Gold: In a class of its own

Gold has been one of the few areas to shine in the chaos of the global financial crisis. It closed 2008 at US$870 and has since briefly moved above US$1,000 before retreating. It has closed every year since 2001 at a higher level in US dollar terms.

The weakness of the Australian dollar in late 2008 and early 2009 saw gold hit record levels of around $1,500. The local gold bullion ETF was the third best performing security on the ASX in 2008, up 29 per cent.

Gold mining stocks struggled for much of 2008 after being caught up in the rush for liquidity but have since staged a dramatic recovery and now more than doubled from their October lows (as measured by the US based HUI index).

Further, over the longer-term bull market in gold since 2000, and despite a very volatile ride, gold stocks as measured by this index have risen in value more than six times compared to an overall US share market that until recently had halved over the same period.

This recent and longer-term performance has done much to demonstrate that gold is not just another commodity and that it deserves a role in investment portfolios, if only as a hedge and diversifier.

In my view, this means one can justify an allocation to gold even if one is sceptical that the bull market will continue.

One approach is to simply put around 5 per cent gold exposure in a portfolio as a hedge and hope that it doesn’t perform well. This is because in an environment where gold does particularly poorly, most of the other assets in a well diversified portfolio should actually perform strongly in the longer term, particularly from today’s (cheaper) levels.

Those who believe that the gold bull market is currently well underpinned by some key drivers may look to a larger weighting as both a hedge and a key source of returns.

Indeed, it seems clear that the global financial crisis is enhancing the major factors driving gold: increased risk aversion; very low nominal and real interest rates; fading confidence in the reserve currency and fiat money generally; and enormous fiscal and monetary stimuli around the world. These drivers are unlikely to fade in the near term.

The ‘wall of worry’ that keeps a gold bull market healthy is evidenced by the plethora of sceptical commentators and investors. Whenever gold rises, there are always a number of articles and comments questioning the sustainability of gold’s uptrend and its outlook.

Indeed, many respected commentators are saying they do not quite “get” gold.

In my view, they are trying to “get” the wrong thing. For gold’s value is derived not so much from its inherent unique characteristics but primarily from the level of confidence (or lack thereof) in the fiat (or paper) monetary system. Gold is an alternative to paper money, even though conventional wisdom is that it officially lost that role in 1971 when the US cut the gold peg to the US dollar.

Only after trying to “get” paper money can the value and role of gold be properly appreciated.

Specifically, only when you understand the fickleness and fragility of the paper money system (particularly today) do you understand the need to consider alternative stores of value and alternative money.

Partly by luck and partly through its unique features (rarity, portability and so on), gold, and to a lesser extent silver, has been the beneficiary of this concern throughout history and particularly during times of major financial instability such as we are experiencing now.

Indeed, the surprise is not that people value a certain shiny metal as money and a store of wealth, but rather that they do not even stop to think to question the value of the paper currencies that can be pumped out at will with near zero cost.

Think about it, major governments worldwide are currently in the process of creating money out of thin air through the process of their central banks buying newly issued bonds from treasury and simply crediting treasury with the proceeds (so-called quantitative easing).

Most investors seem to welcome this process and expect those increased paper dollars in circulation to retain the same value despite the obvious debasement occurring.

Meanwhile, most people also remain hugely sceptical of the value of gold — something that is in limited supply, has been highly valued and used as money and a store of value for thousands of years and outlived every paper currency ever issued in that role.

As Jim Grant, editor of Grants Interest Rate Observer, stated in a recent issue: “It enflames them (economists) to consider that gold, by its nature, is money. Nobody has to tell you that. The human race takes to it without instruction, as it does to water and wine.”

Of course, even accepting this role provides little guidance as to what is an appropriate price for gold in terms of these paper currencies.

Given the gold price is determined primarily by its speculative or investment demand, it is extremely difficult if not impossible to model what the price should be or where it is heading.

Perhaps the more appropriate question is not where the gold price is going but how much paper currencies will fall in terms of gold.

In a country suffering hyperinflation, almost any gold price is worth paying if your currency is on the way to being worthless.

Could the US experience hyperinflation and a near total loss of confidence in its currency and a rush for alternatives like gold?

Currencies and even reserve currencies can lose their status gradually over decades or rapidly within a few years or even months. If history is any guide, this latter scenario, while seemingly improbable, cannot be ruled out.

Certainly, gold is beginning to attract the interest of some of the smartest investors around.

John Paulson, the hedge fund manager who made a fortune shorting sub-prime debt, recently took an 11 per cent stake in South African gold miner AngloGold.

David Einhorn of Greenlight Capital and other prominent hedge fund managers have recently been buying exchange-traded funds (ETFs) holding gold and gold miners.

Even a number of quality traditional equity managers have been adding gold exposure to their portfolios, often for the first time in their careers.

Of course, there are still plenty of sceptics in the mainstream investment industry — a healthy sign.

In Money Management (February 12, 2009), a major Australian fund manager was quoted as saying that it was “ironic that it’s the prophets of doom on the economy who are investing in gold and exacerbating the market problem”. He added: “I don’t think that everyone investing in gold or hiding cash under the bed is likely to be a solution to our current economic woes.” Talk about shooting the messenger!

Gold’s rise is a symptom of investors losing confidence in a financial system that is displaying some major flaws and the results of extended abuse by many participants. Gold is simply a barometer of trust in that system.

Given the excessive build-up of debt, the enormous greed on display, the conflicts, frauds and failed regulatory responses, is it any surprise that investors are looking for an alternative store of value? Should investors just ignore all this and pretend it is not happening?

Meanwhile, governments are getting desperate and implementing unprecedented measures to resurrect failed financial institutions and stimulate economies.

The consequences of such actions in the medium and long term are very uncertain.

Investors need some hedges against this uncertainty and likely ongoing financial instability (including, but not necessarily, limited to inflation).

Grants Interest Rate Observer presents analysis that suggests the current fiscal and monetary stimulus is as much as 12 times that which occurred in the Great Depression. Who knows how these impacts will play out? The odds favour gold being a beneficiary.

But is it too late? It is a natural tendency to worry about jumping onto an entrenched trend too late. At first glance, gold feels like that. It has come a long way from US$250 in 2000.

There is certainly a lot more talk about gold today. But that is the point — much of it is just talk and much of that is still sceptical.

It is also true that the ETFs have grown in size dramatically in recent times. But in the context of money available, these amounts are still small.

For example, there is currently around 1,100 tonnes of gold held by the US gold ETF. This is currently worth around US$31 billion — a big number, but it is worth noting that this is less than 0.8 per cent of the US$4 trillion in US money market funds and just 0.3 per cent of the almost US$10 trillion in total mutual fund assets.

Note that most of these money market accounts are paying near zero interest and that investors are not exactly happy with most of their mutual funds either.

Most conventional equity funds have little if any exposure to gold stocks, and inflows into gold equity funds worldwide have been relatively subdued.

There is still massive scope for ordinary investors and savers to allocate more to gold (and gold stocks), which could drive prices significantly higher. This all suggests that the bull market may have some way to go.

While gold is perceived by many as high risk on a stand-alone basis, the risks of having some gold as a hedge in a diversified portfolio now are low, not just because of gold’s drivers but also because of the level other assets are currently valued.

The environment where gold performs very poorly is one where the current problems facing the world dissipate quickly, in which case the rest of your portfolio will probably do well, especially with today’s lower valuations.

Should investors invest in gold itself (via the gold ETF, bullion or coins) or gold shares (directly or via a fund)?

In my view, investors should have exposure to both, with the amount allocated to gold mining shares dependent on how aggressive they are as an investor.

In the first three to four years of the gold bull market, gold shares dramatically outperformed gold bullion. In the period 2005 to 2008, gold mining shares generally lagged the gold price significantly as did specialist gold equity funds investing in these companies.

Since late 2008 it seems we have moved into another phase where gold shares are outperforming. Such outperformance in the latter part of a bull market makes sense as investors and speculators look for more leveraged ways to invest in the gold story.

Gold is not just a short-term fad in a financial world arguably facing its biggest challenges ever.

While the gold bull market has been in place for eight years, it is only now that the reasons for major concerns about the financial system are becoming obvious. But the roots of these issues — dramatic growth of debt, excessive money supply growth, poor regulation, and so on — have been in place for several decades.

Was it inevitable that gold would be a beneficiary of such developments? Well, to the extent that politicians and societies will always choose to debase paper currencies over time and as a short-term solution to long-term problems, it was.

As I write this, gold and gold stocks are experiencing yet another correction as stocks and other hard-hit assets enjoy a long overdue and substantial rally.

For equities it remains to be seen whether this is the beginning of a new bull market or just a bear market rally. Meanwhile, some newer entrants to the gold story will be shaken out by these sharp corrections.

However, the key long-term drivers to the gold bull market remain intact and they may even be enhanced when an economic recovery eventually arrives given the likely inflationary implications of such a recovery, as a result of the extreme levels of monetary and fiscal stimulus and the delayed supply response given the credit crunch.

Of course, the bull market in gold will come to an end at some point. However, I suspect this is some way off (probably years).

We have not yet seen the broad public participation and excitement indicative of a very mature bull market, although the broadening use of the gold ETFs suggests this phase is starting.

Not all bull markets end as a speculative bubble, but it is those that, like gold, have taken many years to develop, climbing a sceptical wall of worry and only gradually attracting more and more participants, that normally do end that way.