Gold investments - too much of a good thing?

Recent market events have put an emphasis on the value of gold, leaving investors curious to know whether investing in this commodity would be a good decision. Dominic McCormick argues the gold bull market would eventually end as a bubble.

When I last wrote about gold in early April, the editor of this magazine suggested that enough had been said about the topic and it should be the last piece on gold for the year.

However, given the rise in the gold price of almost $US500 since then to a recent peak of $US1,917 and the growing importance and interesting dynamics of gold related exposures in a fragile economic and investment environment, the case to revisit the topic is strong.    

Indeed, the time-worn arguments that gold should be treated as just another commodity, to be included in portfolios only as a small part of a broader commodities basket, has been ruthlessly thrown out by recent events.

Gold has surged in recent months, as most other commodities have fallen sharply in a world increasingly worried by slowing growth – asserting its unique monetary/currency characteristics and role as a store of value against fickle paper currencies.

Of course, it has not been all one-way and volatility has recently increased – after breaching $US1,900 gold fell almost $200 in just a couple of days.

Further, while gold mining stocks held up well in the sharemarket weakness of recent months, they have dramatically underperformed the spectacular progress of the metal itself through 2011 to date. This divergence between gold and gold mining equities has been one of the big challenges for many gold investors in 2011.  

However, as we discuss below, gold shares may well be the best investment avenue for those seeking to maintain gold exposure but cautious about the pace of bullion’s recent rise.

For most investors contemplating gold, the big issues today are: Is gold a bubble? If so, when will it burst? Is it too late to get exposure? How should one go about this?

I have always believed that the gold bull market, which has lasted more than a decade so far, would eventually end as a bubble. Further, I do believe we are seeing some indicators that gold may be entering the final, more speculative phase of its bull market.

Such indicators include the recent near vertical rise, subsequent increased volatility, increasing retail interest, the promotion of a range of new ways to access gold and widely quoted, extremely high price predictions from so called “experts”.

Recently a local TV show presented a ‘go for gold’ segment with an expert predicting a gold price of $5,000 in five years. The front page of the business section of a major newspaper on the same day interviewed a high profile company director who bought $1 million of gold in late 2007.

Of course, no one knows how long this last phase of the gold bull market may last. It could well extend for years and the price gains from current levels could still be dramatic, although volatility is likely to be significantly higher than experienced so far.

Unlike many, I make no attempt to predict the price of gold at its ultimate peak. Indeed, the more precise a commentator’s forecast, the more I ignore their views. Gold’s rise is about the falling confidence in paper currencies and the financial system.

If you can tell me when developed country governments (especially the US) are going to get their fiscal houses in order, when interest rates are going to offer a real return in those countries, and when currency debasement and inflation is not seen as desirable economic policy, then maybe you can develop some (vague) idea when the gold bull market boom will end.   

A key driver for the gold price is, therefore, its ability to gradually ‘recruit’ new buyers who are losing faith in paper currencies and other investments generally.

While retail investors are now being encouraged to buy gold directly, and have a greater array of vehicles to do so, relatively few mainstream investors have done so for any meaningful part of their portfolio. 

Institutions have been even more sceptical, although there are some signs that this is changing. Interestingly, it is central banks – particularly in the rapidly growing emerging economies –  that have become active buyers in the last year, after many years of net sales by ‘old world’ central bankers.

This widespread scepticism suggests that this last phase could go on for some time.

These sceptics have plenty of high profile support, claiming that gold is a bubble about to burst. Of course, most of these have had little or no exposure to gold throughout the course of the bull market.

Take Warren Buffett: as a very successful investor, his views on most issues should be heeded, but on gold he has been consistently wrong – particularly regarding gold’s role in a portfolio.

Buffett has regularly trashed gold, comparing its non-income earning and passive characteristics to other favoured assets such as global companies or farmland.

Yet it is interesting that Buffet’s Berkshire Hathaway continues to hold tens of billions in US dollar cash –  earning close to nothing in nominal terms, losing at least 2-3 per cent per annum in real terms after inflation, and watching the foreign purchasing power of those US dollars depleting. Which is the true dud asset here?

One of Buffet’s challenges in recent years – partly due to his enormous success – is he has become perceived as, and is under pressure to play the role of, saviour and cheerleader for the US financial system and its economy. (Note his recent equity injection into Bank of America.) In that role, he has no choice but to be negative about gold.

Ultimately though, gold is not an either/or story. Investors don’t need to decide to have cash or gold, great companies or gold, farmland or gold. You can have some or all of them. Well diversified portfolios do. Used properly in a portfolio, gold is not some all out, concentrated “Armageddon” bet, but rather just part of a portfolio diversification story.

Of course, those calling for gold to collapse will be right one day, and as noted above, we are beginning to see some warning signs that the gold bull market is becoming more vulnerable. In Select’s own diversified portfolios we have actually sold a meaningful proportion of our gold bullion exchange traded fund (ETF) exposure into the recent strength.

However, we certainly have not given up on gold exposure across our portfolios, and have in fact used the proceeds of these sales to increase our holdings in gold mining stocks.

In our view, a sensible gold exposure has always consisted of a mix of gold and gold mining stocks (and has generally been skewed to the latter).

Looking forward from here, however, we believe the risk reward clearly favours gold mining stocks. They have dramatically lagged the gold price this year, are pricing in gold retracements half to two thirds of current levels, and on a range of valuation measures such as price to net present value are as cheap as they have been in the past two decades. 

After all, gold mining stocks represent real gold exposure – it’s just that the gold is largely still in the ground. They do come with a range of additional challenges and risks – political, cost, technical, and management (etc).

However, even after all this, their attractive valuations suggest they may well be a lower risk way to gain exposure to gold than gold bullion at the current time.

What explains this recent poor performance and cheap valuations of gold stocks in a massive gold bull market?

There are certainly some company and industry specific issues – rising costs, depleting reserves at some big miners, and some questionable management decisions (eg, Barrick’s recent takeover of copper producer Equinox).

However, the main reason seems to be the self-reinforcing effect of the preference of investors for direct gold related exposures, such as the Gold ETFs. At one point in August, the main US listed Gold ETF became the largest ETF in the world (worth over $US75 billion).

As this interest in direct gold exposures helps support the gold price it attracts more investor interest. Meanwhile, in comparison, gold shares have languished as investors seek to avoid ‘equity risk’, which further justifies investors’ decisions to seek direct exposure.

Another factor may be the distorted way the investment community analyses and presents gold mining stocks as investments. In many cases, analysts don’t seem to fully recognise the reality of the gold bull market and are seemingly using inputs from a different era.

For example, in a report on gold stocks issued in July this year, Citigroup used a long-term gold forecast of $US950.

In August, this was revised upwards to $US1,050. The gold price was around $US1,500 at the time of the initial report and around $US1,800 at the revision.

It begs the question: why don’t the analysts simply use the current spot price or the forward price curve as inputs into their models and then also provide an upside and downside case around that?

The standard broking practice of starting with the spot price but using gradually lower prices over the next few years and then a significantly lower long-term gold price – with little, if any, sensible justification for such prices – makes their analysis of the fair value for the shares largely meaningless.

Of course, good investors can use their own numbers and markets ultimately see through such analysis to where real value lies.

Some gold mining companies are also seeking to generate more investor interest through better capital management and higher dividends.

In the case of US gold miner Newmont, these dividends have even been explicitly linked to the gold price. As dividends rise due to current high profit margins, gold mining stocks have a key differentiator from the Gold ETFs. Lack of income has always been the big criticism of gold as an investment.

Many will argue that gold stocks are more volatile and don’t have the same low correlation and portfolio diversification benefits of gold itself, but such an assessment is backward looking and perhaps out of date.

It is interesting to note that in the recent sharp movements up and down in August, the gold stock indices were generally less volatile than the gold price itself.

Arguably, the valuation gap suggests that gold mining stocks could handle some significant weakness in the gold price without similar falls in stock prices.

In any case, the days of low volatility for gold itself are likely over. While the final phase of the gold bull market can keep going for some time, it is likely to be an increasingly wild ride for both bullion and gold shares.

The role of gold in a portfolio has been dramatically vindicated in recent months.

However, its ongoing bull market is a worrying sign for the global economy, and a clear demonstration of the lack of faith in the world’s politicians and policy bureaucrats.

The world faces some major problems, with no easy fixes and some readjustments in the global monetary system necessary. Despite the heady rise of late, some diversification into gold continues to make sense.

In the current challenging environment, investors should be comforted that there is still an attractive, discounted way to get exposure to gold via gold stocks.

If, as I expect, the next phase of this bull market includes a dramatic chase for quality (and non-quality) gold mining stocks, achieving sensible gold exposure from an investment perspective is going to become much harder in the future.

Ironically, that will be a time when it has become increasingly mainstream and widely accepted to include some gold bullion and gold equity exposures in portfolios. When such sentiment and complacency start to rule, it will be the truly dangerous time to own gold exposure. That time is getting closer.

Dominic McCormick is the chief investment officer at Select Asset Management.