Invest in gold for insurance, not growth

Gold has been the most talked-about investment and was the place to be for nearly 12 years. It moved from $250 per ounce to more than $1,900 per ounce while the stock market gyrated on its roller coaster ride. When investing in gold you could not go wrong. Then something happened.
No sooner did gold break $1,900 an ounce, with calls for much higher prices, then it went flat line. Gold has now been declining since August 2011. That begs the question: “How did we get here and what do we do?”
A key driver of the significant rise in gold prices since 2000 has been the emerging-markets consumer. Between 2000 and 2010, consumers in emerging markets accounted for 79 percent of total demand. This expanded framework demonstrates that gold is also positively exposed to pro-cyclical factors in the emerging markets.
Over the past 13 years, the impact of emerging markets on gold prices was unequivocally positive: emerging markets drove gold prices higher. However, this has not always been the case through history and, we believe, will not always be the case going forward. Emerging markets can be both a positive and a negative driver.
The impact of the Asian financial crisis is instructive. As the economies in the region fell into recession, the purchasing power of consumers in Southeast Asia declined commensurately. Thailand, Indonesia and Korea all became net sellers of gold, albeit briefly. In line with the drop in demand and the drop in the regional stock markets, gold prices fell 25 percent.
Another big reason for such a sharp and drastic increase in gold’s price is the creation of ETFs. Roughly $150 billion flowed into the gold market via Gold ETFs. SPDR Gold Shares (ticker: GLD) allowed investors to own gold in their investment accounts as easy as buying stock. GLD went from a fledging new idea in 2004 to holding more than 1,000 tons of gold today. That’s more gold than the reserves of a large government, including Japan, Russia, China and Switzerland. Historically, inflation-adjusted gold prices have remained within a certain range of inflation-adjusted prices of other commodities. In the past several years, gold prices have completely detached from inflation-adjusted prices of other commodities, thus creating a bubble. Like all commodities, gold has a supply-and-demand equilibrium price. New demand for gold fed by fear of hyperinflation quickly outstripped supply and caused a large price spike. The interesting aspect of this surge is the large number of investors who bought gold because they anticipated hyperinflation rather than waiting to observe a rise in prices. These fears are gradually subsiding as inflation remains low, the banking sector becomes stronger, and asset prices are recovering in stocks and real estate.
Gold’s spectacular run through a decade was also fueled by rising government deficits, quantitative easing, wars and financial crisis. The run peaked with the U.S. debt-ceiling fiasco in August 2011 and the first-ever downgrade of U.S. sovereign debt by a credit- rating agency. Economic uncertainty certainly seems to have fueled gold’s massive run. Despite all of the continued uncertainty, the U.S. recovery proved stronger than many people had expected, and equity prices started to rally once again. Since the August 2011 peak, gold has fallen 27 percent, the traditional definition of a bear market.
The new investors who rushed into gold never understood the fundamental case for gold. The story line put out by many analysts is that gold shined as a safe haven during the Great Recession, but its allure has evaporated with the recent improvements in the global economy, particularly in the United States. Ironically, this ignores the fact that gold actually performed better in the years leading up to the 2008 financial crisis than it did during or following the crisis. That may be because the inflationary monetary policy that fueled the housing bubble also powered gold. Deflation fears led to gold’s 35 percent decline in 2008, but once the Fed reopened quantitative easing gold rallied to new highs. But in 2008 gold fell in concert with nearly every other asset class. This time, it’s falling while other assets are rising. The negative spotlight makes the current decline potentially more meaningful.
If gold is no longer serving as the safe harbor that many investors sought, what is it good for? Is gold a worthwhile investment if it can fall as it has? Yes, but we believe that over the long haul, gold works well as a type of insurance policy, not as the centerpiece of a portfolio.
The key is to view it as a hedge instead of expecting it to perform like a stock. There is a value to a hedge and an opportunity cost to using a hedge. If you believe this is a difficult economic environment, gold is one of the things that might do well if things are really, really bad. But there are no guarantees. That’s why you shouldn’t have a large part of your portfolio in gold. Recent improving conditions remind us that gold should just be one, small component of a portfolio along with other diversified assets.
The prudent investor should always think about the downside when looking at an investment. We believe gold offers the potential downside protection for those events which we have no ability to forecast. •


Matthew M. Neyland is the director of investments at SK Wealth Management in Providence.

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