Gold: The 'Lousy' Investment that Outperforms

Gold hit another record last week and was trading over $1,100. However, that didn't prevent several news stories from coming out about how gold is a lousy investment. Investment stalwarts from Warren Buffett to Monish Pabrai have all denounced gold as an investment.

And despite the decent performance of gold over the past 10 years, they’re correct. Gold is a lousy investment. It creates no income and just barely keeps up with inflation.

But do you know what the best performing asset class was during the past 10 years? No, it wasn’t your stock portfolio or your real estate. It was gold, and it returned a decent 270% over that period.

Despite its outperformance of all major asset classes, gold still gets no respect from the investment community. That’s because it is only a store of value and typically only does well in periods of currency crisis, or times of poor monetary policy.

For example, post-WW2 Germany and post-Mugabe Zimbabwe currencies faced severe devaluation and gold prices sky-rocketed against those currencies. Faced with hyperinflation and an inability to buy basic necessities, people flock to gold, causing the price to soar.

But that wouldn’t happen in the US right?

Economic research has shown that consumer psychology is affected by the amount of wealth people feel they have. If they’re broke and living pay-check to pay-check, but have tons of equity in their homes, they still feel wealthy. But if they are upside down on the mortgage and have negative equity in their home, even if they still have a job, they feel poor and their spending decreases. Since the US is a consumer spending driven society, with spending constituting 70% of our GDP, the Federal Reserve has been trying desperately to get the consumer to start spending again. Part of this entails propping up housing prices by keeping mortgage rates low, and another part is keeping interest rates low on non-collateralized consumer debt (that’s credit cards and student loans).

In an effort to stem the free-fall in the housing market, the Federal Reserve has been trying to keep the interest rates for mortgages as low as possible. Historically, the Fed has tried to manipulate the short-end of the yield curve by adjusting the shortest of short-term rates – the Inter Bank Overnight Rate (also called the Federal funds rate in the US. The UK has something similar called the LIBOR). This is supposed to have a trickle down effect to long-term interest rates (such as the 10 year and 30 year Treasuries). The rates for 30 year fixed rate mortgages are impacted by the rates on the 10 year Treasuries. So by keeping the federal funds rate at zero (or 0.2% which is close to 0%), mortgage rates should stay quite low.

However, given the fact that this is not a typical economic scenario, the Fed isn’t quite sure that mortgage rates would stay below 5%. So it has been buying billions of long-term Treasury bonds as well as mortgages, which is a quite a bold move away from its historic stance. When the 800 pound gorilla starts buying bonds, the prices rise and the yields go down. When the Federal Reserve decides to buy $300 billion worth of mortgages and government bonds, something is definitely wrong with the economy.

I’m interested to see the effect on mortgage rates once the Fed stops buying Treasuries and mortgages.

The government is increasing its deficit spending at a steady clip. If this continues, eventually we will be unable to repay the debt and barely just able to service the debt. Obviously this is not a viable long-term strategy, but it doesn’t look like there is any other back-up just in case Helicopter Ben’s strategy of throwing money at the problem doesn’t pan out.

Clearly, we are currently in a crisis period in regards to fiscal policy and gold prices are likely to keep going up. During times of good fiscal policy, gold does nothing. This does not seem to be one those times.

A well-known hedge fund manager (and world poker champion) David Einhorn shares the sentiment. And someone else who agrees with him is Liu Mingkang, chairman of the China Banking Regulatory Commission. He recently said,

Low U.S. interest rates and a weaker greenback have “seriously affected global asset prices, fueled speculation in stock and property markets, and created new, real and insurmountable risks to the recovery of the global economy, especially emerging-market economies.

Someone I know who works at a very well-known bond fund company recently advised me to sell my gold holdings. He advised me the same thing last year when gold was only $800/ounce. And I told him the same thing I said last year – Not yet.

Disclaimer: I’m long gold/silver bullion, gold mining stocks and short long term treasuries.

Comments

[yellowhoard:]

This is a secular move in gold.

As such, it will last about 18 years on average.

The gun went off on 9/11/01, so we've got about another 9 or 10 years left in this move.

More importantly, the best part of any secular move is toward the end when prices go parabolic.

Buy the dips and hold long term.

Nov 16 08:46 AM

[Equilibrium:]

The move in gold will end in the respective country when citizen confidence in government returns.

Nov 16 09:54 AM

[bassmaster17:]

I prefer industrial commodities, but one can't ignore gold and it would be totally irresponsible to shun it completely. Bernanke's stance towards the dollar problem, which is reminds me of his nonchalant attitude towards the mortgage market and the leveraged securities held by banks. When the entire tax base will eventually go to servicing debt there is a major problem and the spend thrifts in DC will continue their out of control spending binge with an attempt to prop up the economy before the 2010 elections while enacting a fiscally irresponsible healthcare bill. Once again don't ignore gold hyperinflation is very possible.

Nov 16 12:39 PM

[William Leg...:]

Gold is a lousy investment, during the doldrums of everyday ordinariness. But it is an ideal SHTF hedge, something that purist investors too often ignore, perhaps at their financial peril.

Nov 16 03:38 PM

[Crocodilian:]

The "outperformance" of gold in the period analyzed here is historically anomalous-- the 10 year period of 1999 to 2009 saw the collapse of a massive equities bubble. And gold in 1999 was at a multi-decade low. Looking at other ten year period would show a very different result.

One basic observation about gold: when it has recently _been_ a good investment-- then it usually won't be for some time again.

Nov 16 04:05 PM

[robert99:]

"Not yet" indeed.

Nov 16 08:59 PM

[Laurence Hunt:]

Your analysis is exactly the correct one.

The interesting thing is that correct analyses of the gold bull market are still not widespread, betraying the reluctance with which most investors still approach the barbaric relic.

Well done.

Nov 17 12:29 AM

[eggfaced:]

Gold is money, period. It is a universal currency and has been so for 1000's of years. This is where 95% of gold's value lies. Sure it has plenty of indutrial uses but that is not what drives demand. In India and other 'developing countries' ones wealth is measured by how much gold they own in forms of bullion but mostly jewlery. It is the developed world that thinks gold is an arcane relic that has no use. I agree that if sound monetary policy is practiced and a fiat money system theoretically worked then there would be no need for gold. Unfortunatly that will NEVER be the case. When money can be created out of thin air by simply pushing a button the system will eventually collapse. This is being realized by the developed world in which gold is extremely underowned. There will always be a need for gold because it is unequivocally the ONLY true currency.

Nov 17 09:52 AM

[bricki:]

Articles like this would be a lot more credible if they didn't use black swan events as the endpoints of the investment period and included dividends in their returns.

Nov 17 02:07 PM

[Billki:]

Get rid of this Scottrade popup, Having some Gold is better then not having any at all.

Nov 17 05:02 PM

[robert.b.fe...:]

While piles of shiny stuff should have a place in any well diversified portfolio they are still just part of the equation. The idea is to get decent returns in any market. Bricki is quite correct in his analysis compounding is a legitimate investing tool and can not be discounted. While not an advocate of market timing careful analysis, sound investing strategy and appropriately placed stops will save you head aches and money.

Nov 17 05:26 PM