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blog: Will gold shine again?

Vitaliy Katsenelson
Vail CO, Colorado

Gold is an important but very different asset class that competes with stocks and bonds, and although it falls in the commodities asset class I’d like to briefly touch upon it in the following discussion.

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 still around today. It is exhibited in museums, worn as jewelry, and buried deep in the vaults of the central banks. Peter Bernstein, in his The Power of Gold, wrote the following:

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 4500 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 100 and 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, as diversifying with gold can reduce a portfolio’s fluctuations (volatility). However, 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.

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”a stock or bond certificate (the overwhelming majority of the time they are actually electronic bytes and bits, anyway). You may do so with real tangible assets, however, 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 (ETFs) will not come to the rescue; these bytes and bits are not superior to default-free bytes and bits (i.e., 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 Corporation (FDIC)-insured checking and savings accounts, U.S. Treasury bills, and Treasury inflation-protected securities (TIPS) may challenge gold’s status as the safest haven in times of inflationary crisis.

GOLD’S RECENTLY EMERGED COMPETITION

TIPS 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. In addition, the inflation component that goes into TIPS pricing is calculated based on the CPI, which is calculated by the U.S. government. Many investors argue that the CPI calculation is outdated and that it chronically understates inflation.

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, as gold is not a cash-generating asset. In fact, it is important to note that gold actually has a negative yield (cost of carry). Gold is a cash-consuming asset (it’s safekeeping and transportation cost money), whereas 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 (CDs); they can buy foreign stocks on foreign exchanges or through American depositary receipts (ADRs); and of course there is a most recent development”currency exchange-traded funds (ETFs).

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.

More information about the book at ActiveValueInvesting.com

Vitaliy N. Katsenelson can be reached at vitaliy.ima@usa.net. View his blog at http://www.contrarianedge.com


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