Gold Revisited

In recent years, gold has seen spectacular price increases. Looking at some history may reveal where gold is heading in the future and why.

In Barron’s March 9, 2009 issue, Andrew Bary reported in the issue’s cover story that over a six month time span, gold had risen $140 to its current price at the time of $942 an ounce.

The point of the article was to show stocks relative value. The relationship between gold and stocks indicated that stocks may be undervalued, as seen in the following quote.

The S&P 500 index is worth about 75% of an ounce of gold, verses a peak of more than five times the value of gold in 2000 when the S&P peaked at more than 1,500 and gold languished around $300 an ounce. Over the past 40 years, the S&P has averaged 1.6 times the value of an ounce of gold.”

Gold and other precious metals are an interesting investment and have gained a lot of press recently through radio and TV advertising. During this current credit crisis, gold has been seen as a “safe” investment that never loses its value like stocks and bonds because it is gold, the asset that was once used to peg many currencies, including that of the US during the time of the gold standard.

Even as a perceived safe investment, the increase in its price shows that investors view that gold is perceived as a quality and safe investment relative to other asset classes. The question is whether gold deserves a long term place in an investor’s portfolio and in what proportion. In the same way, the question is not whether gold is rare or was useful to pegging currencies, but how an investor should view gold as an investment in the short and long term.

There are some that view physically holding gold as insurance for “end of the world” type situations. Other than those investors, gold inventories held by small, individual investors are very impractical. The cost or risks of this kind of investing through physically holding gold must be fully realized. The cost of insurance, security, storage, transporting and inspecting true quality may make this kind of investment completely impractical. A better, more efficient way to purchase gold is through ETFs and ETNs, which track the price movement of gold by following a gold index. These ETFs track indexes, a range of investment options from physical gold to rolling gold futures. Precious metal ETFs like GLD actually hold physical gold in trust in secure bank vaults. There are unique tax implications when investing in these ETFs that should be understood before investing.

The Difference Among Asset Pricing

Theoretically, the price and value of publicly traded companies is the present value of all future cash flows. This may not seem always true and often prices can vary greatly from “fair value” or the present value of all future cash flows. In the long run, investors have been rewarded for purchasing stock in companies below this “fair market price” and selling it above the “fair market price.”

Even if all stock prices reflected the fair market values, investors would still realize gains and receive dividends from the stocks they hold. Why? Because, if stock prices should be the present value of all future cash flows, the more recent cash flows will have the greatest affect on stock prices.

Gold has no expected return. Unlike a stock, gold and other precious metals do not have any future cash flows and therefore their values and prices are only based on supply and demand. Supply and demand forces are more complicated when describing commodities. We could say the value of gas is the price we pay at the pump or the future price that market participants have contracted with each other to deliver gas or oil in the future. This is interesting because the supply and demand of a commodity like oranges is not only the supply or demand of today’s price, but the price in the future. This is why orange producers are so concerned with predicting weather, as weather in Florida will greatly affect the future supply in the marketplace. This helps guide their decisions on the future price of oranges.

When recently asked about investing in gold and where it will be in five years, Warren Buffett said that, “I have no idea where [gold] will be, but the one thing I can tell you is it won’t do anything between now and then except look at you.” He went on to say, “It’s a lot better to have a goose that keeps laying eggs than a goose that just sits there and eats insurance and storage and a few things like that.”

Warren Buffet’s advice is not the bottom line, but an interesting perspective from someone who has had great success investing based on strict principles.

Gold’s Supply and Demand

Many people believe that rare commodities will only get scarcer and that prices of those items must increase in value. This is most popular regarding oil, but relates to all commodities. Before discussing why this may not be true, this same line of thinking happened in many places in the world over the price of land and home values.

The thinking that led to the bursting of the housing bubble in the US and Japan in the 90s, which they have yet to recover from, is that there is only so much land. Reason tells us that as the earth becomes more populated, property values will increase due to a fixed supply and increasing demand.

This is not true. In the short term, the supply curve can be shifted (to the left) signifying less quantity available to consumers and a new equilibrium price will be set above the previous price. But the long term is a different story, (economists define the long term as the period where all costs are variable, meaning that big fixed costs like owning a house is fixed in the short term, but in the long term you can move). In the long term, this new price based on a decreased demand is not sustainable for reasons that will let consumers and suppliers shift the demand and supply curve back to lower or previous equilibrium prices.

Gold’s Difference

The appeal of gold is as a place of safety as investors flee towards quality. There are reasons behind why investors see gold as safe and reasons for the play. As financial systems continue to fail, the system of paper money may fail and the usefulness of gold as a monetary unit will return. In addition, as the government measures continue to not restore investor confidence, the fear that inflation will follow and that gold, as a commodity, will be a hedge against the inflation. Also, there is a popular notion that even in the face of inflation, gold will benefit as an inflation hedge. So in either case, gold works

In a recent analyst report by Keith Lerner, Chief Market Strategist for SunTrust Robinson Humphrey, published in Indexuniverse.com, reported that gold is a difficult asset to place a fair value on

Since gold neither pays a dividend nor generates cash flow, we have never felt a great comfort in assigning a fair value for the precious commodity. Often, in our opinion, its direction is driven primarily by investor psychology and it trades on momentum…”

According to the same report, the analyst views gold as “technical/chart perspective.” He sees the near term risks for the commodity to be outflows in gold as the economy returns back to normal and the need for safety decreases.

Gold in Perspective

12/29/1972 Through 2/28/2009

Risk: Standard Deviation

Annual Return:

S&P 500

15.71%

8.64%

Gold

20.76%

7.71%

What we are seeing above is that gold, as an investment, is more volatile than the S&P 500 and annually over a 36 year period gold has annually returned less.

This is not to say gold is a horrible investment in all cases, but to say that the stock market historically has performed better with less risk than gold.

Commodities in general and especially gold have a low correlation to the stock market. Since it has a low correlation and higher volatility, adding commodities and gold in appropriate amounts can provide long term benefits. The hard part is figuring out the appropriate amount to allocate to gold or commodities as a wider asset class.

The Gold Run Up

As we have already discussed previously, gold has recently seen a large price increase. Investors have been flowing funds into gold due to many factors including gold’s historic uses as currency.

Graphed below is the S&P 500 and the price of gold as seen through the London Fix Gold PM Index from 12/29/1972 through 2/28/2009. This long term price performance difference is important to notice. The better long term investment is the stock market as seen through the S&P 500. This long term perspective matched with a strong theoretical understanding behind asset pricing and value differences goes a long way.

gold-chart5

All this being said, is there a place for gold and other precious metals in portfolios of all risk levels? In short, yes. The trick is in what percent and through what investment vehicle.

Here at Wiser Wealth Management, we have between 3%-5% commodities in our portfolios. We currently use the ETN, ticker symbol DJP, an ETN that tracks that Dow Jones AIG Commodity Index. The breakdown of commodities is diversified and the index follows rolling futures contracts.

As of 2/28/2009

%

Energy

31.86%

Industrial Metals

19.72%

Grains

19.43%

Precious Metals

13.06%

Softs

8.89%

Livestock

7.04%

Precious metals make up 13% of the entire commodity portfolio and gold is 9.41% of the entire commodity portfolio. Please note that the percentages of commodities and gold we currently have in our portfolios is a function of the suitability of our client base and may not be appropriate or suitable for you. Also, please be aware that an ETN is different from an ETF and assumes full credit risk of the issuing investment bank.

An investor can track commodities and gold using ETFs and ETNs. The most popular of these products are the SPDR Gold Trust, GLD, United States Oil, USO, iShares COMEX Gold Trust, IAU, iPath DJ-AIG Commodity, and iShares GSCI Commodity, GSG. All have different exposure to commodities and gain exposure to the commodities they cover in different ways. Careful research is needed to determine proper exposure and suitability and to understand the difference between exchange-traded products and the methods they use to track the underlying indexes.

The information contained in this report is for informational purposes only and is not investment advice. A note about the data: All gold prices are quoted as the London Fix Gold PM Price Return USD index. Data obtained from Morningstar Advisor Workstation Office Editor.

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