Gold has corrected by 17% after peaking out at $1,895 in September 2011. Notable investors like George Soros, Julian Robertson and Allianz's PIMCO have turned bearish on the precious metal and reduced their stakes in gold. Amidst this bearishness, I would like to discuss the reasons for holding on to gold for long-term and using the current correction as a buying opportunity.
29 hyperinflations in the last 100 years
Policymakers tend to repeat the same mistakes again and again. In the last 100 years, there have been 29 instances of hyperinflation. More importantly, paper money has turned worthless in each of these instances.
In the current scenario, phases of financial repression, inflation and hyperinflation are very likely with government debt in advanced economies at record high levels. It is therefore advisable to have gold as an integral part of one's portfolio. The precious metal can be viewed more as a safe currency than as an investment. Even if paper money goes worthless, gold still has value.
Gold is under owned
Contrary to the argument that gold is a bubble, I would like to point out that gold is an under owned asset. A bubble is characterized by irrational exuberance and broad ownership. This characteristic might hold true for government bonds. The chart below gives the outstanding amount of marketable potentially safe assets. Gold constitutes only 11% of the outstanding amount of marketable potentially safe assets. This data certainly does not suggest that gold is a bubble. Instead, investors need to be wary of the government bond bubble and avoid long-term dated government bonds.
Gold is undervalued
Contrary to arguments that gold is a bubble, I would like to argue that gold is undervalued relative to other asset classes and in relation to the monetary expansion in the financial system. The chart below gives the increase in debt and asset class prices from 1980.
In a financial system where debt is money, the increase in debt can be used as a proxy for measuring the expansion in money supply in the economic system. Very clearly, gold is undervalued when compared to the increase in government debt and total credit market debt. At the same time, the increase in gold prices has been moderate when compared to the S&P 500 index. This factor, coupled with the under ownership of gold does suggest that gold is not in a bubble. Rather, the current correction in the precious metal makes gold attractively priced.
Fiat money printers are buying gold
According to the February 14, 2013 report on gold demand trends by the World Gold Council -
The fourth quarter saw 145.0t of buying by central banks across the globe, the second highest since the sector became a source of demand in Q2 2009. The annual total of 534.6t represented the greatest level of demand since 1964 as the net of central banks adding to their gold reserves was cast wider, reaching Brazil, Paraguay, Iraq and Venezuela.
The biggest annual demand for gold by central banks in nearly 50 years is just the beginning of the demand coming from central banks. More importantly, it is surprising to see central banks mopping up gold and wanting individuals to keep trusting paper money. I am also of the opinion that this is just the beginning of the demand for gold coming from central banks. The chart below underscores my point.
With a low proportion of gold holdings as a percentage of reserves, the continued demand from central banks will result in surging gold prices. Another important point to note is that the amount of currency backed by gold was 11.5% in 1Q07. This has steadily increased to 16.0% as of 3Q12. The same is evident in the chart below.
Clearly, central banks are buying more and more of gold along with their swelling currency reserves. This trend is bullish for gold in the long-term.
High geopolitical tensions
Geopolitical tension is escalating globally and gold is a good asset to hold in times of war and conflict. I am not trying to paint a scary scenario for investors. However, a 15-20% portfolio holding in gold makes sense as government spending goes through the roof at times of conflict. Speaking of wars and conflicts, the global currency war is also gold's friend as countries try to devalue their currency in order to increase competitiveness and boost asset valuations.
Prolonged sluggish economic growth
Economic growth in the US and the Euro zone is expected to remain sluggish for a prolonged period as the Western World recovers from the worst financial crisis since the Great Depression of the 1929. With high level of unemployment, slow job creation and overleveraged consumers, government support will be needed to aid economic growth. High deficits are gold price friendly as governments continue to print money to finance their deficits and keep the economy going. Just as an example, the CBO projects deficits of nearly $10 trillion for the US over the next ten years. This would be negative for the currency and positive for gold.
All these factors combined make a strong case for another decade of the bull market for gold. I would personally look to accumulate physical gold, gold ETFs and gold stock in my portfolio on every correction in the precious metal.
Gold ETFs are a good option for near to medium-term, and investors can consider exposure to the SPDR Gold Shares (GLD) ETF. The investment seeks to replicate the performance, net of expenses, of the price of gold bullion.
Investment in gold mining companies is also a good option at a time when gold prices are expected to trend higher and gold mining companies will make significant operating level profits.
The Market Vectors Gold Miners ETF (GDX) is a good investment option for long-term. The ETF seeks to replicate as closely as possible, before fees and expenses, the price and yield performance of the NYSE Arca Gold Miners Index.
The Market Vectors Junior Gold Miners ETF (GDXJ) is another excellent long-term investment option in my opinion. The ETF seeks to replicate, net of expenses, the Market Vectors Junior Gold Miners index. The index tracks the overall performance of foreign and domestic publicly traded companies of small- and medium-capitalization that are involved primarily in the mining for gold and/or silver. Therefore, the risk related to exposure to GDXJ would be relatively higher as compared to GDX.