by Kristin Fafard, CFA, Director of Research
The price of gold has escalated 17% annually from its last low point in 2000, outperforming all major asset classes - and some say it still has room to move higher. This update provides an overview of gold's current popularity and discusses why, despite the factors causing gold to rise higher, Federal Street Advisors is not currently recommending a dedicated allocation.
Before we dive into the details of investing in gold, it may be helpful to refresh your understanding of how we build portfolios. Basically, we recommend core asset classes where we see long-term opportunities and we blend those asset classes together in ways that maximize the probability of achieving your long-term return targets. We recommend that you gain these asset class exposures through the use of talented, third-party investment managers who we believe will reduce risk and/or enhance returns - thus improving the likelihood that you will obtain your desired return targets. We recommend changes to your asset mix along the way if we see an exceptional risk or opportunity, either by making changes to the asset allocation recommendations or to the third party managers. As we move forward with this discussion about gold, let's keep this portfolio construction process in mind.
Why do investors hold gold?
Gold, like any other investment, is only as valuable as what someone else is willing to pay for it. So, as an investor in gold, you are expecting that someone else will pay more for it than what you paid for it. With gold, there are two reasons why that would happen, one more straightforward than the other. The more straightforward reason is that gold has a tangible worth for its use in jewelry and as a metal used in industrial production. If you expect that the demand for gold will go up (driven, for example, by a rising middle class wanting and finally being able to afford gold jewelry, or by growing industrial production), an investment in gold would certainly make sense. The less straightforward reason has to do with gold's history as a currency and as a backing to currencies. As we all know, gold was once widely accepted as currency and as the basis for valuing currency. If you expected that gold would once again become a global currency, investing in gold could make sense.
We look at gold as we do other individual commodities and stocks
Let's go back to the portfolio construction discussion. Given the reasons why investors hold gold, do we feel that gold meets Federal Street's definition of a long-term investment or asset class for our clients' portfolios? The answer is no. First of all, it is not diversified, and secondly, it does not have compelling long-term characteristics, having returned only half as much as stocks since 1926 with much higher volatility. We look at gold no differently than we would any other individual, undiversified investment.
There are periods when the demand for gold is higher than the supply. At those times, a holding in gold could be a component of a well-diversified investment strategy - no different than a holding in any other individual commodity or stock. If we felt that the outlook for demand was strong and persistent enough to warrant an investment, we might consider it an opportunistic allocation and recommend it to our clients based on, perhaps, a 3-5 year outlook. Alternatively, we might hire an active investment manager who has expertise in evaluating the supply/demand imbalances for gold as well as other commodities/investments affected by the same types of trends. Gold would therefore be a part of that manager's opportunity set.
As we look at gold as an investment, however, one factor that distinguishes it from many other commodities is that it stays in circulation. What that means is that unlike oil, which gets burned, or timber, which is difficult to re-use for construction purposes, gold generally maintains its properties. This is a key differentiator because it means that the supply of gold does not diminish. So as growth in demand for gold declines, its price increase should slow much more quickly than a commodity that does not stay in circulation. This means that if you are going to bet on gold, you really need to get it right. In fact, if you were an investor in gold at the peak of the last gold cycle in 1980 (of course, you would not have known it was the peak when you made the investment), you would have lost 57% of your investment within 12 months and it would have taken 27 years to get your money back.
Why are we not recommending a shorter term gold allocation today?
Given the fact that Federal Street is unlikely to recommend a long-term stand-alone gold allocation but may at times recommend a short term allocation in gold, why are we not recommending one today? To answer that question, let's look at why investors are buying gold today.
It is true that the rising middle class, particularly in the emerging economies, has played a role in the demand for gold. It is also true that there has been a rise in industrial production in some of those same economies. We have seen, however, that the growth rates in these emerging economies have started to plateau, so the demand for gold for its tangible value should correspondingly slow. Based on our outlook for slower global growth, a dedicated, opportunistic allocation to gold based on its tangible uses does not make sense to us right now.
Despite a widely held expectation that global demand for its tangible uses will slow, the price continues to increase. So we must conclude that gold demand is coming from those who believe its value is not fully recognized due to the prospect of its future as a global currency. This is not a novel observation. It is no secret that global currencies have been under stress, particularly since 2008 as the developed countries print money to stimulate their economies. The Euro in particular is facing true, fundamental stress and its future as a currency remains in question.
We do not believe that there will be a return to the gold standard
Given the shakiness of the world's currencies, do we believe there is a strong likelihood that there will be a global currency collapse and that we will correspondingly revert to the gold standard? The answer is no. Even if the Euro fails to move forward as the unified currency for much of Europe, we believe it is more likely that each country currently using the Euro will revert to its home currency rather than to gold. Therefore, we do not believe a dedicated, opportunistic allocation to gold for its currency value makes sense right now.
Does the fact that investors have bid gold up to these levels mean that they actually believe that a global currency collapse and the return of the gold standard are likely? Some do believe this - but most do not. For investors who truly believe this is the ultimate outcome, gold is an investment that makes sense for them. For everyone else, they are simply believing that either others will start to believe we are moving in this direction, or that there will simply be persistent demand in the future. This would appear to meet the definition of speculation where one "hopes" that others will be willing to buy at higher prices.
After 2008, many investors would have told you that investing in publicly traded stocks was no different. Some claimed that the stock market was purely speculative and based solely on demand. In fact, the prices of publicly traded stocks are based on demand, but there is a key difference. When the trading in gold stops, all you have left are gold bars that cost money to insure and store and have virtually no use except for the tangible uses we discussed above (unless of course it does become the means for global exchange). If trading in stocks stops, you still maintain ownership in companies that are generating cash flows and/or building their worth.
Gold can be used as part of the opportunity set for an active third-party investment manager
So how can Federal Street clients benefit from what is happening to the price of gold? As we stated earlier, gold can be used as part of the opportunity set for an active third-party investment manager; in fact, some of the managers we have recommended to you have invested in gold or investments related to gold. For example, some have invested in companies that mine gold or are suppliers to the mining or production of gold.
Some of the hedge funds we recommend have also invested in gold, looking at it as a short-term opportunity to balance off some of the other risks in their portfolios. For example, a manager makes an investment in a German auto supplier because of the expected growth of its niche products. This company's revenues or earnings, however, could get hurt in the event of either a Euro collapse or fear of a Euro collapse. To balance that risk, the manager invests in gold to act as a hedge to the currency risk facing this particular company. In this example, a gold investment has a well-defined purpose as a hedge against a particular risk. If the Euro fear finally subsides (which we believe may still take some time), the gold investment could lose money. However, the other side of the investment equation would benefit. Our German auto supplier would be free from that particular currency risk and should have a greater ability to execute on its business plan, and the investment should correspondingly increase in value.
There are many examples like this in the portfolios of the managers we recommend to you. We are comfortable with managers making these investments as long as we understand their purpose in the portfolio and as long as they are sized appropriately.
When the fear abates, history has shown that the decline can be swift and severe
In conclusion, we recognize that a direct investment in gold has been beneficial for investors during the recent past. However, we do not consider gold worthy of a long-term place in portfolios or currently as an opportunistic trade. We view gold as one of the many tools an active investment manager can use based on either its tangible uses or its ability to hedge individual positions or portions of a portfolio.
The fears that have driven the recent price increases in gold are real. However, price increases can only continue as long as there is another investor willing to believe that the fears are going to grow larger than what you believe them to be. When the fear abates, history has shown that the decline can be swift and severe. In the meanwhile, unless we truly believe that gold will become a widely used method of exchange, we prefer to stay out of the game, even if the speculation continues to drive prices higher.
