All that glistens could be gold

It’s been more than 18 months since I last wrote about gold. (“Gold — Volatile times ahead”, MM, March 2, 2006).

In it I suggested gold was still reasonably early in a bull market, but that it would not be a one-way street.

Since then gold has indeed been highly volatile, with the price spiking from below US$585 to US$750 two months later in May 2006, then falling to as low as US$550 in June 2006 before rising steadily to recent highs just under US$850 and coming off recently to below US$800.

Now, one always has to be careful about talking too positively about any market that has done so well recently, but the action in the gold market and the state of the underlying drivers continue to suggest we are in a major bull market that probably has some time left to run.

Of course, even if this proves to be the case, there is likely to be significant volatility and some serious corrections along the way (and we could well be in one now).

However, we should remember that while gold recently came close to the US$850 level it peaked at almost 28 years ago, in inflation-adjusted terms that peak is equivalent to well over US$2,200 today.

Further, in contrast to both the blow-off in 1980 and even last year’s spike of US$750, the recent rise in gold has been reasonably orderly, suggesting the major trend is well supported.

Indeed, in many respects, the current environment is almost ideal for gold. We are seeing a continued erosion of confidence in the US dollar, which has been the cornerstone of the world financial system since (and even before) a formal link to gold was cut in 1971.

The US is at risk of recession, leading to lower real interest rates, which makes the opportunity cost of holding gold minimal.

Despite this, inflationary pressures remain, with strong global growth (and the weak US dollar) keeping pressure on commodity prices, especially oil.

The sub-prime/collateralised debt obligation (CDO) problems have caused considerable damage to the foreign appetite for US dollar-based assets in general.

Meanwhile, the US continues to run record trade and budget deficits, with the enormous costs of its military exploits overseas unlikely to fall anytime soon.

Broader geopolitical instability is another factor providing support, although such support is often short lived.

However, none of these factors supporting gold’s major uptrend are likely to change significantly in the medium term, despite gyrations in the shorter term.

Of course, the vast majority of people don’t quite get gold or its role in an investment portfolio.

Gold is not hard to understand, but to properly understand its value you have to look beyond gold itself to the system of money the world depends upon.

What makes gold valuable is its role as ‘hard money’ and a store of value in a world of changing confidence and purchasing power in paper money.

It is surprising that many can be so critical of gold (‘it doesn’t pay interest, it just sits there,’ and so on) while showing almost unquestioning confidence in a system of paper money that is extremely vulnerable to debasement and that actually has a very poor historical record.

For example, the US dollar has lost more than 95 per cent of its purchasing power in the past 100 years, and it is actually seen as one of the successes of the paper money system. Let’s not talk about some of the ‘failures’, such as the German mark in the 1920s or the Zimbabwean dollar in recent years.

But participating in this gold bull market has not been without issues.

To the extent that the gold bull market to date has been heavily driven by a weak US dollar, its rise in other currencies (including the Australian dollar) has been more muted.

More recently, however, the gold price has been moving higher, even in some of the world’s strongest currencies, and some see this as an indication we are moving into a more mature stage of the gold bull market.

Furthermore, gold mining stocks (and the funds that invest in them), which historically have been the main way that many investors participate in the gold market, have sometimes lagged the precious metal despite the inherent leverage they offer.

In recent years, gold mining companies have been particularly impacted by rising costs (especially labour and energy) and the legacy issue that many miners tended to hedge a large part of their production.

This latter issue has been largely eliminated more recently, as most major miners have bought back these hedges.

In addition, easily accessible gold deposits globally are in short supply. In most major producing countries, such as South Africa, Australia and the US, gold production has actually fallen in recent years.

Still, gold stocks are up more than seven times since the late 1990s, and well-run operations with good reserves are still likely to do well under current gold prices, and probably exceptionally well if gold prices keep moving up.

Still, many might ask why they need specific gold exposure. Don’t they achieve exposure through their resources exposure or even shares more generally?

The problem is that gold stocks are a miniscule part of the global index, and a conventional portfolio’s exposure to gold on a ‘look through basis’ is insignificant.

Gold is too distinctive and important as a diversifier to just be lumped with resources or other commodities.

Gold’s monetary element makes it different from other commodities. It is easy to envisage scenarios where commodities generally do poorly while gold is positive (such as a significant global slowdown accompanied by monetary instability).

There has also been the growth of exchange-traded funds (ETF), which offer an easy way for investors to get exposure to gold bullion. This has created a whole new source of investment demand for gold.

Meanwhile, there is a range of new official buyers, as the fast growing emerging economies accumulate large foreign currency reserves (especially US dollars) and look to diversify.

Will gold ever resume a more formal role in the international monetary system? A few years ago anyone who suggested this would have been laughed at.

Today, such suggestions are taken more seriously, as some of the challenges facing the current global monetary/currency system are being highlighted.

I don’t believe such a development is necessary to make gold-related exposure a good investment in the next few years, but the changing sentiment towards such major questions is increasing gold’s profile as a hedge and portfolio diversifier.

The US sub-prime/ CDO crisis has highlighted the risks of investing in complex financial instruments that rely on the promises of others.

Gold doesn’t promise anything except to be gold. It doesn’t even promise to be valuable, but the fact that it has been for thousands of years (while most paper currencies have depreciated markedly) provides some confidence that people return to it in times of instability.

US newsletter writer Jim Grant calls gold the “anti-structured asset”.

The current bull market in gold will end at some point; however, the odds suggest this is still some time off.

Of course, there will be volatility and some severe corrections along the way, but such corrections, while often scary, will help to ensure that gold doesn’t develop into a bubble, at least not yet.

US ‘contrarian’ analyst Mark Hulbert recently wrote that gold timing newsletters remain cautious despite the strong rise recently, a healthy sign that gold continues to “climb a wall of worry”.

If even the long-term gold bulls are cautious here, there is still likely to be plenty of potential gold buyers yet to step up to the plate and keep the uptrend going in the medium term.

We will be close to a top in the gold bull market when it becomes widely accepted and promoted as normal to include gold exposure as a standalone investment in portfolios. I think we are still a number of years away from this.

It is true that you are no longer looked upon as ‘out there’ if you recommend gold exposure, but it is still far from normal dinner party conversation. It is likely to become so before this bull market is over.

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