The Trouble with Gold
Gold is often touted as an excellent store of value—and it can be, provided it is purchased at a fair price. But therein lies the problem. From 1973 to 2007 the volatility of the S&P 500 Gold Index was 36.9%. The index saw several spans such as a five-year period in 1996 where gold investors would have lost an astounding 55% of their money. Of course there are times when investors in gold could have more than doubled their money.
In order to make an intelligent decision as to whether or not to buy gold, you must be able to answer the question: What is one ounce (or any other measure) of gold worth? But how can you measure that? Valuing a company is straightforward: How much cash can it generate for shareholders? Gold generates no cash flow and has no intrinsic value.
Gold’s value is determined by how many people want it versus how much of it is available. Simple supply and demand. Examining the supply and demand characteristics lately shows some alarming trends. Traditionally jewelry makers (mostly in India) accounted for most of the demand for gold. Gold “investors” accounted for a relatively small portion. In 2003 jewellery demand was 78% of demand while investors accounted for only 10%. From 2008 to 2009 the demand for gold as an investment has skyrocketed by 85%, and from 2007 to 2009 demand for gold in investment products has grown almost threefold. It now accounts for 37.5% of all demand for gold as of 2009. Therefore much of gold’s demand and thus its current price hinges on investors wanting to continue to hold gold. How long will investors be willing to hold an asset that generates no cash flow? This seems to foreshadow the trappings of another bubble where the value of the asset is not based on underlying fundamentals but rather the willingness of investors to pay an ever increasing amount for that asset. When investment demand for gold evaporates, there will likely be a significant price reduction as the demand components return to their normal levels. When will this happen? Who knows. As with all bubbles, it will likely last longer than many expect and a fortunate lucky few will manage to time their buys and sells just right.
The only thing left for a gold investor to do is to attempt to forecast the economic factors that will affect the price. When it comes to forecasting, even the professionals have an abysmal record. Over the past 27 years economists’ attempts at predicting U.S. GDP growth or decline have almost universally been wrong, not just in magnitude but in direction as well.
Furthermore a gold investor must attempt to forecast not only the macroeconomic conditions that lie ahead but also how each individual will react to them, since it is these individuals that will drive demand. Finally if a gold investor can get all of these variables correct, the investor stands only to make money if his view is different from the consensus.
So what can a sensible investor do to protect their portfolio during uncertain times?
In our portfolios we utilize the following to combat the threat of inflation:
• Allocate a portion of the fixed income assets to TIPS.
• Allocate a portion of assets to real estate through REITs. The leases on properties that REITs rent are usually short term, and thus in inflationary environments REITs can rollover expiring leases to new higher rates quickly.
• Focus on investing in companies that produce a good or service businesses and consumers must use and that have durable economic advantages and are available at cheap valuations. Producing a good or service a consumer or business must use means that in the event of protracted recession there will still be a base level of demand for the product. A durable economic advantage gives companies leeway to raise prices in inflationary environments or keep prices at their current level in deflationary environments. Last and most importantly buy only when these companies are available cheaply. Buying at low prices drastically reduces the downside risk. Even during poor economic times and across multiple types of markets (bull, bear, sideways) the strategy of buying good companies cheap has provided investors with good, and even great, returns.
Gold demand data from World Gold Council