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 will 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.

Disclaimer: Larry's opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management.

Comments

[Alan von Al...:]

You spoke about buying at the top ($850 in 1980). Surely you know about dollar cost averaging. What's at issue is buying at $850 today or $750 if we ever see it again. Those of who built a position at $300 and $400 feel pretty good about holding bullion coin with no paper trail.

2008 Dec 23 05:31 AM

[SW Richmond:]

"The main argument made by advocates of gold is that they believe that it is a good hedge against inflation."

Nothing could be further from the truth. I see your firm is a devotee of EMH, so allow me to explain: Gold is THE time-honored, internationally-recogn... way to move wealth into the future. Gold is durable, divisible, and a store of wealth. Gold is most emphatically NOT an "investment". People do speculate in gold during crises in unbacked paper fiat currencies, and now is one such time. People also hide capital in gold for the same reason, as gold is one very good way to hedge "disaster". Economic news continues to be history-making, and in a negative way. It's no wonder that people are rediscovering the true value of gold.

Your article repeats the tired old "investment performance" comparisons based on buying gold at some recent high. The same selective comparisons could easily be made with, say, the Nikkei (back where it was 20 years ago, how's that for an investment horizon?) or the DJIA.


"The problem there is that like all easily storable commodities gold trades in contango"

As has been pointed out innumerable times recently, gold has in fact had a persistent recent flirtation with backwardation, a condition that existed over a time period of several days, a historic first. Did you miss it? Gold, a monetary metal, trading in backwardation shows clear loss of faith in paper currencies and paper financial instruments. Gold is no one's promise, and is not subject to counterparty risk. Physical gold cannot be defaulted or "Madoffed". GLD, on the other hand, is a kind of paper claim on physical gold held by someone else.

I see your firm's Spring 2008 newsletter advised clients to "Stay the Course" and "Diversify Globally". How's that working out for you? Your article treats gold as something it's not, and fails completely to address any of the genuine pressures that exist which affect gold's value. Why should we take your advice?

2008 Dec 23 06:59 AM

[gooter:]

gold is nothing more or less than money, exchangeable in any nations currency. i could care less what it's done historically, i care about what it's current and future value may be. find me another "money" that will react in a positive manner toward the events shaping our current environment, (I see everyone loaded with new dollars but unable to afford anything) i cannot see the USD or, for that matter, any currency, standing stronger after the printing presses get done making the currency to stimulate the global economy.

2008 Dec 23 08:24 AM

[ABG:]

The author of this article is using a selective time period, from 1980 to now. Suppose we used the increase in the NASDAQ stock market from January 2000 to now? We would see a whoppingly big negative return from stock investing! Why not start the gold analysis in 1970, ten years before 1980, when the inter-governmental price was fixed at $35 per ounce, but gold was selling in the free market in Switzerland (Americans were still prohibited from owning bullion) for about $42.00 per troy ounce? That would be a far more accurate time period of 38 years and would provide a better analysis of the investment allure of the yellow metal.

1980 was an exceptional period of time of fear and high inflation. Gold and silver (the latter helped along by long oriented market manipulation) ran up very high on the fear factor. But, the period from 2000 to 2007 was not filled with economic fear. In fact, it was a period of slow dollar declines, relative calm (except for 9/11), low inflation and steady growth in the general economy and in the financial markets. Yet, gold soared from $270 per ounce to $670 or so, during that period of time.

Now, in spite of the fact that we are clearly on the precipice of heavy dollar devaluation (the Fed, for all intents and purposes, admitted last Tuesday that it intends to inflate America out of its debt problems), gold hasn't yet made much of a move. Given the environment, where the dollar is relatively certain to drop like a stone thanks to the Fed's "quantitative easing" program, a 5% per year reduction in mine production in spite of what should be the stimulus of huge price increases, and with demand increasing exponentially all over the world (except at the futures exchanges!), it seems to me that gold, at least at the price for which it can be purchased on the futures markets, is now very low priced and a screaming "BUY" even for those with a shorter-term investment goal of maybe 1-2 year horizon.

I would note that silver has collapsed even lower, and this collapse is completely irrational. Most rational folks among us were jumping on the $9.00 per ounce silver price last month, for example. They aren't making any more of it, and mine production has come to a standstill now. It is bound to have a price explosion soon.

In short, I think the author is very wrong about value of gold in the current economic environment. In all likelihood, given the circumstances of dollar depreciation, as well as shortages of mining supply as well as the end of central bank willingness to lend out large quantities of gold, and China's desire to purchase 3,600 tons of it as soon as possible, the yellow metal is bound to rise in a fast but sustained way.

Gold prices may eventually exceed the rational price, but it is currently no where near that. Logic and reason tells me that the top is probably several years and thousands of dollars per ounce above where the metal is now selling. So, frankly, I will be continuing to buy, at least until the price is several thousand dollars per ounce higher than now.

2008 Dec 23 08:49 AM

[20smoney:]

TIPS are calculated by the government's flawed inflation model, therefore they can keep their inflation figures lower than real inflation. TIPS will not provide you with a real hedge if and when the dollar collapses. Only gold can do that.

2008 Dec 23 09:09 AM

[ussmls7:]

I have read so many articles against holding Physical Gold or Silver & many more expressing manipulation of both by the same institutions that started the melt down in our banking system! It seems some want it both ways? They will tell you holding physical PMs is bad,but I bet they are buying all they can on dips they know are coming!

2008 Dec 23 10:03 AM

[Kelly Liebe...:]

From Larry's website:

Larry Swedroe joined Buckingham in 1996 and co-founded BAM. Beforehand, he had served as senior vice president and regional treasurer at Citicorp, and later become vice chairman of Residential Service Corporation of America, a residential mortgage company.

"The successful
formula for investors is to build a globally diversified portfolio that meets their unique ability,
willingness and need to take risk. Then, they must ignore the noise of the markets, the media and
Wall Street propagandists; and simply rebalance the portfolio along the way."

You are right, but haven't listened to your own advice. Ignore the noise of the markets....and rebalance.

The rest of us are rebalancing our portfolio. We are ignoring the noise of the market and paying attention to the noise of the marketplace! That noise is telling me and others to buy gold. Too bad you are not listening at all.

2008 Dec 23 10:48 AM

[frank90291:]

Hey Larry, can I get a refund on your book that I bought last year.......

Here's what I think of your advice.........

www.youtube.com/watch?...

2008 Dec 23 11:18 AM

[DiggerUK:]

Your arguments are fraudulent. Cheap lawyers would be embarrassed at your spin.
Gold, like everything else, needs to be bought and sold at the right time.
Anybody who bought gold in 1998 would have paid $314.60 tops.Now do your figures.
Your 1980 figures don't show that March 17th that year was bottom price at $480.00. Compare to Mar 17th this year and do your sums.
Prices in 2007 went from $836.50 to $608.30.
Those who traded tulip bulbs at the right time in the 17c made money.

2008 Dec 23 11:42 AM

[fran:]

gold represents a "store" of value, not an investible asset. an ounce of gold has provided man with a suit of clothing and footware over the centuries. the same can not be said of fiat currency. no fiat has lived sufficiently long for comparison purpose. is that the pith behind the moral?

2008 Dec 23 04:45 PM

[Bruce Pile:]

If you believe, as I do, that the markets have looked at more information than you have and have done more analytical thinking than you and have tossed aside the harebrained, baseless conclusions we may draw from that information, half of which are bullish and the other half bearish; then what you have is a look that is clearer than yours or mine with the error canceled out. All baseless, wrong conclusions drawn from all that information are just as likely to be wrong bullish as wrong bearish. After all, they are baseless - like flipping a coin. So the error cancels out.

This is why technical analysis works so well. It just looks at the results of all this high powered research. If you look at charts for the gold miners and compare them to the S&P 500, you see what I call a market break taking hold over the last month or so. This is where a stock or group has been moving in synch with the market but then peels away diverging from the ups and downs of the market. Gold mining stocks are starting to do that now. They have convincingly broken their 100 day moving average for the first time since their decline began as has the price of gold. Their A/D behavior also suggests a climb in the offing. It may be interrupted by more deleverage selling.

I haven't read everything I need to read on inflation/deflation, banks' buying or selling gold, mine production, and all the rest. But this one thing I know - the markets are smarter than I am! And they are smarter than everyone who has posted here.

2008 Dec 24 12:14 AM

[scotty1560:]

I own physical gold, own some residential real estate, own some oil (USO),
and some REO funds.

It makes me a little nervous when I hear how great gold
or any asset is- 3 years ago real estate couldn't fail because of the
growth rate? 12 months ago oil couldn't fail because of peak oil?
10 years ago tech stocks couldn't fail? Tbills? US dollar? gold?

This time it's gold because of currency collapse and hedge value?
I look at a six year chart of gold and it makes me a little nervous-
looks like any other asset that's moved a long way- I look at the
price per barrel of oil at 20x25 times a barrel, that scares me.
If oil can collapse 75-80%, what would make any asset bullet proof.

I have no idea if the US dollar is long term bearish or bullish-
lots of good arguments either way you play it. It does seem the
world is in a full blown contraction with inflation no where in sight
for a long time- so assets including gold will contract. Terrorism
or war could change that quickly. I wouldn't count on a currency
collapse or weak dollar.

Peter Schiff , Marc Faber, Jim Rogers, etc- all make sense and
are smart fellows. I am a fan of these guys and Ron Paul's
and G Edward Griffin's "Fed Reserve" abolishment.
Some have big positions in gold and rightfully are "cheer leaders" -
what else can they be. I for one have been burned way to many times
to count on any theory- my freinds that bought gold circa 1980
remind me of this all the time- nothing is a sure thing right now.

If one plans a 10-15 year hold than you will be rewarded on about any
play, otherwise best to watch from the sidelines.Mr Market will gladly take your money right now- best to be ultra cautious.

2008 Dec 24 12:56 PM

[Bruce Pile:]

I agree that gold is too well liked now. It feels too much like the crowded end of the canoe, where you never want to be. It seems too obvious to buy. So I "feel" bad about gold, but I've found that when my feeling disagrees with technical condition, it is usually technical condition that later proves to be right.

2008 Dec 24 03:34 PM

[phybrr:]

All the arguments made against gold are based on normal past fluctuations in the economy.
Never has the fed created so much fiat money so fast as this year. Can anyone argue that if you create 100%+ more dollars then the old dollar is worth 50% less?
Since gold is priced in dollars the price should increase 50% just to keep a level playing field. That is the definition of inflation.
You say the dollar will rise. Compared to what-the other more fiat world currencies?

2008 Dec 24 03:54 PM

[Siddharth:]

It would be better to compare the purchasing power of Gold with other commodities historically than with paper currency. Gold Oil ratio suggests a Gold dip or a Oil price increase is imminent.

Makes sense to invest in silver & oil.

2008 Dec 25 03:31 AM

[Dollar Pimp:]

Not to mention the fact that TIPS come with the risk of default by the US government. It's time to think the unthinkable.


On Dec 23 09:09 AM 20smoney wrote:

> TIPS are calculated by the government's flawed inflation model, therefore
> they can keep their inflation figures lower than real inflation.
> TIPS will not provide you with a real hedge if and when the dollar
> collapses. Only gold can do that.

2008 Dec 25 06:58 PM

[ozzy43:]

Anyone who relies upon the fraudulent CPI as an accurate indicator of inflation, and uses this metric as a basis for virtually any calculations which directly involve inlfation, can safely be ignored.

2008 Dec 28 11:09 AM

[FoodBoy:]

"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."

Hmmm given that the majority of stocks in our "retirement" accounts have dropped 40% since last December, even your worst case scenario of buying gold at the worst time and holding it until now does not seem so bad! All of the points I wanted to make have already been said. I can sum it up by saying I have made thousands in my gold buying and selling this year alone, while I have lost thousands in stocks. I personally do not feel it is in a "frenzy" state either. Gold had a pullback to around $700 an oz and stayed in the mid 7's to low 8's for quite some time before starting it's recent uptrend. No one is "paying up" for physical gold on the various auction sites. It's selling for approximately what it should sell for. Also, gold is never going to zero, which is where our largest bank, our largest car makers, etc. would be if it were not for our Government bailing them out. Of course gold could go down just like any investable asset. We just need to do the numbers, pay attention to all that is going on around us, and come up with our own investment thesis. You have chosen yours and others here have chosen theirs.

Jan 02 05:50 AM