Jon Nadler, Senior Investment Products Analyst, Kitco Bullion Dealers, shares his thoughts with us in a two-part interview. In this first part Jon gives an overview of why he thinks an individual investor would want to buy gold or silver, and in the second part he weighs the various ways individuals can own gold.
Jon’s gold market commentaries are frequently quoted by the U.S. Canadian and global financial media and his 30-year career has focused exclusively on the precious metals market and on its related investment products.
TGR: Why do you think an individual investor would buy gold or silver?
JON: Fundamentally, apart from being a fairly rare and precious commodity, gold has served as universal money for almost 6,000 years now. In that respect, it is the only commodity that humans produce for continuous accumulation purposes. Unlike oil, which we burn, and so on, gold is produced really for hoarding, if you will, primarily because it fulfills the functions of true money.
And among those attributes there's the classic, most relevant factor – the capability of gold to preserve purchasing power over the long term. That’s really what money should do. Paper money doesn’t really live up to that expectation very well because obviously you can just print more of it at will.
So at one time, gold was the only true form of money known to mankind, and given that gold is no one’s promise or liability, it is also the one asset that no one can default upon when you hold it. It is a pure asset in the strictest sense of the word and the best one at preserving long-term purchasing power for your paper-based wealth.
TGR: In the new international world, where currency has been de-linked from the gold standard, do you believe that gold will continue to play that function going forward?
JON: I think for the individual investor, definitely. Since 1966 when unfortunately, the divorce from paper took place, gold has proven itself quite a desirable asset for individuals. The ownership on the market also bears this out. It’s been shifting away from institutional holders, away from central banks into private hands on a massive scale. And there are only three individual years that we can point to since gold became legal to own that global investors have net sold gold back into the marketplace. In all those other years, they kept accumulating gold, some years less than others, but nonetheless, on a year-in, year-out basis, accumulation has been the name of the game.
And, of course, in years where they buy more than 20 or so million ounces, it becomes very visible and leads to market spikes and a much more noticeable trend. But the effective takeaway lesson here that is people continue to buy gold, even while central banks treat it with benign neglect or worse, actually without selling it from their holdings.
TGR: What’s the long-term impact of the central banks selling gold and individuals owning it?
JON: I think it leads to democratization of the marketplace. It’s going to remove the threat of liquidations that people have felt was very material for quite a number of years, and it, in fact was. It affected the markets in real terms – in price, in psychology. We saw notorious examples; people say the British sale was one. I think what it does is it puts the individual investor in control. Individuals tend to be very long-term holders of gold, and they don’t really have some of the newfound motivations that some central banks do, to “make their money work for them” and put gold to use in some method to make profit as if that were their mandate – which it’s really not. The central banks’ existence is supposed to be all about public trust and confidence.
On the other hand, I think most of the central banks that wanted to sell have already done so. The remaining 28,000 to 30,000 tons of gold in the official sector will probably largely remain there and untouched. With perhaps a few exceptions, we can expect not a whole lot of buying, per se, by central banks. I don’t think the Chinese will be the first to rush out and do it, but we can still expect maintenance of the presence of gold to be at much lower levels than it used to be. In terms of the global reserve structure, it used to be about 60% of reserves; it’s now down to about 10% or 11% at best.
It’s actually a good development – the masses taking over the ownership.
TGR: As an individual investor, how should we look at gold as part of our overall portfolio strategy? When should we buy? When should we sell? And how much should we have?
JON: Probably the most reasonable way to treat this unique asset is to look at it as an insurance policy for all your other assets. And as with an insurance policy, you should hope not to have to cash in on it. Basically, it’s there; it costs you an opportunity if you’re not getting any interest or dividends. But the function that it can provide is in terms of mitigating a loss. If one of the asset classes you own undertakes a severe hit, you can mobilize your gold and offset that loss.
In a worst-case scenario, it can actually rescue your entire wealth, and in some cases, we know people’s lives have been rescued by gold. But that’s for extreme scenarios. The basic situation is to treat it as an insurance asset, and as the proverb goes, “Don’t wait to buy gold; just buy gold and wait.”
If you look at it as such, then of course it removes a lot of the obsession about prices, trends, and all of the minutiae. The baby gyrations are no longer important to you because you bought it really as a long-term policy for being able to do everything else you do. And let’s face it, most people don’t own 95% gold and 5% other. Mostly it’s the inverse. So the ability to continue to enjoy your bonds and real estate and all sorts of other forms of investing should continue unabated provided you have this core holding allocated to gold, really with the objective of not having to sell it. And if the occasion doesn’t arise to sell, then all you wind up doing is giving it to the next generation. It’s a terrific way to transmit wealth across generations.
The component of trading gold for profit – obviously, there’s enough volatility, and there has been certainly in the last five to six years quite a bit of movement – is also there. That, again, is for people who have discretionary funds that they wish to play with. It can be exciting and it can be scary at times. But I look at that as only an adjunct to this core holding that’s already been set aside and that you don’t worry about.
TGR: Just as a general guideline, how big should the core holdings be as a part of the portfolio?
JON: For quite a number of years, it used to be a rather low threshold, between 3% and 5% by most portfolio modeling theories. That has changed, surely not to the extent or to the large slice represented back in the 1979-80 era where even the conservative Swiss money managers were recommending upwards of 20%, 25% or 30% in hard assets.
At the moment, somewhere between 8% and 12% is quite ample. For most people, it’s about 10% on an average as a core holding. And it’s fully owned, fully paid, as a core holding, meaning that you don’t do futures or options. It’s not mining shares necessarily, but it’s an actual physical holding of gold in some form or another that is going to constitute this core.
What happens at an optimal level of gold in a portfolio is that it tends to enhance the returns without adding volatility, and it actually reduces overall risk without sacrificing return. So, it acts as a very nice portfolio improver.
TGR: We’ve been hearing that somewhere along the line, as currencies continue to devalue, buying gold can serve as a hedge against that. This differs slightly from what you’re recommending as a gold investment strategy.
JON: It’s one of the plausible reasons to buy it, of course. Our first objective, as I just mentioned, is portfolio diversification with the idea of insurance, and having a cash-equivalent portion or a cash-like portion – which gold can be, because it’s really like a borderless currency – present in that portfolio. If you add to that the classical reason of inflation hedge, geopolitical hedge, and uncertainty hedge that gold can also provide, that’s where the other components come in. And one of those is this idea of inflation hedge, meaning erosion in the dollar equals higher gold; therefore, you should have it.
It’s not any different from what I said at the beginning, which was that purchasing power parity preservation, or keeping your purchasing power intact, is what gold is good at. Therefore, that’s really the primary objective, so it does relate to an eroding dollar.
I think where we diverge with the conventional mega-bullish scenarios is that we don’t believe the dollar is about to suffer a violent death and/or go into hyperinflationary mode suddenly. The situation doesn’t warrant going and doing a third or more of your portfolio in gold.
The credit crunch will probably work its way through the system, and perhaps in a year or so conditions will stabilize sufficiently for the dollar to actually begin to improve. Of course, at such a juncture, instead of seeing four-digit gold, you could see it revert back to a realistic price range that takes into account the supply and demand regarding gold.
So, yes, we do agree that if you’re going to hedge off against the decline – not just the dollar but any paper currency that one holds that is subject being printed in higher numbers – gold can definitely mitigate against inflation risk.
TGR: Earlier you said that the regular portfolio is 3% to 5% in gold, and then that 8% to 12% is ample? Is the difference due to the kind of volatility we’re seeing in all currencies right now?
JON: Well, I think it’s increased as a legacy, first of all, of having hit a 20-year low of $255 just about the time the events of 9/11 took place. Post-2001, the level of global uncertainty and actual visible turmoil increased strongly. We have had a number of events, from the Iranian nuclear issue to the ongoing war in Iraq to the spread of terror to North Korea last year. All of those backgrounds and geopolitical factors, combined with an increase in energy costs, which we have quite visibly witnessed in the last year and a half now, and then adding all the risk-aversion scenarios and the yen carry trade and the subprime mess and all of the happenings since February of this year – all of that has really played into the hands of present and former and would-be gold buyers to the degree that you saw practically a match for the 1980 high of $850 just three weeks ago.
And so it’s a legacy of what’s gone on since 2001, but we also have to take into account the fact that this is the longest bull market in gold on record now. They generally tended not to last more than three or four years, but some of the arguments are that we had a 20-year bear market, so why couldn’t we have at least a 10-year bull market? But even by that standard, we are still three years away from any correction at this particular stage of the game.
TGR: Do you care to speculate on how long it will last and how high it will go?
JON: Well, that’s always tricky. I was actually pushed against the wall in New Orleans and asked point blank, “What do you think one year from now and five years from now?” My comeback was that a year from now we probably will be oscillating in a range from $640 to $700, after first having spiked significantly higher. And that could be a number anywhere from $900 to $950. But I saw a reversion to the mean and I saw a return to the equilibrium level that’s still fairly high in general terms, and I will give you some perspective on why I thought those numbers.
And for the five years, I said if the average clearing price for gold for 33 out of 35 years – actually for the majority of the time since it became legal to own, it was around $400 or so. Even if we allow for a 50% increase in that clearing price, then we could see levels between $600 and $700 as an average yearly price. And, of course, that doesn’t preclude trading for three months at $1,000 and two months at $400, but you could still get to an average price of “x” dollars.
And people say, “Oh, what kind of a bear are you? What kind of a bullion dealer are you? How can you be talking down your own product?” And I said, “You know, take into account the fundamentals of the marketplace, and those are that two-thirds or more of the demand goes into fabricated jewelry. That demand gets very, very skittish when the price gets anywhere north of $700. If consumers don’t deem those values to be sustainable, they simply hold out and don’t buy.” I think India did that for about 10 months from late 2005 through 2006, and, of course, they were vindicated in waiting because after we hit an $832 last May, we also had a $200 cheaper price within a month.
I am not necessarily suggesting that $845 was the peak, but just today I saw a couple of reports out of Goldman Sachs and JPMorgan, which were forecasting significant correction short- to almost-medium term on dollar improvement. So to hit $900 or $1,000 or whatever people are saying . . . In fact, I’ve heard much higher; there’s some type of crisis effectively required. And I don’t think that a lot of the forecasters who argue for those huge numbers have possibly thought through the scenario in full, meaning, okay, fine, gold at $1,200 maybe in May of 2009. What will your other assets be worth that day, everything else you own? Try to picture that scenario. Or $2,000 gold, or $6,000 gold.
And so that’s where we lose the crowd because, in effect, if that’s your expectation, then you’re saying it’s going to be dire straits. Somehow, I am little more optimistic than to say it will reach that kind of high on some misery situation. There could be short-term spikes – Iran could still get attacked, but hopefully not – but on a short-term basis, can you have a spike to incur the unimaginable numbers? Yes. Is it sustainable? Not so much.
And then on the low end, you can’t do it either, because producers get very nervous once prices start approaching $400. So, the happy medium is somewhere in-between, and the investment demand has been the single largest component here for six years ongoing. The question is, then, will investment demand sustain itself at these historically extremely high levels – about 100 to 105 tons per month? And every investor who wanted to own gold by now is already invested. Or will there be a whole new class of latecomer buyers who are lining up around the corner store? That is the unknown, because something has to sustain it. We have to take into account the increased production, too, and that’s the other side that I don’t think the conventional hard-money newsletter takes into account.
They keep talking about production dwindling away slowly in a very auspicious sort of market. When you go to these conferences, you see hundreds of mining companies proudly proclaiming, “Oh, we spend millions here, millions there” – all in the quest to find new gold. They have probably spent close to $25 billion in five years time to find the gold, and we believe it’s coming to fruition. Inevitably results will start flowing into the market in tonnage terms – about 50 operations coming on line this year forward into 2012, with the combined output capacity of 450 tons annually.
When they reach that level of production, you’ve got the equivalent of a central bank-sized supply in the marketplace as a new factor because the CBs are allowed to sell about 500 tons a year. So when you add 400 to 450 tons to the 1,900-ton supply and you have increased mine production by 25%, you have to ask where the demand will come from. Will it be the investment because there is enough reason to worry? Will jewelry continue strong at $800 or $900 or $1,000? It’s hard to find those answers at crazy high prices. It’s easy to find them at reasonable prices.