Is Gold a Hold?

March 12, 2009 | By: Kyle Waller

“The S&P 500 index is worth about 75% of an ounce of gold, verses a peak of more than five times the value of gold in 2000 when the S&P peaked at more than 1,500 and gold languished around $300 an ounce. Over the past 40 years, the S&P has averaged 1.6 times the value of an ounce of gold.”

Gold and other precious metals are an interesting investment and have gained a lot of press recently through radio and TV advertising. As the stock market has been severely affected by the credit crisis, gold has been seen as a ‘safe’ investment that never loses value like stocks and bonds because it is gold; the asset that was once was used to peg many currencies including the U.S. during the time of the gold standard.

The question is not whether gold is rare or was useful to pegging currencies, but how an investor should view gold as an investment in the short term and long term.

What should be noted is that gold inventories held by a small, individual investor are very impractical. The cost or risks of this kind of investing through actually, physically holding gold must be fully realized. The cost of insurance, security, storage, transporting, inspecting, and insuring true quality may make this kind of investment completely impractical. A better, more efficient way to purchase gold is through ETFs and ETNs, which track the price movement of gold by following a gold index. Precious metal ETFs actually hold physical gold in trust in secure bank vaults.

Even if all stock prices reflected the fair market values investors would still realize gains and receive dividends from the stocks they hold. Why? Because, if stock prices should be the present value of all future cash flows, the more recent cash flows will have the greatest effect on stock prices. If earnings should increase over time, as time moves forward, so should stock prices as increasing amount of cash flows continuously get closer to the present time.

Gold has no expected return. Unlike a stock, gold and other precious metals do not have any future cash flows and therefore their values and prices are only based on supply and demand. Supply and demand forces are more complicated when describing commodities. We could say the value of gas is the price we pay at the pump or the future price that market participants have contracted with each other to deliver gas or oil in the future. This is interesting because the supply and demand of a commodity like oranges is not only the supply or demand of today’s price but the price in the future. This is why orange producers are so concerned with predicting weather, as weather in Florida will greatly affect the future supply in the market place. This helps guide their decisions on the future price of oranges.

Recently Warren Buffett, when asked about investing in gold and where it will be in five years said: “I have no idea where [gold] will be, but the one thing I can tell you is it won’t do anything between now and then except look at you.” He went on to say, “It’s a lot better to have a goose that keeps laying eggs than a goose that just sits there and eats insurance and storage and a few things like that.”

Warren Buffett’s advice is not the bottom line but an interesting perspective from someone who has had great success investing based on strict principles.

Many people believe that rare commodities will only get scarcer and that prices of those items must increase in value. This is most popular regarding oil, but relates to all commodities. Before discussing why this may not be true, the same line of thinking happened in many places in the world over the price of land and home values.

The thinking that led to the housing bubble in the US and Japan’s housing bubble burst in the 90s, which they have yet to recover from, is that there is only so much land. Reason tells us that as the earth becomes more populated, property values will increase due to a fixed supply and increasing demand.

This is not true. In the short term the supply curve can be shifted (to the left) signifying less quantity available to consumers and a new equilibrium price will be set above the previous price. The Long term is a different story, (economists define the long term as the period where all costs are variable, meaning that big fixed costs like owning a house is fixed in the short term, but in the long term you can move). In the long term this new price based on a decreased demand is not sustainable for reasons that will let consumers and suppliers shift the demand and supply curve back to lower or previous equilibrium prices.

In a recent analyst report by Keith Lerner, Chief Market Strategist for SunTrust Robinson Humphrey, published in Indexuniverse.com, reported that gold is a difficult asset to place a fair value on,

"Since gold neither pays a dividend nor generates cash flow, we have never felt a great comfort in assigning a fair value for the precious commodity. Often, in our opinion, its direction is driven primarily by investor psychology and it trades on momentum…”

What we are seeing above is that gold, as an investment is more volatile than the S&P 500 and annually over a 36 year period gold has returned less. This is not to say gold is a horrible investment in all cases but, to say that the stock market historically has performed better with less risk than gold.

Commodities in general and especially gold have a low correlation to the stock market. Since it has a low correlation and higher volatility adding commodities and gold in appropriate amounts can provide long term benefits. The hard part is figuring out the appropriate amount to allocate to gold or commodities as a wider asset class.

As we have already discussed previously, gold has recently seen a large price increase. Investors have been flowing funds into gold due to many factors including gold’s historic uses as currency.

Graphed below is the S&P 500 and the price of gold as seen through the London Fix Gold Index from 1990 to 2009. This long term price performance difference is important to notice that the better long term investment is the stock market as seen through the S&P 500. This long term perspective matched with a strong theoretical understanding behind asset pricing and value differences.

All this being said, is there a place for gold and other precious metals in portfolios of all risk levels. In short, yes. The trick is in what percent and through what investment vehicle.

At Wiser Wealth Management we have between 3%-5% commodities in our portfolios. We currently use the ETN, ticker symbol DJP an ETN that tracks that Dow Jones AIG Commodity Index. The breakdown of commodities is diversified and the index follows rolling futures contracts.

Precious metals makes up 13% of the entire commodity portfolio and gold is 9.41% of the entire commodity portfolio. Please note that the percentages of commodities and gold we currently have in our portfolios is a function of the suitability of our client base and may not be appropriate or suitable for you. Also, please be aware that an ETN is different from an ETF and assumes full credit risk of the issuing investment bank.

An investor can track commodities and gold using ETFs and ETNs. The most popular of these products are the SPDR Gold Trust, (GLD), United States Oil, (USO), iShares COMEX Gold Trust, (IAU), iPath DJ-AIG Commodity, and iShares GSCI Commodity, (GSG). All have different exposure to commodities and gain exposure to the commodities they cover in different ways. Careful research is needed to determine proper exposure and suitability and to understand the difference between exchange-traded products and the methods they use to track the underlying indexes.

Disclosure: Long position in DJP.

To buy Hallmarked 999.9 Pure Swiss Gold Bars, Gold Bullion, Gold Ingots & 916 Gold Coins in Singapore or convert your 916 Physical Gold to physical 999.9 Pure Swiss Gold Bars, Click on Buy Gold to find out more. You may Sell Gold to us too.

[ Back To Home ]