Should I Buy Gold?
Raymond “Scott” Stone
Stone House Investment Management, LLC
“Should I buy gold?” This is a question that is frequently presented to us. In this article, I’ll go over some of the more common and controversial claims of gold marketing firms, then wrap up with our position on gold’s place in a good investment strategy.
Over the years, we have heard sales pitches, analyst reports, and political punditry describing a variety of scenarios that typically end in “so you have to buy gold now”. Is there any credibility to these claims? Let’s take a look at some of the more common scenarios pitched by gold bugs:
1) The U.S. dollar being replaced as reserve currency:
This one is actually a possibility. In fact, given enough time, it is highly likely that the US dollar will not serve as the sole reserve currency. Likely it will be replaced by either a “basket” of currencies or a newly created world currency that is completely independent of the debt of any nation. If a basket of currencies is chosen, gold may be part of that basket which could cause the price of gold to rise.
2) Rampant price inflation:
In an environment where inflation rages out of control due to excess monetary supply, gold would likely appreciate significantly in price. This is not a very meaningful statement, though, as virtually all things would appreciate significantly in price. Commodities would likely benefit as money would rush off “the sidelines” (A.K.A. Cash) and seek investments whose prices would keep pace with or exceed inflation. Additionally, there may be an additional fear-premium bump to gold prices as some people think of it as the asset of last resort.
3) All currencies failing and the world returning to using physical gold as currency:
Put this one on your list of things that are not going to happen… Ever. There are very real reasons that we abandoned gold as a currency. To be completely accurate, gold was never actually a currency. At best, it was a co-currency. Gold has always been thought of as valuable and desirable due to its physical properties and relative scarcity, but it is quite impractical as a currency. It is difficult to denominate because it requires you to actually divide gold the into pieces (hard to make change for a dollar with a piece of gold). It is also difficult to distribute. Currently, very few people have substantial amounts of gold. For it to be adopted as a currency, the gold would have to be removed from vaults, jewelers, and personal jewery collections then melted down, standardized for purity and weight, and then redistributed across the billions of people across the earth. Once distributed (assuming it is even possible) each individual would be responsible for valuing their gold pieces, verifying the purity of the gold being exchanged, and transporting and storing their wealth in heavy metal. Add to this the small detail that there is not enough physical gold to serve sufficiently as a currency even if every ounce available was secured for the purpose of currency. For gold to represent all the value that the currencies of the world represent, it would have to appreciate in price to a ludicrous degree. The reality is that gold as a currency is likely impossible even if it were the only option, but it’s not. It is the worst of a nearly endless variety of options. What are these options?
Human beings have a nasty habit of stealing ideas from nature. One of those ideas is the order of the physical world. The entire universe adheres to a set of laws that presumably something or someone created. Our financial system is based on this idea of rule based order. However, we create the rules, which is very handy because it means we can change the rules as needed. Examples of these rule changes were seen during the various financial crises of 2008 to 2012. The bank bailouts, the auto bailouts, the sovereign debt bailouts, the extension of unemployment benefits, the flood of liquidity from central banks around the world, the unprecedented government purchases of toxic assets, and the extension of special swap agreements between countries are just a few of the examples of how we changed the rules of our financial system to create a new financial reality. Rule changes can be made as long as the majority of market participants are not willing to accept the end result the current rules would bring to bear. Changing these rules typically require some creative thinking, consensus building and the swoop of a pen across a piece of paper. The option to modify the rules to create a new reality that benefits the majority of market participants is so vastly superior to the intense, severe disruption and damage that would be caused by abandoning the financial system in favor of a completely impractical gold currency system that it is virtually impossible to envision using gold as currency. We wouldn’t move everyone to the moon because we dislike natural disasters on earth. It just wouldn’t make sense. Our financial system is imperfect, but using gold as a currency is not a realistic substitute.
4) Returning to the gold standard
As mentioned earlier, I think it is definitely possible that we could create a new standard based on a basket of currencies including gold. I don’t see it as realistic for a currency to be tied solely to the value of a single commodity as that commodity can be effected by supply and demand shocks independent of its value as a currency. It was a bad idea originally and it is still a bad idea. In previous times, it was the best of a lot of bad options, but now we have evolved beyond the need for it largely due to technology. Gold would likely, at best, be included as part of a basket of currencies that becomes the new reserve currency standard. In such case, you may see an appreciation in gold to reflect increased demand for this purpose.
As you can see, the issues regarding currencies are complex and not nearly as black and white as some would like to think. Now let’s look at some common misconceptions about gold investing:
1) If you have physical gold, you don’t have to worry about price fluctuations because you will always have the actual gold in your safe.
This is blatantly false. It is roughly equivalent to saying that if you buy a house it will always be worth as much as you paid for it because you live in it. The value of your house can go down. As many in this country have seen recently, your home value can go down a lot, quickly. When the price of your investments (including gold) goes down, your equity declines which can affect your ability to get credit, your net worth declines, taxation and equalization plans of your estate could be effected and your buying power and retirement income generation potential declines . If you make the assumption that you are buying gold today and that you are going to die owning the same gold and that it doesn’t matter what the effect is on your heirs, then it is true; you don’t need to pay attention to price fluctuations. The same applies to all investments, however. If you have the luxury of not caring what your investments are worth, it doesn’t matter what they are worth. This is as true of any investment as it is of gold. If you do care, however, then physical gold may not be right for you because it REALLY DOES FLUCTUATE IN VALUE (even if it is stored in your personal safe).
2) Gold investing is “safe”
Define Safe? Gold will likely always be worth something. Unlike a share of stock, there will not be a time in the future as we know it where gold might be worthless. Gold can, however, decline substantially in price in a short period of time. It can also stay at these low prices for a considerable amount of time. Over decades most investments, including gold, will trend upward (all else being equal), but you may have to wait years, even decades to get your money back especially if you consider inflation. Gold pays no interest rate or dividend. There is no reward for owning gold other than price appreciation. If you own gold for 10 years and the price does not go up, you have actually lost quite a bit of buying power due to inflation. As Gold is very volatile, and pays no interest or dividends, and has little risk of ever being worthless, it is most similar to a growth stock mutual fund from an investment risk perspective.
3) The value of gold is “more real” than the value of stocks.
The idea that gold has “real value” because it is the only “true currency” is not correct. If you want to get technical, the only “true currencies” are goods and services. If gold ceased to exist, we would be just fine. In fact, most people throughout history have gone through life owning very little gold. Good has always been something that tends to end up in the vaults and showrooms of the rich. So what did the rest of the population do to survive? They worked. They made things, and grew things, and did things and traded these goods and services for the things they needed. Barter is the true system of exchange that our current global economy is based on. We call them “Markets” now.
Throughout history, gold has served as the best material to represent a standardized unit of exchange due to its scarcity, physical properties and somewhat standardized nature. In reality, it is just as fiat as currencies because gold, when used as a method of exchange of value does not reflect the intrinsic value of gold. When gold is used as a currency it is representing the value of the goods and services being purchased or sold. This value can fluctuate from day to day, product to product and community to community. This is the same as any other currency. On Tuesday in Philadelphia, your broken gold jewelry may be worth $500/oz. On Wednesday in London, gold bullion may be worth $1700/oz. The value of gold is contingent upon time, market and condition of exchange, just like fiat currencies.
Like many things, the Information Age has rendered gold obsolete as a unit of exchange. It is likely that in 100 years, we won’t even use cash. So how does this relate to stocks? Stocks represent ownership in a company. The reason you would want ownership in a company is its ability to generate value through providing desirable goods and services to the world. Companies do business using many types of currencies depending upon the country in which they are operating. The collapse of any given currency or even all currencies does not require that we also abandon corporations. In the preposterous scenario that we go back to using physical gold as a currency, we will likely rely on corporate institutions like banks even more to standardize, certify, value and regulate the good order exchange of gold. If you envision a “Mad Max” like apocalypse of society where all of our institutions fail, you will likely be waiting an awfully long time. When faced with global economic implosion or compromising on changes that allow the system to continue (A.K.A. “changing the rules”) modern civilizations will choose to change the rules. Short of nuclear winter, alien invasion, or zombie apocalypse, I am not concerned that our institutions will cease to exist. Consequently, I don’t see a reasonable possibility of a diversified portfolio of stocks ever being worthless. Obviously, the stock of any single company has a certain risk of total collapse, but for the value of a well-diversified portfolio of stocks to go to zero is extremely unlikely.
On the flip side, human understanding of the universe is advancing at an unprecedented pace. According to some scientists, it may be only a matter of years before we can literally change lead into gold. Image what an unlimited gold supply would do to the price of gold! If there were enough supply, it could become virtually worthless.
4) Currencies are a Ponzi Scheme. Gold has real value.
A “Ponzi Scheme” is an illegal investment structure where the money of new investors is used to pay back existing investors. There are LEGAL versions of this structure that are quite prevalent in everyday finance. The reality is that gold is like any other investment that can appreciate in value. Think of it this way; if you buy a piece of gold for $50 how do you get a return on that investment? You get a return by convincing a new investor to give you more than $50. The money that allows existing investors to get their money back and generate a return on their investment comes from new investors. New investors can then only get their money back by convincing even newer investors to buy the gold that they just bought from the last guy and so on and so on. If one day, there were no new investors for gold, the entire market would collapse. All investments, including gold, are only as valuable as what the next guy is willing to pay for them. It is the credibility of an investment that keeps the market from blowing up. An example of a legal structure like this that blew up was the collapse of mortgage backed securities in 2008. As soon as they lost credibility, there were no buyers and the entire market collapsed. Once the government restored confidence to the MBS market, buyers returned and the value of MBS securities rose. Gold is susceptible to this same effect. There are times when a lot of people want gold and times when only a few people want gold. As a consequence, the price of gold rises and falls substantially as people gain and lose confidence in its value.
Relating this to a previous point, the collapse of the mortgage derivative market should have led to the collapse of the entire global financial system, but it didn’t. Why not? Because we changed the rules of how our fiat financial system works. We changed laws, made deals, broke promises, made new promises, bailed out companies, bailed out the unemployed, bailed out homeowners, dropped interest rates, injected stimulus, shuffled balance sheets, etc., until the global financial system regained credibility. We (the human race) changed the rules to create the best outcome for the majority of market participants (human beings) and we will do it again in the next crisis.
5) Gold demand is inelastic.
There is an idea out there that gold can continue to rise in an unlimited fashion like stocks. The problem is that most of the real demand for gold is for the use in making jewelry. Gold is a commodity and it is constrained by supply and demand. As the price of gold rises, it eliminates buyers who either can’t or won’t pay that much for a gold bracelet or wedding ring. In economics, this is called demand destruction. The price elasticity of a good or service refers to how quickly or slowly demand destruction occurs. As demand for gold as a currency or insurance policy against apocalypse rises, so does the price. As price rises, the demand for gold jewelry is harmed. At some price point, the demand for gold jewelry will cease all together. As gold jewelry and other luxury products make up about 70% gold demand, you would have to see a huge increase in demand for gold as a currency/investment to overcome the effect of the demand destruction the price rise in gold would cause.
As you enter a financial crisis, like the one we just came through, you get an increase in demand for gold as a currency/investment. The price rises and the demand for gold jewelry declines. Supply actually increases as people melt down their “Junk Gold” like old jewelry. In the short-term, equilibrium is found at this inflated price as the fear factor keeps the demand for gold as an investment elevated. It is my guess that as the threat of financial crisis subsides, so will the demand for gold as investment. Unfortunately, at the current prices of gold and considering the excess supply from melted scrap gold, prices will likely be above equilibrium of the gold jewelry market requiring that gold fall in price substantially to a point that demand for gold jewelry rebounds. As the price falls, disenchanted gold investors will likely become net sellers, thereby increasing supply and decreasing demand even further driving prices down more quickly. This, however is just a prediction and is subject to assumptions that may not come true.
There are many factors that could drive the price of gold up. There are many factors that could drive the price of gold down. This is true of most investments. Diversifying some of your portfolio to gold may make sense, but on its own, it is an “Aggressive Investment” so only allocate money to it knowing that it could decline in price substantially for extended periods of time and it pays no interest or dividend. Using gold ETF’s is an easier way to add gold to your portfolio, but some investors feel safer with physical gold as an insurance policy against the collapse of the global financial system. One has to question which is more likely; the collapse of the global financial system, or his/her personal gold stash being stolen. As theft occurs every day and we have yet to see the collapse of the modern global financial system, I would have to side with the safety of the global financial system if I had to choose.
7) Liquidity and transaction safety
I heard someone make the case that physical gold is more liquid than stocks because stocks require T+3 settlement. This means that when you sell a stock, you have to wait 3 days to use the cash proceeds due to settlement (paperwork) procedures at the clearing firm. He then went on to say, “Just call me, we will strike a deal, then I’ll send you a box overnight, you put your gold in and ship it back to me overnight, then I will put the money in your account the next morning.” I was dumbfounded by this argument as he perfectly described the gold sales process as “T+3″. He also failed to mention the substantial costs of overnighting gold and how that could greatly eat into your return. Gold is absolutely NOT more liquid than stocks. When you sell a stock, you do it through an exchange that searches for the best price across millions of market participants and transacts your order in seconds. The exchanges and brokers are large, insured, corporations that are heavily regulated. The physical gold market, however, is very lightly regulated and as a consequence, has a higher transactional risk. Calling around to various gold guys to see who has the best price then shipping them your gold based on the promise that they will send you a specified amount of money in a few days is not my idea of great liquidity or transaction safety.
In summary, gold should be considered as part of a diversified portfolio. You should not blindly jump in thinking it is a “Safe” investment, but you should consider it as part of your asset mix. It is volatile and it can and will lose value and it may or may not grow as fast as other investment options. The truth is that none of us really know with certainty what is going to happen in the future. We do our best to understand the economy and various markets and we invest based on probabilities of future events occurring, but no one really knows the future. Strictly from a diversification standpoint, it is reasonable to include gold as an allocation, however, you may consider expanding it out to an allocation to commodities in general instead of solely to gold or other precious metals. There are many food commodities that benefit from inflation, population growth and political instability. You can also consider fossil fuels like oil and natural gas. Each of these has its own risk/return profile and will rise and fall in price independently (to some degree) from one another. Some of these markets are tricky and require advanced knowledge and continuous diligence. If you are not up to the task, there are various options including mutual funds and ETF’s that will do the heavy lifting for you.
For answers to questions about gold investing or any other financial or investment related topics, call Stone House today.