Since the dawn of civilization, mankind has held a special fascination for gold. Originally prized for its beauty, gold eventually became a universally accepted store of value and a medium of exchange. Gold was first used as currency around 1500 BC in Egypt and today it remains a critical component of foreign exchange reserves in central banks around the world.

 

More recently, gold has been one of the few shining stars during a challenging 10+ years for most investors. In May, gold breached $1,500 an ounce, a new all-time record high (in nominal prices). In fact, since bottoming out at $252 an ounce in August 1999, gold has been enjoying a steady long-term bull run¹. This has prompted some prognosticators to warn that the "gold bubble" is ready to burst. On the other side of the coin, the more bullish "gold bugs" view the rally as confirmation of their long-held belief in the value of owning gold.

 

Today, gold is still viewed by many as a somewhat exotic investment with little value. Even the notoriously bearish Jeremy Grantham has said, "I hate gold. It does not pay a dividend, it has no value, and you can't work out what it should or shouldn't be worth...It is the last refuge of the desperate²."

 

Such skepticism has not always been the norm. In the past, investors allocated significantly more of their wealth to gold than they do today. According to Shayne Maguire, who runs a $330 million gold portfolio at the Teacher Retirement System of Texas, gold investments account for barely 0.5% of investable wealth worldwide today, down from 3% in 1980, 5% in 1968, and 20% in the mid 1930s³. He sees the rising interest in gold as a return to the norm.

 

 

 

While gold prices have been on an extended run, the rally is less spectacular than it may appear at first glance. In January 1980, the price of gold reached an all-time high of $850 per ounce as record high oil prices, Russia's invasion of Afghanistan, and the Iranian hostage crisis shook investor confidence. When measured in inflation-adjusted dollars, however, that $850 price equates to approximately $2,300 per ounce today.

 

It's also important to note that gold prices have historically experienced extremely long bull and bear periods. After peaking in 1980, gold drifted downward for nearly 20 years before reversing course over the past 10+ years.

 

Regardless of whether gold prices head higher or lower in the near term, we believe gold is a unique asset that deserves a spot in any diversified portfolio. It can help stabilize portfolio returns during periods of extreme market volatility and may serve several other purposes, including:

 

• A hedge against a weak dollar. Gold typically rises when the value of the dollar declines. For example, when the dollar fell 38% between March 1985 and December 1987, gold prices rose 60%⁴. Of course, this dynamic works both ways. When the dollar rose 22% between May 1995 and September 1998, gold prices declined 25%⁵.

 

• Inflation Protection. During periods of rapidly rising prices, each dollar buys fewer goods and services. Gold, on the other hand, retains its purchasing power and has typically performed well during periods of high inflation, such as during the early 1980s.

 

• A potential safe haven during times of crisis. When geopolitical tensions reach a boiling point, stock markets and other paper assets usually experience sharp declines. That's when nervous investors often turn to gold for protection. In those environments, gold generally holds its value better than other assets and often appreciates in value.

 

• Protection During Deflationary Periods. You have to go back to the Great Depression to find a period of sustained deflation, but when you do, you find that gold stocks performed extremely well. From 1929 until January 1933, the Dow Jones Industrial Average fell 73%. During that same period, the stock of Homestake Mining, the largest gold producer in the U.S., rose 474%. Dome Mines, the largest Canadian producer, rose 558%⁶. This occurred in spite of the fact that gold prices were fixed by the government at that time.

 

• Low correlation to other asset classes. Due to its unique characteristics, gold's performance has historically shown a low degree of correlation to other major asset classes, such as stocks, bonds, or even other commodities. This can help smooth out portfolio returns over time.

 

Supply and Demand Imbalances Ahead?

 

Unlike most other commodities, changes in supply and demand have not been the primary driver of gold prices. That could change, however, as demand from jewelry manufacturers in China, India, and other emerging economiesrises. In fact, demand for gold grew 11% in the first quarter of 2011, according to the World Gold Council.

 

Rising demand for gold as an investment may also be playing a role. Today, gold-related exchange traded funds hold more than $80 billion in assets, as more investors have taken notice of gold's extended bull run and joined the party.

 

Meanwhile, central banks around the world are reversing course and, rather than selling their gold reserves, they are accelerating their buying programs. According to a report from research firm Standard Chartered, only 1.8% of China's foreign exchange reserves are held in gold⁷. To bring this proportion in line with the global average of 11%, China would have to buy 6,000 more tons of gold, equivalent to more than two years of global gold production.

 

While demand is on the rise, supplies have remained stable and there are few large mines coming on line within the next five years. According to Standard Chartered's report, net production will grow by only 3.6% over the next five years.

 

The Long View

 

While supply and demand factors may or may not conspire to drive gold prices higher, we have long held that gold deserves a place in a well-diversified portfolio, regardless of the near-term outlook. We believe gold can provide insurance and act as a hedge against financial calamities, geopolitical turmoil, high inflation, or virtually any negative economic event.

 

Rather than investing in gold bullion (which involves significant expenses to store, safeguard, and insure) we invest in gold ETFs and mutual funds that invest in gold and gold mining stocks. Gold mining stocks are generally more leveraged to the price of gold, so they typically outperform when gold prices are rising and vice versa.

 

Looking ahead, we believe the price of gold will hold up quite well and eventually appreciate more as the risks of geopolitical turmoil, inflation, and U.S. dollar depreciation come to the forefront. As for the gold mining companies, we suspect that their recent weakness despite the increasing value of their gold reserves is a temporary phenomenon and we embrace exposure to these equities as their historical leverage to gold prices resumes. 

 

In summary, we believe including allocations to gold and gold mining companies is a prudent portfolio diversification strategy with solid upside potential. An investor need not be a "gold bug" to appreciate that rationale, and given the current and anticipated market environment, we find this commodity to serve a very useful role.

  

 

1. Smart Money, The Power of Gold, March 2011
2. Value Investors Hate Gold, LewRockwell.com
3. Changing Exposure of Pension Funds to Precious Metals, London Bullion Market Association Conference 2010.
4. As Good As Gold, Fidelity Investments Market Analysis, Research & Education, December 2007.
5. Ibid.
6. How Will Gold Perform as a Hedge Against Deflation?, The Contrary Investing Report, August 12, 2010.
7. CNBC.com, June 14, 2011.

 

 

 

The information herein has been obtained from sources believed to be reliable, but Emerald Asset Advisors, LLC ("Emerald") does not warrant its completeness or accuracy. Prices, opinions and estimates reflect Emerald's judgment on the date hereof and are subject to change at any time without notice. Any statements nonfactual in nature constitute current opinions, which are subject to change. Projections are not guaranteed and may vary significantly. Further information on the firm and its advisory fees may be obtained from the firm's Form ADV Part II, which is available without charge upon request. Complete descriptions of all Emerald's products and benchmarks are available upon request.

 

 

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