Gold -- 2 views

Posted: December 23, 2008, 11:29 AM by Jonathan_Chevreau

gold, Crash of 2008

For centuries, gold has been regarded as one of the world’s most precious possessions. Photo by Reuters

We've commented on gold a few times in recent months but seeing as gold was one of the three gifts the wise men brought to the baby Jesus [along with frankincense and myrrh) it seems appropriate to refer to two recent essays that have markedly different views. The pro-gold argument was also articulated in a series of video interviews that appeared here with BMG Bullionfund president Nick Barisheff.

We've also described the position of financial advisors for whom the "big three" asset classes have always been stocks, bonds and cash. Increasingly, some advisors are assigning a bigger role to gold bullion ETFs or precious metals equity funds. We have previously cited Rogers Financial Group advisor David Chalmers, who views the recent market turbulence as sufficient cause to double his previous 5% "insurance" allocation to gold to 10%.

I was surprised to see a similar argument from Calgary-based McLean & Partners, whose essay I reproduce (in part) below. And beneath that is a more skeptical view of gold from U.S. author Larry Swedroe.

McLean & Partners: Financial Fundamentals -- Getting Back to Gold

As Canada’s stock market success is still largely dependent on the success of its commodity and natural resource sector, Canadian investors may benefit in more ways than one by having a portion of their portfolio in a very traditional asset: Gold. Yet, owning gold may prove to be a risky move, given the fiscal restraints of the current economic climate.

Market Intelligence, December 2008 - Gold

For centuries, gold has been regarded as one of the world’s most precious possessions. It has been traded as currency, treasured and shaped into jewelry and art, and for many nations, served as the basis for their wealth.

During the recent period of global financial turmoil and credit meltdown, the gold market has not acted in a historically traditional manner. In the past, gold has been used as a safe haven during tough economic times, as investors seek safety from declining corporate earnings and move to gold’s physical, tangible value.

Gold at $1000?
Many investors have wondered aloud why gold has not acted in a manner similar to its past behaviour, and the answer may be attributed to the exaggerated fear and anxiety resulting from the deleveraging of the markets, and worldwide decline in economic conditions. The fear among many investors has become so intense such that the only asset class they truly trust is cash and 90 Day US Treasury Bills, the latter now offering a 0% yield.

Analysis of the Gold Market
Looking beyond the collective fear reported in the financial press, we have assessed our position on gold and remain bullish on this unique commodity. Our rationale includes:
1. We believe gold will increase in value as a hedge against a declining US currency, and as a hedge against future inflation. We remain concerned that US inflation rates will rise in light of the recent US monetary and fiscal stimulus package announcements. Many of these packages are analogous to “printing money”.
2. In addition to being an inflationary hedge, gold also serves as a hedge against political risk such as terrorist attacks.
3. Gold is likely to be underweight in many institutional portfolios, especially when compared to other, more cyclical commodities such as oil.
4. Gold is not perfectly correlated with often more volatile commodities, allowing it to provide additional diversification benefits.
5. Analysis indicates that gold has been oversold in the market, and is likely approaching a price bottom. The sentiment for gold has improved off recent oversold levels. Could the cyclical low for gold already be in place?

Gold ownership change
To reflect both the current trend in the gold market, and taking into account economic conditions, McLean & Partners advocates a investment portfolio weighting of 3-5 % in gold or gold related stocks. Until recently, we have held gold through a basket of stocks that was representative of the major mining companies involved in gold mining activities. Now, we own gold in an exchange traded fund based on the pure commodity.

Why did we carry out this change in the way we own gold? Major mining companies are still largely dependent on financing and other credit facilities to maintain or grow operations, and with the current credit climate, we believe it is prudent to move our method of owning gold into a potentially less volatile format.

The Bottom Line
Gold continues to occupy one of a number of key cornerstones in our client portfolios by providing unique diversification benefits not readily available with other asset classes. We do not expect this to change for the foreseeable future. While we do expect to hold a core position in gold for the long term, as with any other portfolio position we do anticipate adopting a trading posture for a portion of the position by taking advantage of various moves in the price of gold to periodically take profits and add back again as circumstances warrant over time.

McLean & Partners is a Calgary-based private client wealth management firm, with a focus on global dividend growth stocks.

Larry Swedroe: As Good as Gold?

Whenever equity asset classes experience bear markets, investors seek out safe havens for their investments. This is especially true in times of financial or political crises. One whose popularity runs in cycles, with short bursts of enthusiasm or “frenzy” as the price soars, followed by long periods of it being ignored, is gold. And while the price of gold has fallen from its peak of over $1,000 in March 2008, we can still say that it is in the “frenzy” stage.
The main argument made by advocates of gold is that they believe that it is a good hedge against inflation. For the period from 1935 (when the price of gold was fixed at $35 an ounce by the Federal Reserve) through October 2008, gold did provide a positive real return of 0.6 percent. Unfortunately, not all individuals have horizons of 73 years. We need to consider more realistic investment horizons. This is especially true for retirees (for whom 73 years would be far greater than their horizon), or those nearing retirement, as they face the greatest risk of inflation negatively impacting their lifestyle. We address that issue by considering the period since 1981—the last time there was a “frenzy” for buying gold.
In 1979, inflation peaked at a rate of 13.3 percent. That was followed by an increase of 12.4 percent in 1980. The price of gold rose as the fear of inflation increased. While we admit to a bit of data mining, the following example demonstrates that gold is not a good inflation hedge, unless perhaps your horizon is “infinite.”

Let’s assume that to provide a hedge against future inflation an investor decides to purchase gold at the end of 1980 with the price at $641 an ounce. Over the next 27 years (1981–07) inflation rose at an annualized rate of 3.4 percent. If gold was an effective hedge against inflation its value at the end of 2007 should have been at least $1,528. Yet, it was worth just $833 (an annualized return of just under 1 percent). In other words, an investor in gold experienced a reduction in purchasing power of 2.4 percent per annum, or a cumulative loss of purchasing power of about 55 percent. For an investor who was unlucky enough to purchase gold at its peak of $850 an ounce on January 21, 1980 (as some undoubtedly did), the inflation-adjusted price would have had to been in excess of $2,300 by the end of 2008. If gold can provide negative real returns of that size over almost a thirty-year period, it cannot be considered an effective hedge against inflation.

Even worse is that our example does not consider the costs of investing in gold. Strategies have no costs, but implementing them does. The most direct way to invest in gold is to purchase actual gold coins or bars, which may require additional transportation, storage, and insurance costs. Another common option is to use the futures market. The problem there is that like all easily storable commodities gold trades in contango—the futures price is higher than the spot price by an amount equal to the cost of carry (financing, storage and insurance costs). Therefore, over time the investor while have the incremental trading costs involved in rolling over the futures contracts as they mature, but also the cost of the contango. A third way to invest in gold is by purchasing shares of an ETF such as the SPDR Gold Trust ETF (GLD). The fund has an expense ration of 0.4 percent (plus the costs of storage, etc.). Thus, no matter the method used to gain access to gold as an investment, the already poor real returns would have been negatively impacted.

While commodities as a broad asset class (as opposed to gold specifically) are too volatile to act as a hedge against inflation, we believe they are a superior hedge against inflation than gold. The price of gold itself has very little impact on the economy or the rate of inflation. On the other hand, while a commodity index such as the GSCI does include gold, it also includes a wide range of commodities that can have a significant impact on the rate of inflation (i.e., energy, industrial metals, livestock and agricultural commodities). Note that for the period 1981 through November 2008 the GSCI returned 6.7 percent per annum, outpacing inflation by over 3 percent per annum, and far outpacing the return on gold.

Summary
While gold has provided a slightly positive real return over the very long term, the price movement is far too volatile for gold to act as an effective hedge against inflation. For those investors who desire to hedge the risk of inflation the preferred instrument is TIPS, which directly hedge the risks of inflation.

Larry Swedroe is the author of Wise Investing Made Simple (2007), Rational Investing In Irrational Times, How to Avoid the Costly Mistakes Even Smart People Make Today (2002), and The Only Guide to Alternative Investments You’ll Ever Need (2008). He is a Principal and Director of both Research of the Buckingham Family of Financial Services in Clayton, Missouri (www.bamservices.com).