Questioning The Case Against The Case Against Gold

Includes: BRK.B, GLD, GLL, UDN, UUP
by: Ted Barac

A recent article by a fellow Seeking Alpha contributor supporting gold investments stated the following:

In fact, the author [another author criticizing gold investments] notes that "historically, gold has been known as an effective store of value." I would have thought such a statement would end the entire debate...

My question is, why would that end the debate? Shouldn't we examine the extent to which gold has been an effective store of value, and how it has performed against other asset classes? It seems to me that one of the main arguments made by some gold advocates amounts to little more than gold is a good investment because it will outperform any cash that you stash under your mattress (although almost no one actually invests in such a manner).

For example, one of the points made by gold advocates is the observation that: "In Roman times, an ounce of gold would buy you a fine suit and today, an ounce of gold will still buy you a fine suit." It's interesting to me how some people hear that anecdote and conclude that gold is a good long-term investment.

In reality, I believe that the more logical conclusion to take away from that statement is that, since Roman times, gold has provided a real return (after inflation) of exactly ZERO. In other words, an ounce of gold back then would buy you exactly the same as today (i.e., it hasn't appreciated, at all, in REAL terms).

Cash is clearly a poor long-term investment, which (typically) devalues year-after-year. The reality, however, is that investors tend to put their cash into banks and brokerage accounts where they buy CDs, bonds, and equities -- all which, typically, offer real returns over time. This is particularly true with respect to equities (which we will discuss later). This begs the question as to why many gold enthusiasts are terrified about inflation, yet have an apparent aversion to stocks (one of the best long-term inflation hedges that exists).

A recent study by Credit-Suisse and the London School of Business looked at the real returns of stocks, bonds, and gold from 1900-2011. During that period of time, they found that the real return for stocks (using a global index) was 5.4%, while the bonds that they analyzed returned 1.7%, and gold returned 1.0% (all in real terms). Similar conclusions were drawn in the famous book Stocks for the Long Term by Jeremy Siegel, who has estimated that stocks have provided real returns of about 6.6% over the long-term.

It seems that some of the more passionate gold advocates almost view stocks in the same way that they view fiat currencies (i.e., as some make-believe instruments with no underlying value that are part of a huge Ponzi scheme/conspiracy theory). Of course, the reality is that stocks are real assets that represent ownership interests in companies that own factories, stores, buildings, heavy equipment, and other income-producing assets. Not only do these real assets increase with inflation, but they provide income and dividends while you hold them (unlike gold).

All thing considered, it seems clear that the long-term real returns of gold have been poor (compared to stocks and bonds), and I see no reason to expect long-term price appreciation for gold to be above inflation. In fact, as with any non-income producing asset, it would be unreasonable to expect for gold to provide significant positive real returns over an indefinite period of time (as gold would ultimately cost billions per ounce, even when adjusting back to today's dollar).

And what about the view of some gold enthusiasts that U.S. dollars (and other fiat currencies) have no underlying value, and are effectively just a huge Ponzi scheme? Well, technically, the actual physical piece of paper that represents U.S. currency doesn't have much intrinsic value (nor does a car title, a mortgage certificate, a paycheck, etc.), but that's not what's really important. What's important is the underlying value of the dollar, which is substantial.

The dollar is the currency in which income taxes must be paid. Whether your employer pays you in dollars, gold, free room and board, Mexican pesos, or equity grants, you have to translate that compensation into dollars and pay taxes on that income in U.S. dollars. Hypothetically, massive demand for dollars would exist, even if the entire country became convinced that dollars were worthless, everyone demanded that they be paid in gold bars, and everyone went to a barter system where no cash was exchanged for goods and services. In such an (unrealistic) scenario, there would still be demand for trillions of U.S. dollars each year, in order for people to pay their taxes. For that reason alone (although there are many others), the dollar has, and always will have, substantial value.

Gold, on the other hand, has limited intrinsic value and is an asset that trades largely on emotion, perception, and the "greater fool" theory. Because gold generates no income or cash-flow on which to fundamentally value the asset, investors buy gold solely on the expectation that someone else will eventually believe that it's worth more and buy it back from them at a higher price.

Such an investment rationale -- based purely on emotion and no fundamental valuation considerations -- makes me very nervous, although I acknowledge that many very smart people have made substantial profits speculating in gold. Personally, I prefer to invest where I see fundamental value based on expected profits from income-producing assets.

While, I see limited intrinsic value in gold, I also see no reason why the scarcity premium that it has carried for centuries will dissipate anytime soon, and it seems reasonable to expect that inflationary type long-term returns (i.e., zero real returns) will continue. That said, I would argue that buying gold is an unpredictable short-term gamble that is completely dependent on the unpredictable vagaries of perception and market psychology. I think Berkshire Hathaway (NYSE:BRK.B) CEO and renowned investor Warren Buffett best summed up the issue of gold's questionable value when he famously said:

It gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.

That's not to say that gold can't be a good short-term trade and offer superior returns over shorter periods (as has been the case in recent years). Longer-term, however, I do believe that stocks will continue to substantially outperform gold over time -- particularly following gold's dramatic run-up over the past decade.

Disclosure: I am long BRK.B. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.