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In this article I lay out two myths propagated by gold bears and explain why they are misguided. These myths are:

  1. Gold has very little use value, and so it is a poor investment.
  2. Gold does not pay a dividend, and so it is a poor investment.

After I debunk these myths the reader should have a better understanding of the benefits of holding gold (GLD, GTU, PHYS, IAU…etc.) in a well-diversified portfolio.

1: Gold has very little use value, and so it is a poor investment.

The initial clause of this myth is simply incorrect. The fact is that gold does have a use value in that it functions as a good medium of exchange. Its use value, in effect, is identical with its exchange value. Gold is a good medium of exchange for several reasons. While there are individual categories discussed below where other assets exceed gold, only gold satisfied all of them.

1: Because gold has limited industrial demand, its supply is relatively stable. This is not the case with other potential mediums of exchange: other commodities and fiat currencies.

While most commodities are consumed in industrial production, gold is not. Consequently the supply of other commodities is largely dependent upon their use values in industries specific to today's economy, and a shift in the economy such as a technological advance can change the supply-demand fundamentals of commodities consumed by industry. Consider oil as an example. Before cars became ubiquitous oil had very little use value. While it is true that oil was used in lamps and for lubrication in machinery, the industrial demand for oil was negligible relative to its supply. Now virtually all of the world's economic activity involves the use of oil-based fuels in some way. Given that oil is burned and therefore unrecoverable, a small increase in economic activity can create a shortage, while a small decrease in economic activity can create a glut. Furthermore, if a more efficient form of energy is discovered and/or harnessed so that it can replace oil as a dominant global energy source the use value of oil will plummet to virtually zero.

The supply of fiat currencies changes constantly, and it can change extremely rapidly. The supply of fiat currency, or the money supply changes as a combination of: (1) the Federal Reserve, or any central bank, increasing or decreasing the monetary base by buying or selling bonds, and (2) banks increasing or decreasing the total amount of credit by changing lending standards or increasing or decreasing their reserve ratios: the amount of depositors' money that is kept on hand by the bank to the amount of depositors' money that is lent out.

Of course the supply of gold, like with anything else, is not constant. But consider the following two charts. The first is the U.S. Dollar money supply; the second is the supply of above-ground gold.

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Looking at just the period starting in 1959 (where the money supply chart begins), we see that the gold supply has increased by about 2.5 times, while the M2 money supply begins at such a small base relative to its 2010 level that the magnitude of increase cannot be determined by the chart, although by zooming in we can see that it has gone from roughly $286 billion to $10.4 trillion, which is a 36-fold increase.

(click to enlarge)

It is interesting to note that myth No. 1 can be applied to fiat currencies as well as to gold, yet people who are bearish on gold neglect to mention this, and by simply looking at the supply of gold and dollars, gold has been a far more favorable holding in the long run.

2: Gold is relatively easy to store. Gold is not the easiest potential mediums of exchange to store, yet it is among them. Other precious metals, particularly platinum (NASDAQ:PLTM) enables investors to store a large amount of value in a small amount of space. Other commodities generally are not, although there are exceptions (see my article "Portfolio Strategy for an Inflationary Environment" for a list of high value to weight commodities).

Fiat currencies are extremely easy to store. Either they are in paper form where a few pennies worth of paper and ink can be worth $100, or they are mere book entries or computer entries. There is little doubt that fiat currencies offer an advantage to gold in this category, yet with so much money existing now in cyber-space as mere computer entries, and with the possibility that hackers can break into computer databases and alter this information, or with the possibility that the "grid" can cease to function, this ease of storage comes with a price.

3: Gold is durable. While other commodities can rot (agricultural commodities) or rust (base metals) it is extremely difficult to destroy gold. Once an ounce of gold has been mined it will likely remain in existence.

Fiat currencies in paper form can be destroyed very easily, and electronic money is only as durable as the computer network(s) supporting it (assuming that the term "durable" can be applied to something virtual).

4: Gold is fungible. Not all commodities are fungible. For example: (1) there are various grades of oil, (2) each cow is different from every other cow, (3) each ear of corn is different from every other. Non-fungible commodities do not have a fixed-price-to-weight ratio that doesn't take quality into consideration, and determining quality requires a high level of expertise that most people do not have.

Fiat currencies are fungible as well.

5: Gold is divisible. Gold can be divided into small or large quantities in order to be used for exchange. Industrial products and various commodities, especially livestock, cannot.

Fiat currencies are also divisible to a point, although amounts smaller than a penny are insignificant, and so I maintain that fiat currencies are fungible.

While some commodities satisfy some of the conditions for a good medium of exchange, only gold satisfies them all. While fiat currencies satisfy many of the conditions for a good medium of exchange, they fail miserably in that they do not have a stable supply, and they are not durable. Only gold satisfies all of the conditions necessary for something to qualify as a good medium of exchange, and consequently this is gold's use value, and this is why gold is valuable in the marketplace.

2: Gold does not pay a dividend, and so it is a poor investment.

While it is true that gold does not pay a dividend, this is not a reason to neglect it in your portfolio. The primary reason for this is that a stock's or a bond's dividend may be too low to justify the risk assumed by its owner. Dividends and interest rates fluctuate. Thus there may be periods in time where the claim: "Stock dividends and bond yields are high enough to make them better investments than gold." Yet this is not always the case.

Let us analyze this focusing on stocks. Consider the following long-term chart of the dividend yield of the S&P 500:

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Currently the yield on the S&P 500 is roughly 2%. Historically it has been as low as 1.11% in August, 2000, and as high as 13.84% in June of 1932. It has had an average dividend yield of 4.44% during its existence. Consequently the S&P 500 could fall by 50% and still be over-valued based on the historic average dividend yield. It is argued that the low dividend yield on the S&P 500 is justified because Treasury Bond yields are so low. Yet this argument does not take into consideration the possibility that both treasuries and stocks can be overvalued, despite the fact that such an observation makes perfect sense to people when it applies to other assets. For example, suppose a Toyota Camry cost $100,000, and a Honda Accord cost $80,000. Nobody would argue that the Accord is cheap because it is cheaper than a similar car made by a different company. Like with cars stocks and bonds can be undervalued or overvalued, regardless of the fact that one might have better value than the other. During the 1970s the price action in bonds, stocks, and gold provide clear evidence that both bonds and stocks can lose value at the same time. This is especially evident when these assets are priced in gold. The same situation exists today as that which existed in the 1970s: stocks and bonds are losing value relative to gold. The first chart is the S&P 500 priced in gold; the second chart is the 10-year U.S. Treasury Bond priced in gold.

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Furthermore, since the U.S. dollar was backed by gold up until August 15, 1971, the dividends paid out for most of the index's history were essentially paid in gold. Since August 15, 1971 this has not been the case. However, consider the performance of gold and the S&P 500 since that time. Gold went from $35 to $1,600, which is a 4,571% return. The S&P 500, assuming that dividends were reinvested, returned 5,542% during that same time period. While the S&P 500 has outperformed, it has not done so by much. Furthermore the compounding assumes that dividends were not taxed. If taxes were taken into account it becomes clear that investors would have been better off holding gold over stocks since the U.S. went off the gold standard.

The fact is that there are periods of time where investors will do better holding stocks, and there are other periods of time where they will do better holding gold, despite the fact that it does not pay a dividend. This is evidenced by the following long-term chart of the Dow Jones Industrial Average priced in gold.

(click to enlarge)

From this chart it is clear that the Dow Jones fluctuates relative to gold. The fact that Dow Jones stocks pay dividends implies that over very long periods of time, that is, over several Dow Jones to gold fluctuation cycles, the Dow Jones Industrial Average is a better investment than gold. After all, if the Dow Jones fluctuates in value relative to gold and it pays dividends while gold does not, then the Dow Jones is ultimately a better investment. However, there are just three cycles on this chart over 113 years, and consequently there are certain periods of time, potentially 10-20 year periods, where the Dow Jones loses a tremendous amount of value relative to gold, and during these time periods investors are far better off holding gold. When the Dow Jones becomes undervalued, that is, historically when it reaches parity with gold (as the chart suggests), investors would be wise to exchange their gold for Dow Jones stocks. Currently, however, the Dow Jones is trading at about 9X the price of gold, and it remains in a downtrend relative to gold.

(click to enlarge)

Ultimately the claim that gold is a poor investment because it does not pay a dividend is at best true to a minimal extent when looking at a time frame spanning several generations, and consequently it is not an actionable claim.

Conclusion

The two myths that I debunk in this article are often cited as reasons not to own gold. Yet the arguments I use against them suggest that there are very good reasons to own gold:

The myth that gold has no exchange value reflects a misunderstanding of gold's role in the economy, and given its function as a medium of exchange, it should be a cornerstone of any portfolio.

The myth that gold is a poor investment because it doesn't pay a dividend fails to state the risks in owning dividend-paying assets, and instead considers only the benefits. Gold ownership is most attractive precisely when these risks are highest.

Investors who are interested in purchasing gold should look at my article Buying and Owning Gold Part 2: Specific Investments in Gold, and my instablog 11 Reasons to be Suspicious of the SPDR Gold Trust to see my reasons for preferring PHYS and GTU as gold investment vehicles.

Source: 2 Myths About Gold Propagated By The Bears (And Why They Are Wrong)