Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.
- Warren Buffett

The reasons why one should sell the cat, pawn the mother-in-law, and use the proceeds to buy gold are well known: the Fed is printing money faster than you can read this, which will result in inflation; the government is borrowing like a drunken monkey, so the dollar will be devalued; this will debase all currencies, so the only thing that will save you is the shiny metal.

However, here are some arguments why one should think twice before jumping in bed with gold bugs, or at least remain sober while determining gold’s weight in the portfolio . 

1. For investors (not speculators) it is very hard to own gold, because you cannot attach a logical value to it. Unlike stocks or bonds, gold has no cash flow and has a negative cost of carry  – it costs you money to hold it.  It is only worth what people perceive it to be worth right now.  The argument I commonly hear is, “What about all those Enrons, Lehmans, Citigroups, etc. that either went bankrupt or got near it?  What was the value of those?”  If the lesson learned is not to own stocks but to own gold, it is the wrong lesson.  The lesson should be: own companies you can analyze (the aforementioned companies were unanalyzable) and diversify – don’t put your all net worth into one stock. 
2. The gold ETF SPDR Gold Shares (GLD) is the seventh largest holder of physical gold in the world.  If its holders decide to sell (or are forced to sell; think of hedge-fund liquidations), who will they sell it to?  This is extremely important, as the presence of GLD changes the dynamics of the gold price, both to the upside and downside.  If gold keeps climbing, the ease of buying will drive gold prices higher than in GLD’s absence.  In the event of a significant sell-off, there are not enough natural buyers of physical gold. It is a bit like a roach motel – easy to get in, hard to get out.
3. In the past, gold had a monopoly on the inflation and fear trade. Not anymore.  Now you have competition from Treasury Inflation-Protected Securities (TIPS), currency ETFs, short US Treasury ETFs, government guaranteed/insured FDIC checking accounts, etc.  TIPS suffer from the flaw of the CPI being measured and reported by the US government, which has an inherent bias to understate inflation; returns of commodity ETFs are skewed by price differentials between financial derivatives and spot prices of underlying commodities; returns of leveraged ETFs diverge significantly over the intermediate and long run from the underlying index; FDIC reserves are being depleted with the every-Friday-night bank bailout (but believe you me, the US government will not let FDIC go bankrupt, even if it means it has to raise taxes and impose draconian fees on the banking sector).   

   The bottom line here is this: none of these investment vehicles are perfect, in fact many have significant flaws; but despite their flaws they attract money away from gold, thus undermining gold’s monopoly on the fear/inflation/currency debasement trade.  (I’ve discussed it in greater detail in my book).

4. If, because of points 2 or 3 above, gold fails to perform as expected, the perception  of what gold is worth may change dramatically. 
5. Inflation is a possible but not a guaranteed outcome of what is taking place in the economy today.  Deflation or a muddle-through economy with very low nominal growth are possible and probable outcomes.  We are seeing signs that point away from inflation: the money supply declined at a 12% annualized rate over the past four weeks, according to David Rosenberg of Gluskin Sheff.  

   Though gold bugs argue that gold will perform well in either an inflationary or deflationary scenario, history doesn’t support that conclusion. Gold has done well in inflationary environments but not during deflation or low nominal economic growth.  In the 1970s, when inflation in the US was raging, gold performed better than any other asset class (though remember, at the time gold had no competition in the inflation trade, no TIPS, or ETFs that long other commodities, short US Treasuries etc..).  However, one had to know exactly when to get on and off the gold bus.  If gold was bought after considerable appreciation, that investment/speculation resulted in losses.  Gold has more than doubled in price since 2005, but has it already priced in future inflation?  I have no idea; you cannot value it.

Though gold bugs make it sound as such, gold is not the only and not the best alternative if the worst fears come to pass.  The best way to deal with the risks of dollar devaluation and high inflation – with a much lower cost to being wrong – is, instead, to own stocks of companies that have pricing power of their product. When inflation hits, they will be able to raise prices and thus maintain their profitability.  Also, companies that generate a large portion of their sales from outside the US will benefit from the declining dollar. 

Gold bugs look at gold as a currency, but it is not one and unlikely to be one in our lifetime. Here is why: there is not enough of it around, so even if world government were to adopt a fractional system (currency in circulation as a multiple of gold reserves), they will never go for it, because central banks and governments will never give up their monetary tools – inflation is a very addictive tool to fight growing monetary obligations.  

There is a wild card in the price of gold, though: China (John Burbank made that argument at the Value Investor Congress in Pasadena). If it decides to switch partially from owning US Treasuries to owning gold, the price of gold will skyrocket.

Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo.  He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).  To receive Vitaliy’s future articles my email, click here.

To receive Vitaliy’s future articles my email, click here.

 The arguments for why one should sell the cat, pawn the mother-in-law and use the proceeds to buy gold are well known: The Fed is printing money faster than you can read this, which will result in inflation; the government is borrowing like a drunken monkey, so the dollar will be devalued; this will debase all currencies, so the only thing that will save you is the shiny metal.   However, here are some arguments why one should think twice before jumping in bed with gold bugs. 

1. For investors (not speculators) it is very hard to own gold because you cannot attach a logical value to it. Unlike stocks or bonds, gold has no cash flow and has a negative cost of carry — it costs you money to hold it.  It is only worth what people perceive it to be worth right now.

2. The gold ETF SPDR Gold Shares (GLD) is the sixth largest holder of physical gold in the world.  If its holders decide to sell (or are forced to sell; think of hedge-fund liquidations), who will they sell it to? 

3.   In the past, gold had a monopoly on the inflation and fear trade. Not anymore.  Now you have competition from Treasury Inflation Protected Securities (TIPS), currency ETFs, short US treasury ETFs, etc.  (If you want to know more, I make this case in my book)

4.  If, because of points two or three above, gold fails to perform as expected, the perception that gold is worth something may start disappearing. 

5. Over the last 200 years, gold was really not a good investment. It may have a day in the sun, but it may not.  And the cost of being wrong is fairly high.

The best way to deal with the risks of dollar devaluation and high inflation — with a much lower cost to being wrong — is, instead, to own stocks of companies that have pricing power of their product. When inflation hits, they will be able to raise prices and thus maintain their profitability.  Also, companies that generate a large portion of their sales from outside the US will benefit from the declining dollar. 

There is a wild card in the price of gold, though: China. If it decides to switch partially from owning US Treasuries to owning gold, the price of gold will skyrocket. (John Burbank made this case at the Value Investor Congress in Pasadena in May).

In fact, most of the gold ever mined is around today. It is exhibited in museums, worn as jewelry and buried deep in the vaults of the central banks. Peter Bernstein, in The Power of Gold, wrote:

“Despite the complex obsession it created, gold is wonderfully simple in essence. Its chemical symbol AU derives from aurora, which means “shining dawn,” but despite the glamorous suggestion of AU, gold is chemically inert. That explains why the radiance is forever. In Cairo, you’ll find a tooth bridge made of gold for an Egyptian 4,500 years ago; its condition is good enough to go into your mouth today. . . . Stubborn resistance to oxidation, unusual density, and ready malleability-these simple natural attributes explain all there is to the romance of gold.”

Despite its unique properties, gold has not been a good investment. Over the past 200 years, its returns have barely kept up with inflation. Its value has a low correlation with stocks (prices of gold and stocks move independently of each other most of the time), which is a big positive from the portfolio construction perspective; diversifying with gold can reduce a portfolio’s fluctuations(volatility). But the diversification benefit comes at a large cost: Once added to the portfolio, gold substantially reduces that portfolio’s risk-adjusted returns. Its dismal returns negate any benefit the portfolio receives from reduced volatility.

One thing about gold, however – it is real! You can hold it and touch it and see its shine. This tangibility makes it seem impervious to the whims of politics, nature and time, as opposed to paper assets such as stocks and bonds. Gold’s physical attributes attract investors during times of economic uncertainty, and so it serves a purpose in the markets and society – it is a stabilizing influence. It feels safe.

Doomsday currency

The thinking of the so-called gold bug (a believer in gold’s supremacy, a gold aficionado) often takes on a variation of this form: While in the bunker (or any other variance of the “world-falling-apart” scenario), you cannot pay for food with paper money or a stock or bond certificate. You may do so with real tangible assets, such as gold. If this scenario played out (God forbid), it is conceivable that gold could become the de facto currency. In that event, you need to have real gold in a safe or buried in your backyard. The wise gold bug would have managed portfolio risk by also investing in a good arsenal of guns, as the demise of government bonds would likely lead to the end of the rule of law as well. Gold held by your broker or through ownership of gold stocks or exchange-traded funds will not come to the rescue; these bytes and bits are not superior to default-free bytes and bits, for example, U.S. Treasuries. Canned food may actually be a better store of value in this “world coming to an end” scenario.

The ever-increasing complexity and globalization of the financial system, rapid spread of international trade and the availability of risk-free investment instruments that were not available to investors in previous economic crises may have changed investor behavior during economic doomsday times. Financial instruments such as Federal Deposit Insurance Corp.-insured checking and savings accounts, U.S. Treasury bills and Treasury inflation-protected securities may challenge gold’s status as the safest haven in times of inflationary crisis.

Treasury inflation-protected securities may turn out to be the key challenger to gold’s store-of-value supremacy status in the future. Aside from being issued by the U.S. Treasury and therefore backed by the full faith of the U.S. government, they also protect investors from inflation – one of gold’s most-valued qualities. TIPS’ principal is tied to the CPI: The principal value increases with inflation and falls with deflation. When the security matures, the original or adjusted principal is repaid, whichever is greater.

Though TIPS appear to have superior financial properties to gold, they still lack one of gold’s main attractions – tangibility. After all, they are still just bytes and bits on a brokerage firm’s or bank’s mainframe, or pieces of flammable paper stored in a safe.

Holding gold has costs

Any cash flow-generating asset, like a stock or a bond, can be valued on the future cash flows that it is expected to generate. Predicting gold prices is extremely difficult because gold is not a cash-generating asset. In fact, it is important to note that gold actually has a negative yield. Gold is a cash-consuming asset; its safekeeping and transportation cost money. TIPS, as well as any bonds and dividend-paying stocks, have a positive yield; they pay investors for holding them.

Gold is also considered a good currency hedge, especially for the U.S. investors who are concerned about the declining dollar. Again, our financial ingenuity is stealing gold’s long-held exclusivity on that trade, providing options that were not available a few decades ago. To protect themselves against the declining dollar, U.S. investors can use currency futures and options, foreign-currency-denominated mutual funds and certificates of deposit; they can buy foreign stocks on foreign exchanges or through American depositary receipts; and, of course there is a most recent development – currency exchange-traded funds.

In both the long run and the short run, gold prices are driven by fear of the world coming to an end and investors’ expectations of future inflation. Although gold has some industrial applications – in jewelry, dentistry, computers, jet engines, electronics, as a superconductor, etc. – linking its intrinsic value directly to its price is difficult. Perception of its ability to store and preserve real value, especially in an inflationary environment, is the key driver of gold’s price.

As long as investors perceive gold to be a refuge in times of uncertainty, gold will act as such. It is important to note that gold’s monopoly as an instrument of choice at the time of fear and uncertainty has been undermined by other very capable and often superior financial instruments.

Vitaliy Katsenelson, CFA, is a portfolio manager at Investment Management Associates Inc. in Denver. The above selection is an excerpt from his book, “Active Value Investing: Making Money in Range-Bound Markets,” published this fall by John Wiley & Sons.

After muting CNBC for years, I turned it on by accident yesterday and learned something very interesting. The gold ETF (GLD) is the 6th largest holder of gold in the world – the whole world, even ahead of China.  When investors buy GLD they have to go out and buy gold driving up the prices. This raises a little question – who will be buying this gold from GLD when investors will decide to sell it?

Gold is one of those weird assets where nobody knows what it is really worth. You cannot run discounted cash flow analysis to value it – it has no cash flows. It is an asset where perception and reality are deeply intertwined.

Investors buying the gold ETF (GLD) are influencing the price of gold which is fair for the most part as otherwise they’d be buying the real thing. Though of course the ease of buying GLD creates a slightly higher artificial demand, but still it is fair game.  The violent sell off in GLD will drive the prices of gold down dramatically unless a real buyer steps in (like another government sick of owning the US debt for instance) and the gold price could get cut in half overnight. Suddenly perception of not being a store of value will create a reality of gold not being a store of value. The gold game will be over.

 “Salt has more applications than virtually any other mineral. Besides being a dietary necessity, salt can be used as a preservative, an antiseptic, a dentifrice, a cleanser, an abrasive, a fire-retardant, a defroster and a deodorizer. The list goes on and on.”

   

The problem with gold is that it is very hard to determine its worth.  It is only worth something if market participants perceive it is worth something.  Unlike bonds or stocks, it is not a cash flow producing asset thus traditional valuation metrics cannot tell you if it is cheap or expensive.  You look at Microsoft, you may disagree on the assumptions that you put into the discounted cash flow model, but it is worth somewhere between $20 and $50.  It is analyzable.   Gold is only worth something if people consider it to be a store of value – the doomsday currency.  But if it lets people down even once, it is done!  Here is what I wrote about gold in my book.

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