? As Stoeferle notes, net purchases in 2011 were the highest seen since 1964.

However, we're not so sure we need to be worried yet. As Stoeferle points out, the majority of the gold has been bought by central banks in developing economies, such as Mexico, Russia and Turkey. At this stage, such central banks are generally just 'catching up' with developed markets.

For example, troubled peripheral eurozone nations Portugal and Greece have 90% and 80% respectively of their central bank reserves in gold. The US isn't far behind. China and Saudi Arabia, on the other hand, have less than 10% of reserves in gold.

"Compared with the industrialised nations, the majority of central banks in emerging nations remain clearly underweighted in gold." That means they need more to hedge their huge exposure to the US dollar. It's also worth noting that China and Russia have been net buyers in the last decade, so it's not as though their behaviour has suddenly changed.

However, if developed economy central banks started buying gold again, that would be more worrying. Indeed, says Stoeferle, given the BoE's track record, if it "were to announce purchases, we would regard this as a warning signal for the gold price".

The good news is that this hasn't happened yet. And it may be some time before it does. As Tim Price pointed out the other day in Money Morning, most developed-world central banks are more preoccupied with money printing and setting negative interest rates in order to inflate away some of their debt burdens. Given these policies, we think gold could see more significant gains before its time in the sun is over.