Why gold still makes sense for long-term investors
Dominic McCormick argues gold exposure in a diversified portfolio still makes very good sense for most long-term focused investors.
The case for including gold in portfolios is being questioned and challenged, perhaps more strongly than at any time in its 12-year bull market.
Since late 2011 the gold price has been on a rollercoaster ride, peaking at over $US1900 in September 2011 before trading in a large range in the 18 months since, with lows around $US1500 and trading around $US1580 at the time of writing.
Gold stocks have fared worse, having fallen twice as much as gold - or more than 35 per cent - since the gold peak in September 2011.
Cost blowouts, low grades, production shortfalls and limited exploration success have all combined to accentuate the lower gold price.
A view that some miners are focused on empire building and not shareholder returns has also been a factor.
Despite this recent weakness we should not forget that gold is still up more than 500 per cent since the beginning of the bull market in 2000.
Given the speed that gold went from $US1500 to $US1900 in 2011, it is no surprise that a serious consolidation has occurred.
Even the gold stocks are still up around six to seven times since their 2001 bear market lows, although the best of those returns occurred in the first half of the bull market so far.
Finally, what is forgotten is how well gold is doing recently in some weakening currencies, particularly the Japanese Yen, Euro and British Pound.
Now, however, an increasing number of investment participants and finance media are arguing that the gold bull market is over.
For example, in the Wealth section of The Australian on March 9-10 there was an article ‘Confident Investors Dump Gold - Bullion’s run could be over as investors take stock’.
Numerous other articles have been along the same lines. Of course gold has always had its critics, but the negative case has become much more widespread early in 2013.
Investment banks and brokers such as Nomura, Citigroup, Macquarie, Societe Generale and Goldman Sachs have all recently downgraded their gold forecasts and most are suggesting gold’s bull market is over.
UBS has been a lone dissenter suggesting a strong rally this year.
The irony is that through most of the gold bull market up to 2011, most investment banks/brokers had near-term gold price estimates well below the current spot price and consistently failed to anticipate gold’s ongoing strength.
It was only in late 2011 as the price spiked, and during early 2012, that they finally became much more optimistic, lifting forecasts above the spot rate and projecting gold to go over $2000.
Now they are revising down near- and long-term forecasts to well below the current spot price. (Note that their longer-term forecasts have typically always suggested lower prices).
Any wonder why investors are so sceptical of investment bank recommendations.
In my view, most investment bank and broker reports on gold seem to simply reflect and justify the recent momentum in the gold price, and then build short-term fundamental stories around this to support this view.
This is not surprising when they are catering to clients who themselves often have a short term view and forget new recommendations quickly.
The key question remains though - is the bull market over for gold? I doubt it. As discussed below, the key longer term fundamental drivers of the gold bull market remain firmly in place.
Many of the bearish views are focusing on short-term factors and downplaying these true major long-term drivers to the gold story.
Clearly, the gold price move became a little frothy in 2011 - and we reduced our gold bullion exposure at this time - but a strong case can be made that the ongoing consolidation since is healthy and setting up the base for new highs in coming years.
Instead, many commentators have jumped on the inability of gold to quickly revisit this high in the last 18 months as the primary evidence the 12-year bull market is over.
Meanwhile, the increasingly pessimistic outlook has seen gold, and particularly gold stocks, moving from short-term, weak holders (only recently coaxed into gold by the investment banks’ enthusiastic 2011 and 2012 views), towards stronger, longer-term holders, focusing on the true major longer-term drivers.
Further, the level of short positions held by momentum traders has increased dramatically, but these will be quick to reverse when the trend changes.
Indeed, I believe that the next phase of the gold bull market could be quite explosive, particularly for the gold mining stocks that have recently been pushed to depressed levels.
The positive view
Below are some reasons to maintain a positive view and a reasonable gold exposure in portfolios:
- Short-term interest rates in major developing countries are likely to stay close to zero (and negative in real terms) for some years yet. Historically gold does very well in such environments, as the opportunity cost of holding gold is reduced.
- The central banks of major developed countries continue to implement extreme monetary measures through quantitative easing (ie, printing money) to buy mainly debt securities. This is unlikely to end soon and, even when it does, reducing bloated central bank balance sheets will represent a major policy challenge.
- In fact, exiting this extreme monetary policy will be very difficult without inflation taking off at some point and/or a recession being created by sharply higher rates (which could likely quickly halt that process and necessitate continued extreme measures).
- Fiscal woes are set to continue contributing to high and rising debt to GDP levels in a slow-growth, debt-burdened, world. There are no easy paths to escape this and confidence in politicians to remedy the situation is likely to remain low.
- Currency wars are accelerating, with a falling currency seen as one way to spur growth in a low-growth world, although this can’t work for everyone. More extreme currency volatility is likely, highlighting the flaws in today’s unbalanced and unstable global financial system and benefiting gold as the only currency that cannot be debased.
- The developed market central banks, whose economies are better placed and with growing foreign reserves, recognise these problems and see gold as part of the solution and continue to accumulate. Overall, central banks have been net buyers of gold for the last three years, but that is after 20 years of net selling. This trend has probably only just started.
A haven during market volatility
Therefore, for the next few years I can envisage an environment of declining confidence in, and increased volatility of, major currencies along with increasing inflation risks in some countries.
These factors continue to support gold as an alternative currency/diversifier while the world slowly works through these issues.
I also see some smaller possibility of a more formal restructuring of the global financial system where gold once again resumes a more central role if the current highly indebted and unstable structure continues to inhibit a proper global recovery.
The former is likely to see a gradually rising gold price with new highs, albeit with continued volatility, while the latter could at some point see an abrupt step change upwards (ie, it is likely that only at significantly higher prices could the current official world stock of around 36000 tonnes be able to provide that formal role in the monetary system).
Of course, as a believer in the case for gold through its 12 year bull market – albeit with varying degrees of enthusiasm – one would expect me to be arguing the case for gold here.
However, I’m willing to be somewhat more definitive on gold mining stocks.
I believe that gold mining stocks in particular currently offer the best buying opportunities since the end of the last gold bear market in 1999 through 2001 and are one of the best contrarian investment ideas around today, particularly after a strong recent run up in many other markets.
Indeed, finding good contrarian investment ideas in current markets has recently become very difficult following the big move up, more expensive valuations, and dramatic improvement in sentiment.
Indeed, gold mining stocks, are in my, mind one of the few investment themes that currently tick the boxes on three key requirements we are looking for in attractive investment opportunities, ie;
- An attractive medium to long term fundamental/environment backdrop,
- Attractive valuations (versus gold itself and versus the market generally), and
- Extremely negative sentiment and investor positioning which provides the fuel for strong upward moves.
The turnaround underway?
Meanwhile, there are signs that some of the specific negatives that have hampered gold miners in recent years are slowly turning around.
Labour and other cost pressures may have peaked as the mining boom slows, and boards and management are becoming more discerning over capital investments and more focused on returning value to shareholders via dividends, buybacks and the like.
The next few years will prove or disprove this outlook, but in my view now is not the time to give up on the gold or gold miner story. Indeed, their poor performance and negative correlation with mainstream equities recently suggests that strong performance in a period when equities do badly is a strong possibility.
This could make them a valuable portfolio contributor and diversifier in a world where most traditional assets are currently priced for either subdued or poor future long-term returns.
Of course, buying into severe weakness in an investment theme or asset class is a challenging, sometimes sickening, experience.
Picking the bottom is impossible and more pain cannot be ruled out, which would weigh further on short-term absolute and relative portfolio performance at a time when investors are once again chasing rising but increasingly vulnerable equity markets.
While the gold bears have focused on shorter-term factors (poor recent momentum, increased stability in Europe, signs of improving US growth,) they are neglecting the much more important factors listed above that will drive gold in the longer term.
When one thinks about the dramatic impact these risks can have on portfolios, it is vital to seek out investments that have a chance of hedging/prospering in such challenging environments.
While none of these come with any guarantees, I think gold exposure is certainly one that still deserves some role in most portfolios.
Perhaps you think the above problems are overplayed. Maybe the US recovery will accelerate to a sustained higher level, assisting global growth and gradually solving its own and the world’s fiscal/sovereign debt issues. Maybe US politicians will soon get serious about long-term fiscal reform.
Maybe the risks of higher inflation in the long term are exaggerated.
Maybe the Federal Reserve will be able to soon raise rates to more normal levels, providing real returns and also selling several trillion dollars worth of assets without any significant disruption to the US economy.
Maybe the currency wars fizzle out as global growth improves.
Maybe developing country central banks will regain confidence in holding more of the major currencies and their bonds.
If you are highly confident that this is the way things will develop over the next few years then, yes, gold will likely be a poor investment, although it may still make sense to hold a small exposure as a hedge if you are wrong.
However, the success or failure of incorporating gold in portfolios should only be properly judged over the long term, and looking back from when the world is much closer to the point of resolution of these many ongoing problems emanating from the global financial crisis.
Even the gold bears would have to admit that we are still a minimum of several years away from that point.
It is in this context that I find most of the investment bank/broker reports and views on gold so naively short term, excessively momentum-based, arrogantly definitive and ultimately useless to the average long-term investor.
Doing the opposite of their consensus view through the gold bull market would have been a better bet to date.
The danger is long-term investors are now being encouraged to take too short-term a view, and are at risk of exiting their gold investments at the worst possible time, only to add to traditional equities at increasingly expensive levels.
Isn’t this just another example of investors chasing recent short-term performance?
While the perception of short-term risk in traditional equities is currently low, the reality is longer-term risks are high and growing. In a range of scenarios, gold could be one of the few winners if those risks play out.
A modest gold exposure in a diversified portfolio therefore still makes very good sense in most long-term focused portfolios.
Dominic McCormick is the chief investment officer and chief financial officer of Select Asset Management.
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