Observer: Does gold make good investment sense?

If you talk positively about gold as an investment, most people look at you strangely.

In an adviser presentation in October last year, covering the asset sectors that one might include in an absolute return focused portfolio, I was asked to exclude reference to the gold sector because it might scare advisers.

At a recent conference, one of Australia’s best stock pickers was asked for his ‘best idea’ for a five per cent weighting in an investment portfolio. He said gold stocks. The audience laughed.

Of course, these anecdotes are all indications of a great contrarian investment opportunity. Value is usually found where most investors refuse to tread. When many are denigrating a certain investment area, there is a good chance that it is poised to deliver sound returns going forward.

How can gold and gold stocks be a good contrarian investment when they were among the best performing investment areas in 2001 and 2002?

The answer lies in recognising that contrarian investing involves more than simply being willing to buy what’s done badly recently and sell what has done well.

While this is often a good starting point, two other elements are relevant in identifying a good contrary investment opportunity strategy, even before fully considering the investment fundamentals:

(1) The timeframe being considered; and

(2) The extent to which the investment has been embraced by the investing public.

In regard to (1), it is worthwhile noting that while gold has risen strongly in the last two years, it is coming out of a 20 year bear market. Gold peaked at more than US$850 in 1980. It was about US$250 in 2001. Today it is about US$368 — an increase of almost 50 per cent.

Gold shares experienced a number of mini bull markets in the 1980s but were largely neglected throughout the 1990s. In this context, the two-year bull market in gold and gold shares could still be seen as very immature.

Further, in relation to (2), a contrarian opportunity is largely defined by how many people are currently participating in the trend. The aim is to buy before the crowd has bought and sell when the crowd has jumped on board and become true believers. Very few investors have participated in gold investments, despite the extremely good returns over the last two years. Indeed, there is enormous scepticism present.

Gold stocks represent just 0.5 per cent of the Australian share market. The last unlisted gold fund in Australia was actually closed in 2001 — in the late 1980s there were around a dozen funds available. Even in the US, where there are more funds, inflows have been relatively poor.

Bull markets by nature climb a wall of worry. If most people were not sceptical, the reserve of potential buyers to take gold prices to higher levels would not exist. However, investors cannot expect an easy ride. Early phases of major bull markets are characterised by dramatic and sometimes terrifying corrections that scare off many investors. This has definitely been the case with gold and gold stocks during the last two years.

So what is the fundamental investment case for gold?

Gold is first and foremost money. While one of the major criticisms of gold is that it does not pay interest, one should recognise that paper money doesn’t pay interest either. Only once money is exchanged for a loan (such as a bank deposit) does it earn interest, in which case it ceases to be money.

The last three decades is the first period in the last few thousand years where no world currency has been explicitly linked to gold. Demonetisation of gold seems to have been a key objective of central banks and the ascendancy of the US dollar as the world’s reserve currency was seen as a sign of success in meeting this objective.

However, all paper currencies are essentially a confidence trick. Paper currency is almost costless for a central bank to produce, yet it is worth much more in terms of goods and services while people have faith in the government issuing it.

When economies are well managed, governments do not print excessive money and there are few major economic imbalances, thus there is little need for hard money such as gold. Over such periods, gold has tended to be a poor investment.

However, there has been no paper currency throughout history that has avoided being dramatically debased over time. Gold cannot be debased in this way, because unlike paper currencies or other paper assets, it is no one else’s liability.

A key consideration today is that confidence in the US dollar is fading. The US money supply has expanded dramatically in the last three decades and while this did not generally translate into price inflation, it did find its way into the prices of assets such as stock and property markets.

The share market boom has burst and the property market is showing signs it has peaked. The US has a massive and growing trade deficit and relies on significant inflows from overseas. The country has also recently embarked on more interventionist and aggressive foreign policy, with likely detrimental impacts on an already burgeoning deficit. The expense of waging war has been a key factor in the debasement of currencies in the past.

In addition, while gold does not pay interest, we have now reached the point where US short-term interest rates are less than inflation. With low interest rates worldwide, the opportunity costs of holding gold versus short-term deposits is minimal. While all the talk is about deflation, central banks have already indicated they are willing to effectively print money in an effort to stave off deflation and promote growth. The line between deflation and inflation is much thinner than people think. Gold can be a good hedge in either environment.

Some may say that gold is not needed because investors can just switch to other currencies. In practice, however, the only candidates for an alternative ‘reserve currency’ — the Euro and the Japanese Yen — have problems of their own. The Euro has only been around a few years and the Japanese economy is lumbered with internal debt. I expect that the next leg of the gold bull market will see it rise in value against all currencies, rather than just the US dollar.

Yearly global production at around 2,500 tonnes would fit into the average person’s lounge room — all the gold ever produced throughout history is only around 145,000 tonnes. Annual gold demand at about 3,500 tonnes exceeds production, with some of the shortfall provided by dis-hoarding while the balance is provided by central bank sales.

Central banks hold around 33,000 tonnes. Some countries have sold significant parts of their gold reserves in recent years (including Australia, Canada and the UK) but interestingly, the US has not sold any, and Asia (especially China) has begun buying aggressively.

One must question whether central banks will keep selling if the price continues to rise and if confidence in paper currencies fades further?

In addition, as much as one-third of the central banks’ holding is believed to have been leased or loaned out, with the central banks receiving about 0.5 per cent to one per cent per annum for doing so. This gold has typically been borrowed by mining companies or investment banks and their clients, sold forward and the proceeds then invested at higher interest rates.

In the case of mining companies, the proceeds of forward sales are typically used to finance the development of mines.

While gold miners who sell forward have a natural hedge with the gold they have in the ground, the degree to which the investment banks and other market participants have hedged their exposure against a rising gold price is unclear. However, with gold miners reducing their hedging activity, the potential unwinding of mining and other sold short positions could help propel the gold price higher in coming years.

No one knows the future with precision, but there is a strong case that gold is experiencing a major multi-year bull market that may have much further to go, despite significant corrections along the way.

The low correlation of gold with other investments means that it may deserve a role in portfolios, even if one is agnostic on the price outlook.

There are times when the global economic and investment environment is such that investors could feel comfortable without carrying any ‘gold insurance’. In my view, now is not one of those times.

As to how investors should get some exposure to gold — that’s a topic for a future article.