Gold as an Investment? Think Again

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Includes: DGL, DGP, DGZ, DZZ, GLD, IAU
by: Adam Katz, CFA

The bulls may feel frustrated as gold draws on the $850 mark, kind of like the frustration felt by those who bought in at around the $800 mark in 1979. Not that I am implying that this is the turning point, or that I am shorting the precious metal, but it is important to analyze the historical under performance of gold as an investment. This article is intended for those with significant exposure to the yellow metal.

The same arguments will always hold in the bull camp. Governments inflate money, gold production is dwindling, gold will return as a form of money, and the ever popular idea amongst gold bugs that we should return to the gold standard. Unfortunately, I don't have time to say everything that I want to say today, but I will definitely address all of these points in future articles.

In this article I hope to accomplish 3 things:

  • Let's look at the big picture of gold as an investment.
  • Following this we will analyze the past 10 years in brief
  • Finally we will look at the prospect of holding gold for the future

Gold as an Investment

If you buy gold because you are a U.S dollar bear, you are really just a dollar bear, in my opinion, and not a gold bug. And while many people are in fact dollar bears (and quite justifiably so), most do not rush straight to gold - as has been the historical case.

Let's look at a popular alternative. Instead of buying gold over the past several years, you could have simply put the same money into a euro-denominated high yield savings account or an ETF such as CurrencyShares Euro (NYSEARCA:FXE). Not only would you have seen remarkable capital appreciation versus the dollar, but you also would have earned around a 4% yield.

Compare that to the holding and insurance cash outflows of gold, and you can immediately see the benefits of an interest yielding asset. Staying on the theme of currencies as an alternative, there are still many responsible central bankers left in the world. Consider the Reserve Bank of Australia who has been raising rates for quite some time now to combat inflation. Once again, great capital appreciation AND CurrencyShares Australian Dollar ETF (NYSE:FXA) now has yields sitting at 6.78%. Besides for currencies, there are many other hard asset alternatives, and although housing is usually one of them, its obviously not this time around.

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Looking at the chart above, we can see that gold's performance has been anything but consistent over the past 30 years. The cries for gold to reach its inflation adjusted highs are quite absurd considering that the precious metal has always lagged inflation; why should it be different this time around?

Considering that gold is an alternative to cash, not yield producing assets, this statement makes perfect sense. The weighted average increase in the purchasing power of cash, bonds and stocks will ultimately put cash (or gold) below the long term average. Reward comes from taking a certain amount of risk and the effective allocation of capital, not from leaving the capital in your safe.

In addition, keep in mind when looking at the chart above that about half of the return from the DJIA is actually in the form of dividends and is not reflected on the chart. Compare that to gold, where the past 30 years have likely seen billions wasted on gold insurance which includes storage and security costs.

Warren Buffett on Gold:

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 stream of dividends is fairly safe, with little volatility (not that the long term DJIA chart looks too volatile in any case), and is a result of economic value added. If we want to talk about long term investments, being vested 100% in equities is the way too go. Obviously short term volatility becomes an issue, as well as the need to spend money along the way, so a person's portfolio should consist of a cash component that may or may not have a percentage of that in gold.

After breaking it all down, gold should not be more than 2-3% of a persons target long term portfolio. As Peter Bernstein correctly pointed out, a very small holding of gold is great insurance of a big catastrophe. However, in this author's mind, that insurance does come at an opportunity cost.

That being said, gold will gain value in certain scenarios, as it's done in the past 10 years

Gold Over the Past 10 Years

Gold has made a remarkable climb over the past 10 years. Will it continue? Let's look at some of the events that have contributed to this:

  • The Asian Financial Crisis
  • The Dotcom Bust
  • September 11 Terrorist Attacks
  • Iraq War
  • Global Terrorist Attacks
  • U.S Housing Bubble
  • Skyrocketing Oil Price

No wonder gold, the asset considered to be a safe store of value, has become so popular. Jon Nadler of Kitco said in an article about a month ago that the bugs who see $5000 gold are expecting something so bad that they are better off buying lead, for bullets, because that will be far more valuable than gold. Consider the events that propelled gold up 300% over the past 10 years. If you believe, as some of these bugs do, that this is nothing compared to what we will see in the next 10 years, then maybe you should buy gold.

However, speculation of what the future holds aside, this looks very similar to the 70s. Food and energy crisis, war, and inflation. I'm sure that those who bought in the $800s back then saw things getting twice as worse in the next decade. Then what happened? Possibly the greatest economic boom the world had ever seen.

Looking Forward

To re-iterate, gold is cash, it's riskless, it doesn't work to produce further capital. When you look ahead, what do you see? Do you see oil running out and global war breaking out? Buy lead in that case! I am less pessimistic. I have always believed that the ingenuity of the combined human brain power can solve any problem critical to our existence.

So where do the real returns exist over the next 30 years and why don't you want to be invested fully in gold? Simply put, opportunity cost of capital. Next time that you want to buy another ounce of gold, ask yourself, is there anything in China growing at a rate slower than 10% per year? When will we discover alternative energy? How significant an effect will widespread computer usage have on the micro-economic picture and business productivity as a whole?

These are just a few factors that will likely produce great returns over the next 30 years. On top of that, consider that most of the really big societal changing events cannot even be conceptualized before the fact. However, being diversified across all industries will undoubtedly give you some exposure to the next big thing without having to play the guessing game.

If I am right that the next 30 years will see marvelous scientific discoveries and that expectations of war and famine are overblown, those that hold gold will be punished for wasting valuable capital that could have otherwise served a real purpose.

Lastly, I just have to point out that gold could possibly return to its highs of two months ago, but should that happen, and should the market continue to force it up, $100 drops in short periods of time will become characteristic. It's hard to call the top of a bubble.

As I write this article, you are seeing gold buy recommendations outweigh sells by as high as 100:1. Every man, woman and child is telling you to buy some. Could it be… a bubble?

Disclosure: none