From a portfolio management standpoint, in the theme of falling paper currency values and higher inflation, gold may not always be the best way to invest. The last year has seen a substantial double digit drop in the value of the US dollar yet gold was not the best performing commodity asset. For example:

Agora Financial’s 5 Minute Forecast ¹

Gold fared quite poorly when compared to several basic materials (industrial metals) and some agricultural products. Much of this is likely due to increased demand from countries like China. By being invested in silver rather than gold an investor could have made twice as much money this year. The major difference between the two precious metals is that gold does not have much industrial use outside of jewelry manufacture, which limits its value for true business. Silver on the other hand has a variety of industrial uses and, just like gold, also serves as an inflation hedge (protection) or anti-currency investment. If the current trend continues then gold may not be the best material asset to invest in.

There are times where the best anti-currency (or inflation) investment is another currency. For example, take the Australian dollar:

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As is evident in the chart above, gold is up from February in US dollar terms while the, “Australian dollar denominated gold prices peaked on February 20 of this year at 1563 AUD/toz are currently 17.5% off their highs.”² In the case since February 20th an investor would have been much better off to be in the Aussie dollars than gold. The tail end of the chart, which reflects recent market action, does show gold going up even against the Australian currency. Even though gold is not always the best asset class, there are times where it does shine relative to other investment opportunities. At the very least, it can be a good addition to a diversified portfolio.

In a free market every asset runs in cycles. This means that nothing makes money indefinitely and that everything will go through periods of highs and lows. For example, since 2000, “the S&P 500 has delivered a total return of -11%. The gold price has quadrupled.”³ The two decades prior to that were a 180-degree difference where, “gold’s value fell by more than half. During the same 20-year period, the S&P 500 delivered a dazzling return of more than 2,500%.”³ Obviously things changed during the last 10 years that have propelled gold’s price higher while hurting the value of stocks. Two items that will likely propel the gold price higher are more buying from central banks around the world and a weaker US dollar for investors using that currency.

What seems like continuously dropping U.S. dollar value is causing many a sleepless night for foreign holders of the currency. Around the world, “roughly 65% of the total foreign exchange reserves of foreign governments are held in U.S. dollars.”¹ Asian and emerging governments hold especially high amounts of their reserves in dollars. These high reserve amounts and angst over dropping value has led some to call for more diversification in their reserve holdings. This has resulted in “the first time in a quarter century (where) central banks are buying more gold than they’re selling.”³ During the 20 year period between 1980-2000 central bank gold selling was a large inhibitor of upside price movement. Goldman Sachs provides the following synopsis of this situation:

“Although central banks have historically been net sellers of gold, we have witnessed a significant slowdown in the pace of sales since 2008 with the latest data suggesting an outright halt in aggregate sales. Compared to the late 1990s when many central banks viewed gold as a low-yielding asset and their gold sales put downward pressure on gold prices, the more recent movement among central banks is to view gold reserves as an important source of diversification away from the US dollar in their reserve holdings.

Furthermore, emerging market central banks have explicitly stated their intentions to gradually diversify reserves into gold as well as currency reserve assets other than the US dollar. From a positioning point of view, Asian nations as a group hold only a small percentage of their reserves in gold vs. the major European nations holding more than half their assets in gold (56% as of October). China, for example, holds only about 1.49% of its reserve assets in gold and surprised earlier this year when it announced that it had increased its gold holdings by 76% since 2003 to 1,054 tons, mostly from buying from their domestic mine production. Similarly, only 4.7% of Russia’s reserves are in gold and it has stated its intention to increase its gold holdings and has done so by 19% this year alone. Furthermore, the recent announcement that India was to purchase 200 tons of the 403 tons of gold the IMF plans to sell has substantially reduced the outlook for central bank sales in 2010 and 2011. Net, we expect selling by central banks and other official sector institutions to remain near subdued, less than 100 tonnes per year on net (0.25 million toz per month). Should Central Banks continue to be net buyers of gold in the next two years, the upside risk to gold prices would be considerable.”²

Interestingly enough these same central banks are also one of the largest potential risks to gold’s value.

The last gold price spike in the early 1980s ended, “as the dramatic tightening of US monetary policy under Chairman Paul Volcker drove US real interest rates dramatically higher and drove gold prices down substantially.”² Increasing rates normally cause a spike in the valuation of the nation’s currency. A dollar rally would not be a good thing for gold’s value. If the Federal Bank should raise rates, or if the dollar rally’s on its own, it should be expected that gold and similar assets will lose value. Therefore “an earlier than expected tightening of US monetary policy is the primary downside risk to gold.”² Fortunately low interest rates are expected to remain for the extended future. The outlook from Goldman Sachs is that, “the gold price-real interest rate cycle will turn when the US Federal Reserve begins to raise interest rates, but do not expect that to happen this year or next.”² In other words, for at least the time being, the risk to gold from this action should be minimal. This opinion is likely formed around the continuing market turmoil and the Feds desire to support growth through low rates. However, everything is always subject to change in the investing world.

Looking at historical data to help predict what may happen can be useful. The last time that we had a similar Fed rate situation in the 70s, “gold prices spiked to $1870/toz in today’s US dollars,”² which would be approximately a 50%+ gain from today’s current value. This gain would not likely occur all at once or in a straight up-line. More likely its value will fluctuate between growth contraction as all investment assets do. The important part is to be along for the ride and not get bucked off during periods of consolidation (that is as long as the consolidation periods don’t violate the exit strategies designed for protection). Gold may not be the best asset to obtain the most gain from the current situation, but it is looking increasingly like a good item to incorporate into a well designed and diversified portfolio.

Morgan L. Arford
Investment Strategist
MorganA@ComprehensiveWealth.com

Sources:

The material has been prepared or is distributed solely for informational purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. The investments discussed may not be suitable for all investors. Investors must make their own decisions based on their specific investment objectives and financial circumstances. Past performance does not guarantee future results.