Five Reasons to Avoid the Gold Rush
Vitaliy N. Katsenelson presents the counterpoint for the gold argument:
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The reasons why one should sell the cat, pawn the mother-in-law, and use the proceeds to buy gold are well known: the Fed is printing money faster than you can read this, which will result in inflation; the government is borrowing like a drunken monkey, so the dollar will be devalued; this will debase all currencies, so the only thing that will save you is the shiny metal.
However, here are some arguments why one should think twice before jumping in bed with gold bugs, or at least remain sober while determining gold’s weight in the portfolio .
1. For investors (not speculators) it is very hard to own gold, because you cannot attach a logical value to it. Unlike stocks or bonds, gold has no cash flow and has a negative cost of carry – it costs you money to hold it. It is only worth what people perceive it to be worth right now. The argument I commonly hear is, “What about all those Enrons, Lehmans, Citigroups, etc. that either went bankrupt or got near it? What was the value of those?” If the lesson learned is not to own stocks but to own gold, it is the wrong lesson. The lesson should be: own companies you can analyze (the aforementioned companies were unanalyzable) and diversify – don’t put your all net worth into one stock.
2. The gold ETF SPDR Gold Shares (GLD) is the seventh largest holder of physical gold in the world. If its holders decide to sell (or are forced to sell; think of hedge-fund liquidations), who will they sell it to? This is extremely important, as the presence of GLD changes the dynamics of the gold price, both to the upside and downside. If gold keeps climbing, the ease of buying will drive gold prices higher than in GLD’s absence. In the event of a significant sell-off, there are not enough natural buyers of physical gold. It is a bit like a roach motel – easy to get in, hard to get out.
3. In the past, gold had a monopoly on the inflation and fear trade. Not anymore. Now you have competition from Treasury Inflation-Protected Securities (TIPS), currency ETFs, short US Treasury ETFs, government guaranteed/insured FDIC checking accounts, etc. TIPS suffer from the flaw of the CPI being measured and reported by the US government, which has an inherent bias to understate inflation; returns of commodity ETFs are skewed by price differentials between financial derivatives and spot prices of underlying commodities; returns of leveraged ETFs diverge significantly over the intermediate and long run from the underlying index; FDIC reserves are being depleted with the every-Friday-night bank bailout (but believe you me, the US government will not let FDIC go bankrupt, even if it means it has to raise taxes and impose draconian fees on the banking sector).
The bottom line here is this: none of these investment vehicles are perfect, in fact many have significant flaws; but despite their flaws they attract money away from gold, thus undermining gold’s monopoly on the fear/inflation/currency debasement trade. (I’ve discussed it in greater detail in my book).
4. If, because of points 2 or 3 above, gold fails to perform as expected, the perception of what gold is worth may change dramatically.
5. Over the last 200 years, gold was really not a good investment. It may have a day in the sun, but it may not. And the cost of being wrong is fairly high.
Though gold bugs make it sound as such, gold is not the only and not the best alternative if the worst fears come to pass. The best way to deal with the risks of dollar devaluation and high inflation – with a much lower cost to being wrong – is, instead, to own stocks of companies that have pricing power of their product. When inflation hits, they will be able to raise prices and thus maintain their profitability. Also, companies that generate a large portion of their sales from outside the US will benefit from the declining dollar.
Gold bugs look at gold as a currency, but it is not one and unlikely to be one in our lifetime. Here is why: there is not enough of it around, so even if world government were to adopt a fractional system (currency in circulation as a multiple of gold reserves), they will never go for it, because central banks and governments will never give up their monetary tools – inflation is a very addictive tool to fight growing monetary obligations.
There is a wild card in the price of gold, though: China (John Burbank made that argument at the Value Investor Congress in Pasadena). If it decides to switch partially from owning US Treasuries to owning gold, the price of gold will skyrocket.
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Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo. He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007). To receive Vitaliy’s future articles my email, click here.
September 9th, 2009 at 9:36 am
1.) Analysts fail to understand the allure of gold is that it is seen as prudent and not speculative.
2.) A valid point, one should note that the price of gold has gone up $600 since this ETF started trading in 04. However a look at GLD since its inception shows the bulk of volume is a) at a price point above $800 and b) occurs between the March high and now.
3.) The demand for these instruments relative to gold is a function of trust in these days of financial and accounting alchemy.
4.) If an investment fails to perform as expected then yes one will generally cut exposure to it. Gold has performed as expected over the past 200 years so I don’t see much risk here.
5.) See point 4.
6.) There seems to be an assumption in this post that every person out there that owns gold or intends to own gold has sold every asset they have in order to do so.
September 9th, 2009 at 9:51 am
I only have time to comment on the cost of carry argument. While true, gold’s cost of carry is negative compared to a dividend/yield-providing asset, if your alternatives are “safe” vehicles like money markets, US government securities, then your cost of carry is extremely low.
If you measure cost of carry in terms of opportunity cost, that is something else. However, opportunity cost is price you pay for *any* investment, not just one in gold.
As long as you avoid seigniorage, which you’d pay if you were buying gold jewelry or beautifully-cased coins and gold bars, and you use accounts with high liquidity and ease of transactions then the cost of carry is negative, yes, but meaningless.
A more important question, is what is your gold weighting in your portfolio? Asset allocation is key and even if we knew years ago when gold was $200/ounce that the “right price” down the road would be $1000/ounce, no adviser or rational investor would advocate going all-in in anticipation.
September 9th, 2009 at 10:40 am
Thank you for your arguments. I was hoping to find some intelligently contrived counterpoints to my gold thesis and you have provided them. Alas, they aren’t new arguments. As these are many of the same arguments raised over the last few months and still completely fundamental context defining today’s economic environment, I am even more convinced that the case for gold is sound. This doesn’t mean the price of gold expressed in U.S. Dollars will not decline over the near term from today’s $1,000/oz, but gold’s (and silver’s) utility as a medium of exchange is likely to increase. I posted an article about this last week, which can be found at (http://www.harnessimg.com/blog/2009/09/store_of_value_myth/). What you refer to as logical in your first point is what I would call rational, (or more like rationalizing), which is not the same as reasoning.
September 9th, 2009 at 10:42 am
oops…typo. In the above post it meant to write “and still completely misses the fundamental context”.
September 9th, 2009 at 10:55 am
Thanks, that being said, donyocham, I continue to hold some gold in a liquid account, having sold a rather large position (for me) this summer. I also think that the quoted prices available, whether we’re talking COMEX, spot, or in markets in Dubai or Mumbai to be representative of a particular basis with respect to another price, which some have calculated to be in multiples of what we consider to be gold’s current price. My concerns about holding gold are governments’ sensitivities to its use as a fiat currency alternative as well as the effect of hedging and Central Bank sales.
September 9th, 2009 at 11:32 am
The wild card mentioned – China – isn’t so much a wild card but an ace in the hole. China is accumulating gold and quietly and not so quietly moving away from the dollar. Any softness in the price of gold will be met with renewed buying and mainly from Asia. We are entering the age of the ‘China Put’ on gold. For holders of gold, this means good upside potential and limited downside risk.
September 9th, 2009 at 2:54 pm
1. I was at a conference where Jean Marie Eveillard was questioned on this very point. He said gold is not a value investment unless you view it as a monetary alternative. So it needs to be compared to the “intrinisic” value of yen, euro, dollars, etc.
2. I think this misunderstands how GLD works. The trust does not buy or sell bullion based on investors buying or selling GLD. In fact the trust does not buy or sell bullion, period, except regular very small sales to cover operating expenses. If people started selling GLD en masse, it is as liquid and as continuous as market as most any other NYSE listed security. GLD will exchange baskets of 100,000 shares of GLD for bullion or bullion for 100,000 shares of GLD, but the trust is under no pressure to sell bullion whatsoever if people start selling GLD. All that would be expected to happen is that arbitrageurs would buy GLD on the open market exchange it for bullion from the trust.
3. I agree with this, but gold still has some unique characteristics as compared with the other inflation and fear trade options, among these physical control, fungibility, zero counterparty risk.
4. The perception of what anything is worth can change dramatically.
5. Whether or not was a good investment over the last 200 years depends on your frame of reference. If you could transport yourself back to 1809 to a random country or even to America, but with a chance of being in the South or Spanish part of America, and you wanted to do something then to preserve wealth, such that it would be available in 2009, what strategy would have been most successful? Which “stocks” would you have bought? How many of those entities are still in existence? How could you be sure to have chosen the winners? Buying land would have been good, but without constant monitoring, payment of taxes, etc, it could well have been liquidated or converted to other uses before 200 years. Name something else you could have put in a steamer trunk for 200 years, thereby eliminating the risk of mismanagement or the need for hindsight guided active management, and done better with than a steamer trunk full of gold. Some collectibles or art might meet the test, but all those require hindsight compared to the robust, international and seemingly timeless appeal of gold.
September 9th, 2009 at 7:26 pm
For many, a core holding of gold is seen as insurance. When purchasing insurance one doesn’t dwell on the opportunity or holding cost. I don’t go without health insurance because of opportunity cost. I buy health insurance because the possibility of a catastrophic loss however hard to define is always present.