There are six primary reasons why investors own gold:
- As a hedge against inflation.
- As a hedge against a declining dollar.
- As a safe haven in times of geopolitical and financial market instability.
- As a commodity, based on gold’s supply and demand fundamentals.
- As a store of value.
- As a portfolio diversifier.
Gold is a monetary metal whose price is determined by inflation, by fluctuations in the dollar and U.S. stocks, by currency-related crises, interest rate volatility and international tensions, and by increases or decreases in the prices of other commodities. The price of gold reacts to supply and demand changes and can be influenced by consumer spending and overall levels of affluence.
Gold is different from other precious metals such as platinum, palladium and silver because the demand for these precious metals arises principally from their industrial applications. Gold is produced primarily for accumulation; other commodities are produced primarily for consumption.
Gold’s value does not arise from its usefulness in industrial or consumable applications. It arises from its use and worldwide acceptance as a store of value. Gold is money.
In contrast to other commodities, gold does not perish, tarnish or corrode, nor does gold have quality grades . Gold mined thousands of years ago is no different from gold mined today. Therefore, gold existing in the above ground gold stock is interchangeable with newly mined gold. The early 1980s presented an once-in-a-lifetime opportunity to buy stocks. Today, economic and political conditions appear to offer a similar opportunity in tangible assets. The macroeconomic and political landscape has not looked like this since the hard asset bull markets of the 1970s. The problems plaguing your stock portfolio are jet fuel for hard assets.
“A RECIPE FOR DISASTER? The global economic and financial market climate looks increasingly precarious. Financial imbalances have never been greater following an extraordinary period of easy money. Many countries have experienced housing bubbles and massive increases in leverage, and global trade imbalances are at unprecedented levels. Rising U.S. interest rates and high oil prices now threaten to push the system to a breaking point.” (BCA Research)
Like today, the 1970s were a time of huge budget deficits, loose monetary policy, soaring oil prices and the open-ended costs of war. Today, the combined costs of fighting the war in Iraq and fighting terrorism at home could match the 12 percent of GDP that the Viet Nam War cost. In the coming decade, as the dollar suffers one of the great meltdowns in monetary history, gold will reclaim its place at the center of the global financial system. Gold’s value, relative to most national currencies, will soar. “When East Central Bank buying outstrips West Central Bank selling, and it will in the not-too-distant future, the other remarkably bullish fundamentals for gold will take over and drive the gold price to levels that most people can scarcely imagine today.” (John Embry, Investor’s Digest, March 4, 2005)
Take a look at the following summary of the six primary reasons for investors to own gold. They may never be more relevant than they are today.
1. HEDGE AGAINST INFLATION
Gold is renowned as a hedge against inflation. The most consistent factor determining the price of gold has been inflation – as inflation goes up, the price of gold goes up along with it. Since the end of World War II, the five years in which U.S. inflation was at its highest were 1946, 1974, 1975, 1979, and 1980. During those five years, the average real return on stocks, as measured by the Dow, was -12.33%; the average real return on gold was 130.4%.
Today, a number of factors are conspiring to create the perfect inflationary storm: extremely stimulative monetary policy, a major tax cut, a long term decline in the dollar, a spike in oil prices, a mammoth trade deficit, and America’s status as the world’s biggest debtor nation. Almost across the board, commodity prices are up despite the short-term absence of a weakening dollar which is often viewed as the principal reason for stronger commodity prices.
Oil, Inflation and Gold
Although the prices of gold and oil don’t exactly mirror one another, there is no question that oil prices do affect gold prices. If oil prices rise or fall sharply, investors can expect a corresponding reaction in gold prices, often with a lag.
There have been two major upward moves in the price of gold since it was freed to float in 1968. The first occurred between 1972 and 1974 when oil prices climbed 325%, from $2.44 to $10.36. During the same period, gold prices rose 268% (on a quarterly average basis) from $47.45 to $174.76. The second major price move occurred between 1978 and 1980, when oil prices increased 105%, from $12.70 to $26.00. Over the same period, quarterly average gold prices rose 254% from $178.33 to $631.40.
2. GOLD – HEDGE AGAINST A DECLINING DOLLAR
Gold is bought and sold in U.S. dollars, so any decline in the value of the dollar causes the price of gold to rise. The U.S. dollar is the world’s reserve currency – the primary medium for international transactions, the principal store of value for savings, the currency in which the worth of commodities and equities are calculated, and the currency primarily held as reserves by the world’s central banks. However, now that it has been stripped of its gold backing, the dollar is nothing more than a fancy piece of paper.
3. GOLD AS A SAFE HAVEN
Despite the fact that the United States is the world’s only remaining superpower, there are a myriad of problems festering around the world, any one of which could erupt with little warning. Gold has often been called the “crisis commodity” because it tends to outperform other investments during periods of world tensions. The very same factors that cause other investments to suffer cause the price of gold to rise. A bad economy can sink poorly run banks. Bad banks can sink an entire economy. And, perhaps most importantly to the rest of the world, the integration of the global economy has made it possible for banking and economic failures to destabilize the world economy.
As banking crises occur, the public begins to distrust paper assets and turns to gold for a safe haven.
When all else fails, governments rescue themselves with the printing press, making their currency worth less and gold worth more. Gold has always risen the most when confidence in government is at its lowest.
4. GOLD – SUPPLY AND DEMAND
First, demand is outpacing supply across the board. Gold production is declining; copper production is declining; the production of lead and other metals is declining. It is very difficult to open new mines when the whole process takes about seven years on average, making it hard to address the supply issue quickly. Gold output in South Africa, the world’s largest gold producer, fell to its lowest level since 1931 this past year as the rand’s gains prompted Harmony Gold Mining Co. and rivals to close mines despite 16 year highs in the gold price.
Growing Demand – China, India and Gold
India is the largest gold-consuming nation in the world.
China, on the other hand, has the fastest-growing economy in modern history. Both India and China are in the process of liberalizing laws relating to the import and sale of gold in ways that will facilitate gold purchases on a mammoth scale.
China is teaching the West something new. Its economy, growing at 9 percent per year, is expected to become the second largest in the world by 2020, behind only the United States. Last year Americans spent $162 billion more on Chinese goods than the Chinese spent on U.S. products. That gap has been growing by more than 25 percent per year. China’s consumer class, meanwhile, is spending on everything from bagels to Bentleys – and will soon outnumber the entire U.S. population. China’s explosive growth “could be the dominant event of this century,” says Stapleton Roy, former U.S. ambassador to China. “Never before has a country risen as fast as China is doing.”
China recently passed legislation that will allow the country’s four major commercial banks to sell gold bars to their customers in the near future. Currently, individuals in China are only allowed to buy gold-backed certificates from the Bank of China and the Industrial and Commercial Bank of China.
5. GOLD – STORE OF VALUE
One major reason investors look to gold as an asset class is because it will always maintain an intrinsic value. Gold will not get lost in an accounting scandal or a market collapse. Economist Stephen Harmston of Bannock Consulting had this to say in a 1998 report for the World Gold Council,
“…although the gold price may fluctuate, over the very long run gold has consistently reverted to its historic purchasing power parity against other commodities and intermediate products. Historically, gold has proved to be an effective preserver of wealth. It has also proved to be a safe haven in times of economic and social instability. In a period of a long bull run in equities, with low inflation and relative stability in foreign exchange markets, it is tempting for investors to expect continual high rates of return on investments. It sometimes takes a period of falling stock prices and market turmoil to focus the mind on the fact that it may be important to invest part of one’s portfolio in an asset that will, at least, hold its value.”
Today is the scenario that the World Gold Council report was referring to in 1998.
6. GOLD – PORTFOLIO DIVERSIFIER
The most effective way to diversify your portfolio and protect the wealth created in the stock and financial markets is to invest in assets that are negatively correlated with those markets. Gold is the ideal diversifier for a stock portfolio, simply because it is among the most negatively correlated assets to stocks.
Investment advisors recognize that diversification of investments can improve overall portfolio performance. The key to diversification is finding investments that are not closely correlated to one another. Because most stocks are relatively closely correlated and most bonds are relatively closely correlated with each other and with stocks, many investors combine tangible assets such as gold with their stock and bond portfolios in order to reduce risk. Gold and other tangible assets have historically had a very low correlation to stocks and bonds.
Although the price of gold can be volatile in the short-term, gold has maintained its value over the long-term, serving as a hedge against the erosion of the purchasing power of paper money. Gold is an important part of a diversified investment portfolio because its price increases in response to events that erode the value of traditional paper investments like stocks and bonds.