By Charles Webb
The Modern Gold Rush
We're often asked by our friends and clients if we think something or another is a good investment. That something or another is usually a security or asset class that has had a meteoric rise in value the year before. Over the past year, we have fielded a lot of questions about gold. This should be no surprise to anyone who is familiar with what gold prices have done over the past couple of years. Therefore, we felt this would be a good topic for this month's memo.
I think it's first important to discuss what an investment is because that word is used pretty loosely these days. An investment is something that will either provide you income or increase in value. If the investment is something that generates income, it has to have some sort of earnings that generates the cash flow. Investments that increase in value usually have an earnings stream too. That's what makes them more valuable over time. But not all appreciable assets are backed by earnings. Instead, they are scarce in supply and high in demand. Commodities, gold included, are a good example of this. Collectibles are another good illustration of scarce assets with high demand. So if you want to invest in something, it needs to fall into one of these camps - income or appreciation.
Too often money is directed towards things that on the surface look like investments but in fact are something else. Two common examples are insurance and options. These are really risk management tools and not investments. Another area that we see money flow into is various stores of wealth. These assets are parking places for wealth. Currencies are the best example of this and you'll often see money flow into different currencies in times of political turmoil. Precious metals are another popular parking place for wealth.
This is where things get a little confusing because some things are both commodity investments and stores of wealth. So the question of should I buy gold, silver, platinum, etc. really depends on what you're trying to accomplish. If you truly want to invest in gold, you should do so because you think the demand is rising. The question then becomes what is the best way to buy the gold? In our opinion, exchange traded funds (ETF's) are the best way to own it. These are shares issued against actual gold deposits held in a vault at a bank. Probably the least efficient way to own gold would be through the futures market. This is because you don't own the gold but instead own the right to purchase it at some predetermined price over some period of time.
In most cases though, we are asked about owning gold as an inflation hedge. This is more akin to using it as a store of wealth. The appeal here is that it is believed gold's value will change with inflation and thus as a store of wealth, your wealth in gold will rise or fall with inflation. As Americans, our wealth is stored in the U.S. dollar. Your bank accounts are held in dollars. Your stocks and bonds are priced in dollars. Whenever you sell something, you receive dollars. Many people today are worried about the value of the dollar and are looking for something else. Foreigners also own a lot of our currency. They too are nervous.
These concerns arise because of the budget crises and the huge increase in the money supply promoted by the Federal Reserve. In theory, as the money supply is increased, the value of each dollar is diminished. It's simple supply and demand. Over the last few years, we have seen some decrease in the value of the dollar but nothing dramatic. The reason for this is that there has also been a corresponding increase in demand for our currency, keeping things in check.
So we've identified two possible reasons why you might like to store your wealth in gold. The next question is how good is gold at addressing these concerns? As it turns out, gold doesn't do a good job at all. As a reserve currency, there quite simply isn't enough of it to fill the need. Since the beginning of time, it is estimated that 165,000 tons of gold have been mined. At $1,200 per ounce, that is only 6.6 Trillion dollars. That's only a tiny fraction of the value of the worldwide economies.
As an inflation hedge, time and time again, gold's price has shown itself to march to the beat of a different drummer. There is no better example than today. Inflation and interest rates have been at record lows for years. Yet, in spite of this, gold's prices are at record highs. Clearly, something else is driving the price. In addition, it is completely impractical to transfer enough of your wealth from dollars to gold to make much of a difference in your finances.
The thing really driving gold prices is the aspect of gold as a commodity. The consumption of gold produced in the world is about 50% in jewelry, 40% in investments, and 10% in industry. India is the world's largest single consumer of gold, as Indians buy about 25% of the world's gold, purchasing approximately 800 tons of every year, mostly for jewelry. What I believe is the real driver of gold's price lately is the 40% used for investment. This smells a lot like a bubble.
Gold is being bought just for the sake of owning it. Without a corresponding increase in industrial demand, it's reasonable to wonder what will be the underlying support to the price. Through modern finance, it's incredibly easy for large sums of money to flow in and out of any asset. When the crowd moves away from gold, you have to wonder what that will mean for the price.
Like any asset bubble, there will be those who win big. There will also be those who lose big. The problem is you can't research, forecast or model the crowd. At this point you have to ask, is this investing or gambling?
