Gold Is Just a Brick ('Active Value Investing' Book Excerpt) 20 comments
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An excerpt from the new book 'Active Value Investing' by Vitaliy Katsenelson, reprinted with permission of the author and publisher:
• • •
Gold feels safe
Gold is an important but very different asset class that competes with stocks and bonds. Unlike stocks and bonds, its main attractions are scarcity, durability and resistance to oxidation - it simply never stops shining.
In fact, most of the gold ever mined is around today. It is exhibited in museums, worn as jewelry and buried deep in the vaults of the central banks. Peter Bernstein, in The Power of Gold, wrote:
Despite the complex obsession it created, gold is wonderfully simple in essence. Its chemical symbol AU derives from aurora, which means "shining dawn," but despite the glamorous suggestion of AU, gold is chemically inert. That explains why the radiance is forever. In Cairo, you'll find a tooth bridge made of gold for an Egyptian 4,500 years ago; its condition is good enough to go into your mouth today. . . . Stubborn resistance to oxidation, unusual density, and ready malleability-these simple natural attributes explain all there is to the romance of gold.
Despite its unique properties, gold has not been a good investment. Over the past 200 years, its returns have barely kept up with inflation. Its value has a low correlation with stocks (prices of gold and stocks move independently of each other most of the time), which is a big positive from the portfolio construction perspective; diversifying with gold can reduce a portfolio's fluctuations(volatility). But the diversification benefit comes at a large cost: Once added to the portfolio, gold substantially reduces that portfolio's risk-adjusted returns. Its dismal returns negate any benefit the portfolio receives from reduced volatility.
One thing about gold, however - it is real! You can hold it and touch it and see its shine. This tangibility makes it seem impervious to the whims of politics, nature and time, as opposed to paper assets such as stocks and bonds. Gold's physical attributes attract investors during times of economic uncertainty, and so it serves a purpose in the markets and society - it is a stabilizing influence. It feels safe.
Doomsday currency
The thinking of the so-called gold bug (a believer in gold's supremacy, a gold aficionado) often takes on a variation of this form: While in the bunker (or any other variance of the "world-falling-apart" scenario), you cannot pay for food with paper money or a stock or bond certificate. You may do so with real tangible assets, such as gold. If this scenario played out (God forbid), it is conceivable that gold could become the de facto currency. In that event, you need to have real gold in a safe or buried in your backyard. The wise gold bug would have managed portfolio risk by also investing in a good arsenal of guns, as the demise of government bonds would likely lead to the end of the rule of law as well. Gold held by your broker or through ownership of gold stocks or exchange-traded funds will not come to the rescue; these bytes and bits are not superior to default-free bytes and bits, for example, U.S. Treasuries. Canned food may actually be a better store of value in this "world coming to an end" scenario.
The ever-increasing complexity and globalization of the financial system, rapid spread of international trade and the availability of risk-free investment instruments that were not available to investors in previous economic crises may have changed investor behavior during economic doomsday times. Financial instruments such as Federal Deposit Insurance Corp.-insured checking and savings accounts, U.S. Treasury bills and Treasury inflation-protected securities may challenge gold's status as the safest haven in times of inflationary crisis.
Treasury inflation-protected securities may turn out to be the key challenger to gold's store-of-value supremacy status in the future. Aside from being issued by the U.S. Treasury and therefore backed by the full faith of the U.S. government, they also protect investors from inflation - one of gold's most-valued qualities. TIPS' principal is tied to the CPI: The principal value increases with inflation and falls with deflation. When the security matures, the original or adjusted principal is repaid, whichever is greater.
Though TIPS appear to have superior financial properties to gold, they still lack one of gold's main attractions - tangibility. After all, they are still just bytes and bits on a brokerage firm's or bank's mainframe, or pieces of flammable paper stored in a safe.
Holding gold has costs
Any cash flow-generating asset, like a stock or a bond, can be valued on the future cash flows that it is expected to generate. Predicting gold prices is extremely difficult because gold is not a cash-generating asset. In fact, it is important to note that gold actually has a negative yield. Gold is a cash-consuming asset; its safekeeping and transportation cost money. TIPS, as well as any bonds and dividend-paying stocks, have a positive yield; they pay investors for holding them.
Gold is also considered a good currency hedge, especially for the U.S. investors who are concerned about the declining dollar. Again, our financial ingenuity is stealing gold's long-held exclusivity on that trade, providing options that were not available a few decades ago. To protect themselves against the declining dollar, U.S. investors can use currency futures and options, foreign-currency-denominated mutual funds and certificates of deposit; they can buy foreign stocks on foreign exchanges or through American depositary receipts; and, of course there is a most recent development - currency exchange-traded funds.
In both the long run and the short run, gold prices are driven by fear of the world coming to an end and investors' expectations of future inflation. Although gold has some industrial applications - in jewelry, dentistry, computers, jet engines, electronics, as a superconductor, etc. - linking its intrinsic value directly to its price is difficult. Perception of its ability to store and preserve real value, especially in an inflationary environment, is the key driver of gold's price.
As long as investors perceive gold to be a refuge in times of uncertainty, gold will act as such. It is important to note that gold's monopoly as an instrument of choice at the time of fear and uncertainty has been undermined by other very capable and often superior financial instruments.
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This article has 20 comments:
I've been saying for years, I don't see why gold shouldn't be $10 instead of $850 - ~99% of all gold mined still exists today
If Oil was like that and we kept storing it in barrells instead of burning it, what would it be worth?
At some point in the future it's price will no longer matter...
Interesting choice of time frame... 200 years. How about the last 5 years? (300+% returns) Or, for that matter, how are those Enron, HomeGrocer, or homebuilder stocks doing these days?
"Treasury inflation-protected securities may turn out to be the key challenger to gold's store-of-value supremacy status in the future. Aside from being issued by the U.S. Treasury and therefore backed by the full faith of the U.S. government, they also protect investors from inflation - one of gold's most-valued qualities. TIPS' principal is tied to the CPI"
Does anyone paying attention for the last 10-15 years actually believe the BLS hedonically-adjusted CPI "inflation" figures any more? They are about as credible as "progress" reports on the War on Terror (or Drugs), or cooked "unemployment" figures (that exclude the marginally employed, millions of illegals, and the long-term unemployed).
"It is important to note that gold's monopoly as an instrument of choice at the time of fear and uncertainty has been undermined by other very capable and often superior financial instruments."
Yeah, those Alt-A & subprime MBSs, CDOs, Super-SIVs and other derivates are working out great! They're definitely "superior" at spreading the risk around. Thank God for the Wall Street Wizards, creating all these cool, new "innovative" financial instruments that hedge risk so well.
"Any cash flow-generating asset, like a stock or a bond, can be valued on the future cash flows that it is expected to generate. Predicting gold prices is extremely difficult because gold is not a cash-generating asset. In fact, it is important to note that gold actually has a negative yield. Gold is a cash-consuming asset; its safekeeping and transportation cost money. TIPS, as well as any bonds and dividend-paying stocks, have a positive yield; they pay investors for holding them."
Physical gold may not pay dividends, but gold mining stocks certainly do. It's also fair to point out that most tech stocks or VC start-ups do not pay dividends. And, thanks to the easy-money Fed, TIPs, Treasuries and most corporate bonds today pay well below the true rate of inflation --in other words, a negative yield.
Gold and Silver have been valuable for over 4000 years. While every fiat currency in history has collapsed at some point.
RON PAUL!!!!!!!
Gold is money. It has acted as insurance
to protect one's wealth for thousands of years.
It is nobody's liability.
Gold is going up recently because people have
lost faith in the paper dollar system, and all
those complex financial instruments, i.e. MBSs,
CDOs, and who knows what else derivatives that
are all going down the tubes.
Governments, central banks, have alot of power when they can issue paper currency with nothing backing them. Inflation is always the end result. It's a hidden tax on the average working man who works for a steady paycheck that doesn't rise as fast as cost of living expenses do. It's a big fraud perpetrated against the average man, and people are more and more waking up to this fact.
Sure there is no guarantee that you'll make
money holding gold in the long run, but you
sure as heck wont lose money. People think
if you just put money away in stocks for
10 to 20 years you automatically will make
money. There's absolutely no guarantee of that.
It is by far easier to lose one's savings in the
thousands of investment options out there than
to make money.
People have used gold as the standard for money
for many years. Now all money has lost that anchor. Soon people will realize the paper money they hold has nothing behind it but by then it'll be too late.
The DOW/GOLD ratio should be trending to 3:1 over the next few years. DOW 9,000 / GOLD $3,000/oz is my prediction.
I was also going to leave a few choice comments for some other posters here that are at least as ignorant (as in "don't confuse me with the facts") as the writer of the article, but then the compassionate side took over. The fact is that the American people in particular have for the most part been utterly brainwashed when it comes to almost ALL things financial for many years, and especially over the past 10. Lies, lies, lies, and more lies.
The reality is SO far from the spin given the American public, that to understand the truth would require them to think what they don't want to think: for one thing, that their govt does not tell them the truth and that the dollar is not "almighty" just another fiat currency fraud used to rob the working class of its wealth. Many prefer the brainwashing and the lies to the possibility that our govt allowed the fraud of fiat currency to destroy our economic and financial systems, along with everything else that connects to them...which is, well, just about everything. And now our govt, to keep this "free" money system (which always works to keep those in power in power and rob those who actually work), have to simply invent even more and more diabolically twisted lies to keep the truth from the people.
Gold (and silver) is simply the "truth" about the value of a currency. And that truth has been suppressed for so long, esp here, that people believe the result of the suppression rather than try to understand why "some crazy people" keep talking about it, and what that might mean for them. But the truth always ends up being the reality, because foundations are always shaken in this world just to find out what "shakes out" and what remains afterward...gold and silver will remain what they have always been--true stores of usable wealth. jt
More importantly, gold has more than tripled since 2001 when it was about $256 an ounce, while (and because) fiat currencies like the US dollar have been losing value at the same time. As the dollar and other currencies lose value gold will pass $1,000 an ounce within the next 24 months or less. It could pass $2,000 an ounce in the next 60 months if the loss in confidence in the dollar and other currencies becomes extreme.
Writing an article about gold referencing a 200 year time frame is mostly ridiculous. Prior to 1933 we were on a gold standard, and the government could fix the price of gold and then successfully defend that price because they were not rapidly running up debts and the money supply. (After 1933 the price of gold was fixed at $35 an ounce until 1971. It was a bad investment mainly because the US government made owning gold illegal until 1975.) All this changed, and the connection between gold and "dollars" has been gradually eliminated (1913 - creation of the Federal Reserve; 1933 - FDR's gold confiscation; 1971 - Nixon closes the gold "window"; 2000-2008 - central banks dump gold reserves onto the market each year while increasingly ramping up the money supply).
What is a barbaric relic is not gold, it is those little pieces of paper that get devalued year after year!
It is true that strong governments will try to support their "official" paper in a numerical sense when it suits them, but they also actively devalue the base fiat unit of account when times get tough. You might be able to redeem the face number of fiat units but you never get back the real value invested regardless of interest payments.
For recent examples look at Argentina and Russia, historically, check out Germany in the first half of the 20th century, and Rome a couple of thousand years ago. The US government may look to be reliable now, but so did Rome and hundreds of other governments at various times in history. The only constant historical fact is that all of them have eventually failed and their fiat currency failed with them. Gold on the other hand has always retained value.
Closer to home, Americans who bought and held Continentals and paper denominated that way certainly would have wished they had bought gold instead at the end of the war...
The author refers to "the full faith of the U.S. govt." as if that's
a good thing! :) I wonder how many people in argentina, russia,
germany, etc. believed in the full faith of their respective govts?
The monetary and gold price events we are seeing unfold today are the beginning of the fallout of Acton's dictum having come to pass with regard to the world's "new age", and recently much-abused, paper currencies. The rate and extent of printing press abuse has been on the rise since 1995, and I currently see no credible reason to believe that any relief is on the horizon. If anything, the current trends may accellerate.
I am no conspiracy theorist or "survivalist", but my sense is that the monetary genie is finally beginning to escape from the bottle, and that no one who is likely to be put in power by the American electorate will either be willing or able to effectively reverse this. Anything beyond just a temporary reversal would require a DRAMATIC (ie., Ron Paul or Milton Friedman style) and permanent change in behavior by both our government and the Fed, and quite possibly committing the American public to a painful, deflationary economic retrenchment beyond most anyone's voluntary ability to tolerate. I just do not see this happening pre-emptively in our current "pain-averse" society. The abuse of our unbacked paper currency will not likely stop until there is simply no further abuse that can be wrung out of the system.
At the moment, only a limited number of people are openly decrying the "new clothes" of the fiat money "emperor" for what they really are (mainly just the unsophisticated, un-indoctrinated "children"). That trickle of un-influential, youthful humanity may one day become a powerful adult flood, however, which is when the world's most recent experiment with paper-only money will meet an ignominious and possibly very ugly end.
1. Read Warren Buffett's article in Fortune Magazine about the US Trade deficit which you can access at the Berkshire Hathaway website attached to his 2004 (I believe) letter to shareholders. He has a way of explaining things that is most helpful.
2. After over 30 years as a confirmed (and chagrined) gold bug I would like to say that gold will go where it wants to go and thinking that you know where that will be is a big error. $500, $1000, $2000, $5000 who knows? How many of us knew the Dow would go over 14000 way back when? Having a position in gold gives you at least some counter balance to the massive amount of paper out there.
For the author I remind him of Will Roger's famous witticism " I am not concerned about the return on my money; I am concerned about the return of my money". The gold market is telling us that the return of our money's purchasing power is indeed in some significant jeopardy.
3. My guess is that we are relatively early in the cycle as silver is not roaring.
4. Bravo to all who have spoken so eloquently about the mortgage mess. Is this just the tip of the iceberg? I look at SLM, COF and other charts and wonder what may be coming.
Take care.
B/c of this perpetual "war on terror" in afghanistan
and iraq, and possible escalation in to Iran as well, the US gov't will have to print more money and go into more debt. You can count on more gov't deficits. Trade deficits are @ all time highs. My feelings that we are in a repeat of the 70's now. Gold's has run up b/c the market's are
sensing this, despite all the press bashing out there trying to suppress the gold price.
What's more currently 1 oz of gold buys only 9 barrels of oil. This is historically @ all time lows. Which suggests gold is still very underpriced.