Is Gold a Hold?

Gold has seen spectacular price increases over the past six months rising from $140 to $942 an ounce, reported by Barron’s in their cover story. An interesting relationship noted also by Barron’s in the same report is stock prices relative to the price of gold.

“The S&P 500 index is worth about 75% of an ounce of gold, verses a peak of more than five times the value of gold in 2000 when the S&P peaked at more than 1,500 and gold languished around $300 an ounce. Over the past 40 years, the S&P has averaged 1.6 times the value of an ounce of gold.”

Gold and other precious metals are an interesting investment and have gained a lot of press recently through radio and TV advertising. As the stock market has been severely affected by the credit crisis, gold has been seen as a ‘safe’ investment that never loses value like stocks and bonds because it is gold; the asset that was once was used to peg many currencies including the U.S. during the time of the gold standard.

The question is not whether gold is rare or was useful to pegging currencies, but how an investor should view gold as an investment in the short term and long term.

What should be noted is that gold inventories held by a small, individual investor are very impractical. The cost or risks of this kind of investing through actually, physically holding gold must be fully realized. The cost of insurance, security, storage, transporting, inspecting, and insuring true quality may make this kind of investment completely impractical. A better, more efficient way to purchase gold is through ETFs and ETNs, which track the price movement of gold by following a gold index. Precious metal ETFs actually hold physical gold in trust in secure bank vaults.

The Difference Among Asset Pricing

Theoretically, the price and value of publicly traded companies is the present value of all future cash flows. This may not always seem true and often prices can vary greatly from ‘fair value’ or the present value of all future cash flows. In the long run investors have been rewarded for purchasing stock in companies below this ‘fair market price’ and selling it above the ‘fair market price’.

Even if all stock prices reflected the fair market values investors would still realize gains and receive dividends from the stocks they hold. Why? Because, if stock prices should be the present value of all future cash flows, the more recent cash flows will have the greatest effect on stock prices. If earnings should increase over time, as time moves forward, so should stock prices as increasing amount of cash flows continuously get closer to the present time.

Gold has no expected return. Unlike a stock, gold and other precious metals do not have any future cash flows and therefore their values and prices are only based on supply and demand. Supply and demand forces are more complicated when describing commodities. We could say the value of gas is the price we pay at the pump or the future price that market participants have contracted with each other to deliver gas or oil in the future. This is interesting because the supply and demand of a commodity like oranges is not only the supply or demand of today’s price but the price in the future. This is why orange producers are so concerned with predicting weather, as weather in Florida will greatly affect the future supply in the market place. This helps guide their decisions on the future price of oranges.

Recently Warren Buffett, when asked about investing in gold and where it will be in five years said: “I have no idea where [gold] will be, but the one thing I can tell you is it won’t do anything between now and then except look at you.” He went on to say, “It’s a lot better to have a goose that keeps laying eggs than a goose that just sits there and eats insurance and storage and a few things like that.”

Warren Buffett’s advice is not the bottom line but an interesting perspective from someone who has had great success investing based on strict principles.

Gold’s Supply and Demand

Many people believe that rare commodities will only get scarcer and that prices of those items must increase in value. This is most popular regarding oil, but relates to all commodities. Before discussing why this may not be true, the same line of thinking happened in many places in the world over the price of land and home values.

The thinking that led to the housing bubble in the US and Japan’s housing bubble burst in the 90s, which they have yet to recover from, is that there is only so much land. Reason tells us that as the earth becomes more populated, property values will increase due to a fixed supply and increasing demand.

This is not true. In the short term the supply curve can be shifted (to the left) signifying less quantity available to consumers and a new equilibrium price will be set above the previous price. The Long term is a different story, (economists define the long term as the period where all costs are variable, meaning that big fixed costs like owning a house is fixed in the short term, but in the long term you can move). In the long term this new price based on a decreased demand is not sustainable for reasons that will let consumers and suppliers shift the demand and supply curve back to lower or previous equilibrium prices.

Gold’s Difference

The appeal of gold is as a place of safety as investors flee towards quality. There are reasons behind why investors see gold as safe and reasons for the play. Firstly as financial systems continue to fail, the system of paper money may fail and the usefulness of gold as a monetary unit will return. Also, as the government measures continuously fail to restore investor confidence, the fear that inflation will follow and that gold, as a commodity, will be a hedge against the inflation. Also, there is a popular notion that even in the face of inflation, gold will benefit as an inflation hedge. So in either case, gold works.

In a recent analyst report by Keith Lerner, Chief Market Strategist for SunTrust Robinson Humphrey, published in Indexuniverse.com, reported that gold is a difficult asset to place a fair value on,

"Since gold neither pays a dividend nor generates cash flow, we have never felt a great comfort in assigning a fair value for the precious commodity. Often, in our opinion, its direction is driven primarily by investor psychology and it trades on momentum…”

According to the same report, the analyst views gold as “technical / chart perspective”. He sees the near term risks for the commodity to be outflows in gold as the economy returns back to normal and the need for safety decreases.

Gold in Perceptive

12/29/1972 Through 2/28/2009	Risk: Standard Deviation	Annual Return:
S&P 500	15.71	8.28%
Gold	20.76%	7.45%

What we are seeing above is that gold, as an investment is more volatile than the S&P 500 and annually over a 36 year period gold has returned less. This is not to say gold is a horrible investment in all cases but, to say that the stock market historically has performed better with less risk than gold.

Commodities in general and especially gold have a low correlation to the stock market. Since it has a low correlation and higher volatility adding commodities and gold in appropriate amounts can provide long term benefits. The hard part is figuring out the appropriate amount to allocate to gold or commodities as a wider asset class.

The Gold Run Up

As we have already discussed previously, gold has recently seen a large price increase. Investors have been flowing funds into gold due to many factors including gold’s historic uses as currency.

Graphed below is the S&P 500 and the price of gold as seen through the London Fix Gold Index from 1990 to 2009. This long term price performance difference is important to notice that the better long term investment is the stock market as seen through the S&P 500. This long term perspective matched with a strong theoretical understanding behind asset pricing and value differences.

All this being said, is there a place for gold and other precious metals in portfolios of all risk levels. In short, yes. The trick is in what percent and through what investment vehicle.

At Wiser Wealth Management we have between 3%-5% commodities in our portfolios. We currently use the ETN, ticker symbol DJP an ETN that tracks that Dow Jones AIG Commodity Index. The breakdown of commodities is diversified and the index follows rolling futures contracts.

As of 2/28/2009	%
Energy	31.86%
Industrial Metals	19.72%
Grains	19.43%
Precious Metals	13.06%
Softs	8.89%
Livestock	7.04%

Precious metals makes up 13% of the entire commodity portfolio and gold is 9.41% of the entire commodity portfolio. Please note that the percentages of commodities and gold we currently have in our portfolios is a function of the suitability of our client base and may not be appropriate or suitable for you. Also, please be aware that an ETN is different from an ETF and assumes full credit risk of the issuing investment bank.

An investor can track commodities and gold using ETFs and ETNs. The most popular of these products are the SPDR Gold Trust, (GLD), United States Oil, (USO), iShares COMEX Gold Trust, (IAU), iPath DJ-AIG Commodity, and iShares GSCI Commodity, (GSG). All have different exposure to commodities and gain exposure to the commodities they cover in different ways. Careful research is needed to determine proper exposure and suitability and to understand the difference between exchange-traded products and the methods they use to track the underlying indexes.

Disclosure: Long position in DJP.

Comments

[5142152-337:]

Lots of good information here--with --one glaring exception! To suggest that buying ETF's are the best method to own gold "because the gold is stored in trust in bank vaults" cannot be substantiated, thus it is largely reckless to give this advice.

Mar 12 08:38 AM

[Sakata:]

The author of this article seems to overlook one important fact: investments are made with an expectation of position returns. While I have a lot of respect for Warren Buffett I have to take expection to the quote in this article.

I am reminded of the story of the prisoner sentenced to death. "You will be hung one day next week, but will not know in advance which day it is" says the judge. The prisoner figures he cannot be hung on Saturday because it is the last possible day and he would know in advance. So he can be hung no later than Friday. But it cannot be Friday either, because that has to be the last possible day. And so on. On Tuesday he is surprised to be hung.

This story is sort of like gold. "You cannot buy gold because it had no expectation of positive returns" says the expert. But then one day you sell gold for 100% more than you bought it for. The expert does not believe it happened. But the investor knows better.

Gold is bough not for its dividends or earnings. It is bought because peope believe they will later be able to exchange it for more dollar than they bought it for.

Mar 12 09:42 AM

[GMiki1:]

Gold is an investment AND a safety play. Hold some gold--physical. It's not that complicated to buy. Buy from some reputable dealer such as Miles Franklin or Kitco--buy a few ounces at least--and some silver. I like gold and silver eagles to have in the house. Even though all they do is sit there, they can for sure increase in value. Yes, precious metals are volatile, and if you don't have the stomach for it, just buy a few ounces--and a few hundred of silver.

Mar 12 10:34 AM

[Vuke:]

A strange article. It wanders an endless landscape of possibilities without seeming to reach a destination.

One stong point on which to be critical. It is not difficult to hold, insure or store physical gold. Enough fits under your mattress to see one through some pretty tough times.

Mar 12 11:19 AM

[silverwood:]

Yep. another "brilliant" article by a PAPER gold owner.

Mar 12 11:25 AM

[User 102161:]

The Dollar is going to become worth less and less. Most other currencies will lose value also, but not like the dollar. Gold and silver are the only place to put your wealth where it is safe with all the spending we are seeing.

Mar 12 11:47 AM

[Sakata:]

On Mar 12 10:34 AM GMiki wrote:

> ... Buy from some reputable dealer such as Miles Franklin or Kitco--buy a few ounces at least--and some silver.

I have never bought from Miles Franklin but have heard good things about them. But why would you recommend Kitco? They have a terrible reputation for long delays in delivery.

If you are looking for at least 5oz of Gold or 100oz of Silver go to www.seekbullion.com. It has the best prices out there. Apmex would be my second choice. They are a bit more expensive but there are no delays (unless stated on the website).

Mar 12 12:18 PM

[Jake2:]

Author made the mistake of posting on Seeking Alpha, where Gold Bugs run free. I for one appreciate his efforts.

GMiki said: "I like gold and silver eagles to have in the house. Even though all they do is sit there, they can for sure increase in value." Not necessarily, Mr. Miki.

Mar 12 01:44 PM

[tb1975:]

The quote from Buffet is funny. How has he done in the last year? Hasn't his BRK-A shares lost about half their value? Aren't his company's profits down 90+%?

Let's compare that to gold's performance, shall we?

People like to compare gold's performance to indices over long periods of time. Why? Gold is for extraordinary times like these, not for holding long term.

Buffet can keep his stocks that he has been buying in the last year- GE, USB, etc. They are all tanking. I'll keep my gold. I'll see him at the finish line in this depression and buy all of his penny stocks with my $2000 gold.

Mar 12 04:31 PM

[Mad Hedge F...:]

A lot of investors believe so. Noted international monetary economist Judy Shelton believes the US should return to at least a partial gold standard to help damp volatility in the $4.4 trillion a day foreign exchange market to hasten an economic recovery. The current “dirty float” system, where a free market is subject to occasional coordinated central bank intervention that emerged after the collapse of the original Bretton Woods agreement in 1973, is not working. The US currently holds 260 million ounces of the yellow metal, which for some arcane government accounting reason is still carried on its books at the old fixed rate of $42 an ounce. At today’s prices the holdings are worth no less than $231 billion. Such a system would make it easier for governments to manage interest rates and control inflation. The highlight of the evening came when she passed around a ten ounce gold bar worth $9,000 and a one billion deutschmark Weimar Republic bank note, both of which were miraculously returned to her. In the meantime, the recent bounce in global stock markets raise the risk that we have put in a medium term double top in the chart for the barbaric relic.

Mar 12 06:00 PM

[mr freddo:]

I believe the author is correct in believing that gold should be held in one's portfolio at some percentage. The ETF's which I hold are GLD and GTX. Also SLV. I understand the risks associated with holding paper instead of the real thing. If the banks close, and the worse case scenario unfolds, you are going to want something that can be easily exchanged for cash like a silver coin or a bottle of vodka. I seriously doubt whether we will get to that point but I don't think that my house is going to burn down either but I do have fire insurance and a fire extinguisher just in case.

My favorite market days are days like today when the market is up strong and gold is up as well. I think gold will be in a trading range for a while until something happens on the inflation front. That is when the price of gold will shoot up to new levels. It doesn't have to be hyper inflation either.

Mar 12 06:06 PM

[Mr. Ed, Jr.:]

The author has missed the point of buying and keeping physical gold.

If it becomes a real crisis, possession of the gold is a must. A crisis is no time to be trusting your assets to total strangers.

If it's not a real crisis, an ETF is just fine and dandy, but who cares about gold if there is no crisis ?

Furthermore, just because someone says they have a gazillion dollars worth of gold stored somewhere doesn't make it true. And it doesn't mean you will ever see it if there is a real crisis.

To summarize...

Real crisis: have the gold in your possession.
Not a real crisis: no real need to have gold in any form

Mar 15 02:09 AM