The Glittering Temptress

“What the wise man does in the beginning, the fool does in the end.” – Proverb

After a rather depressing year, investors started 2012 in a happy mood, perhaps buoyed by the realization that the world as they knew it had not come to an end, at least not yet. Alas, the party didn’t last. Looming public revolt against austerity measures, insolvent Spanish banks and grave growth projections for the entire euro zone sent investors’ spirits into a downward spiral once again. For many investors the antidepressant medicine of choice in such gloomy times has become that shiniest of metals: gold!

Once the realm of central banks, jewelry lovers and dentists, gold has become the object of affection of hedge fund giants and retail investors alike. Not only does the emergence of many gold ETF’s (Exchange Traded Funds) mean that gold investments are now but a mouse-click away, Harrod’s has started selling gold bullion over the counter and ATM’s dispensing gold instead of cash have emerged in Abu Dhabi, Germany, Italy, Spain and even outside a chocolatier in a shopping mall in Boca Raton, Florida.[ref]From: “In Gold we Trust? The Future of Money in an Age of Uncertainty”, Bishop & Green (2012)[/ref]

At Triple Partners we have had a small investment in gold as part of our Core portfolio (currently around 2.5% of the overall value) since our inception in 2010.[ref]It’s been a rocky ride from our initial purchase at around $1240 per ounce, through to a peak above $1900 to its present price of around $1600.[/ref]Truth be told, we have been debating the rationale for including it from the very start and the public’s apparent love affair with the shiny metal has only intensified those discussions.

The biggest issue we have with gold is that nobody knows how to value it. Gold is a classic example of what the late, great economist John Maynard Keynes called the “beauty contest” approach to investing. To guess who will win a beauty contest, Keynes explained, the key is “to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of ‘the judges’.”[ref]From “The General Theory of Employment, Interest and Money” by John Maynard Keynes (1936)[/ref]

Gold after all does not generate any cash flows nor is the majority needed for actual industrial, or even jewelry applications. According to the World Gold Counsel for instance, nearly 30,000 tons of gold were purchased between 2000 and 2010. Contrary to popular opinion, a staggering 80% of these can be attributed to retail purchases from emerging markets. Despite all the attention in the media, gold backed ETF investments accounted for only 7,5%. Central banks were actually net sellers.Will retail consumers in emerging markets keep buying at such a frantic pace?[ref]“Emerging Consumers Drive Gold Prices: Who Knew”, GMO white paper January 2012.[/ref]Will central banks get back in the game to restore some confidence in their lackluster currencies?

These questions make it clear that the future value of gold, like fine art for example, cannot be derived or predicted from some inherent quality of the metal itself, but is solely dependent on what someone else will pay for it in the future. One could therefore argue that gold is not an investment, but a speculation. This does not mean you should never own it. In fact, many arguments can be made why you should. We’ll dive into these arguments below.

1. Diversification benefit
The price of gold moves differently from the price of equities. Technically speaking, the correlation between the two assets is low.[ref]Between 1969 and 2011 for instance the correlation between the gold price and the returns of worldwide equities was not materially different from zero (in plain English, the movement of equity prices is unrelated to the gold price)[/ref]Therefore, adding gold to a portfolio can decrease the overall volatility (changes in value of the portfolio), and thus add some ‘protection’.

Because of its meteoric rise over the last decade, with prices multiplying more than 4.5 times(!), gold’s addition to an investment portfolio not only would have decreased volatility, but would have very handsomely increased the overall return. Less fluctuations and more return. Almost too good to be true!

The problem is that, as explained, the value of gold is solely dependent on future buyers’ fancy as it does not pay any dividends or interest. For the argument of diversification, you should therefore probably assume the expected real return to be zero (of course, you can expect gold prices to increase, but that’s a different argument for buying it). In fact, unless you build your own Fort Knox in your backyard, you will need to pay someone to hold the gold for you and therefore the expected real return is actually negative.[ref]In the case of investors in Triple Partners, you are paying 0,29% of the value per year to RBS to hold your gold, on top of the fee you pay us to make that decision for you.[/ref]Adding a low correlated, but negative expected return asset to your portfolio may decrease volatility, but will usually also decrease your expected return.[ref]Except in rare circumstances, where you have negative correlation and great timing on rebalancing the assets in your portfolio.[/ref]

Even worse, the price of gold has been tremendously volatile over longer periods (more on that later). So regardless of the low short term correlation to equities, it may actually increase the long term volatility of your portfolio and could also lead to an investor’s worst enemy: a permanent loss of capital.

It also has not always proven to be a good safety net in times when it really counted. In the three-month period from July to October 2008 for example, when Lehman went bust and stocks declined by around 30%, gold took a 20% plunge, while global government bonds went up. That pattern is actually not uncommon. The correlation between fixed income (such as government bonds) and equities has quite often been lower than that of gold (even negative, meaning bonds sometimes do zig when equities zag). It is doubtful if fixed income currently has positive expected real returns, but at least it is not as volatile as gold. Therefore, from a diversification perspective we believe it is better to hold fixed income in your portfolio than gold.

In conclusion, we feel diversification is not a compelling reason to hold gold in a portfolio. The lack of real yield means that ceteris paribus expected return is negative, and because of its high volatility, the risk of permanent loss of capital outweighs the benefit of potentially lower volatility.

2. Inflation protection
The western pillars of the global economy are shaking under a burden of public debt. With no solution in sight in Europe, and US politicians holding each other in gridlock, many investors fear that government defaults are inevitable. Even if we are spared a hard default of the US or a major European country, we may very well have to face the ‘soft default’ of inflation. In fact hedge fund billionaires like John Paulson (who made his fortune betting against the US housing market in 2008) are betting that inflation is an inevitable consequence of the Fed’s quantitative easing and the ECB’s injections into the European banking system.

It seems plausible that in either scenario gold would do well. In fact, merely an increase in a threat of this happening, accompanied by a decrease in the public’s faith in governments, might already boost the price of gold. It is for this reason that Jim Grant has suggested to value gold as “1/n, where ‘n’ is the world’s confidence in paper currencies and the ’bureaucrats’ who manipulate them.” He adds however: “Regrettably, ‘n’ is unknown.”

Nonetheless, there certainly is historic evidence to support the ‘inflation hedge’ argument. It could plausibly be stated for instance that over centuries gold has kept its real value. According to the World Gold Council this ‘constant’ value of gold is reflected in the fact that an ounce of gold was worth a “mid-range outfit of clothing” in the 14th century, in the late 18th century and in the first few years of the 21st century. So gold seems to function as an inflation hedge over generations.

Over shorter periods gold also does quite well. Data since 1919 shows that over a 5- year period, as inflation rises, the real price of gold tends to go up. Interestingly, the same research shows that equities, except for the short run, also offer fairly good inflation protection: when inflation hits, pessimism usually erupts and the equity markets suffer as a result. However, companies produce real things or generate ‘real’ ideas, whose nominal value rises with inflation. Over a 10- year time horizon, equities and gold have tended to be equally valuable as an inflation protector.

Where gold does not always hold up so well is over ‘medium term’ horizons, as illustrated by the following example from Larry Swedroe’s blog: “In January 1980 the price of an ounce of gold hit a high of $850. By the end of the year it had fallen to $590, a drop of more than 30 percent. By March 1982 it reached just $316, a fall of 63 percent. In March 2002, gold traded at $293, below where it was 20 years earlier. The U.S. inflation rate this 22-year period was 3.9 percent.[ref]Which is similar to the Dutch inflation rate since 1969 by the way.[/ref]A gold investor who was unlucky enough to have bought at that $850 peak not only would have seen the investment fall by 65 percent in nominal terms by the spring of 2002, but would have experienced a real loss in purchasing power of about 85 percent. Given this terrible performance over more than 20 years, it is hard to consider gold a good hedge against inflation.” The same argument could be made about equities of course, but here again the difference is that equities have real intrinsic returns (real people generating real profits that flow through as dividends to real investors), whereas gold does not.

In conclusion, gold has shown to possess inflation protection characteristics, but mostly over the short and very very long term. The short term (as in less than two years) may be relevant to traders, but it should not be to investors. The very very long term, as in centuries, seems too far a horizon, even for us at Triple Partners.

3. Disaster protection
Some doomsayers believe inflation, or even a default of a major Western government, is not a worst-case scenario. They believe a total collapse of the world’s faith in fiat money is possible, if not likely. (The Latin word Fiat means ‘let it be done’. Fiat money then has value simply because governments say it is so (‘let it be money’). Fiat money therefore derives its value from a government’s promise that it is worth something, rather than from a right to exchange it for something real, like a set amount of gold or silver.) This financial Armageddon might begin with a collapse of the Euro, the Chinese refusing to buy more US government debt or OPEC countries refusing to sell oil in exchange for dollars or euros. Next the central banks in a desperate effort to rescue the financial system would pump trillions of dollars into the system. What would ensue is hyperinflation or even a total collapse of faith in the currencies as we know them. Gold would be one of the few things to retain its value.

Such a scenario seems farfetched, but even in today’s world, there are families who need to flee their country, for instance to escape from war or prosecution, taking only what they can carry. In such cases gold, as a store of value, will be much more practical to take than say, an antique cupboard. But so are many other valuables like diamonds, platinum and precious jewelry. And, since you can’t eat gold, cans of food or essential medicine may prove to be even more useful in such trying times.

If you believe these are plausible scenarios, it probably doesn’t make much sense to invest in gold ETF’s, or even to have your own pile of gold locked away at a nearby bank. You would probably want to hold an insurance stash of valuables in your own home, although you should probably add some serious artillery to your supplies, as you may need to defend your home from hungry neighbors who didn’t share your foresight and paranoia. (Glenn Beck, the former Fox presenter and Tea Party kingpin, did not call it the 3G – God, Gold and Guns – scenario for nothing.)

In conclusion, although disaster protection might be a good reason to personally own gold, it doesn’t seem like a valid reason to hold it in an institutional investment portfolio like ours, as you might not be able to get hold of it when you need it most.

4. Back to the gold standard?
To stave off the threat of a total breakdown of faith in the world’s currencies and the ensuing collapse of the world economy, there are an increasing number of voices that recommend going back to the gold standard. These so called ‘gold bugs’ like to talk about gold having been the basis of money for millennia, which is actually a bit misleading. For most of human history, the metal that was typically used as money was silver. As Michael Green and Matthew Bishop eloquently describe in their book ‘In gold we trust’, the fact that gold became the world standard for money, was basically a coincidence. It came about through a slightly off-base official English exchange rate between gold and silver, set by none other than Sir Isaac Newton[ref]Sir Isaac Newton’s track record as an investor is an interesting subject for another investment letter. He made and lost his fortune in the stock market several times and concluded “I can calculate the motion of heavenly bodies, but not the madness of people.”[/ref](who, after setting the world of science upside down with his Principia Mathematica, had been appointed as warden of the English Royal Mint). This official exchange rate made it lucrative for the English public to exchange silver for gold in continental Europe, and use the subsequently reminted gold rather than silver coins at home. A 17th century arbitrage opportunity that left England with gold, instead of silver money. As England, and the City of London in particular, went on to become the dominant power in the world economy, the US later followed suit, which made gold the preeminent standard for currencies around the world.

One can see that a return to the gold standard, or indeed, going back to using gold as money, may lead to a huge increase in its (real) value. However, it is very doubtful that this will happen. Although ‘commodity’ backed standards of money have offered a safe store of value in some periods, governments throughout history found ways to debase the value of money even then (for instance by meddling with the purity of the metal in the coins).Another problem with gold was that, due to its limited supply, it often had a deflationary bias (not enough gold could be found to keep up with economic growth). Of course, new finds did occur, but this uneven growth in the supply created more instability than it solved. It was not for nothing that President Nixon announced in 1971 that the US would no longer guarantee a fixed price of $35 per ounce of gold, which signaled the death of the ‘gold era’.

Going back to a system with that many flaws does not seem to make much sense. This does not mean that we will always stick with the current version of fiat monies, which evidently also has its problems. Money is basically a technology that has been improved over centuries. It has three functions: a medium of exchange, a unit of account and a store of value. We believe the technology of money will be further developed in the years ahead. It is unclear how. Perhaps some new, demand driven technical form of money, will be invented. Hopefully one, that is less dependent on the short-term folly of our government institutions.

In conclusion, although a return to the gold standard would probably significantly increase the real value of gold, it seems unlikely that this will happen.

The Bottom Line
Gold has made its return as a glittering temptress to greedy and fearful investors alike. As a result, its current price of around $1,600 per ounce is significantly above its average real price since 1900 of around $500. Does this mean it will not go higher? Who knows? That’s the biggest issue we have with gold. It cannot be valued based on real cash-flows.

It also does not provide very reliable protection against inflation (not better than equities over the medium term) and its cushion effect during financial crises has not proven to be very robust. Some gold coins in the safe can make sense as insurance against catastrophes such as war or hyperinflation. Just like quality diamonds, platinum or some forms of rare art. In this sense gold is best seen as personal.

However, we feel that the risks and speculative form of return makes gold unsuitable for inclusion in an institutional portfolio like the Triple Partners Core portfolio. We will therefore divest our position in gold and reinvest the proceeds in equities, or as we like to call them, real companies, that employ real people to generate real returns for investors.

We wish you lots of investment peace of mind.

Jolmer & Marius

P.S. for our Dutch readers, here is a link to a classic Van Kooten & De Bie clip from the early 80’s (just before gold started its 85% decline in real value), that shows you this is not the first time that gold has captured the imagination of the ‘investing’ public. Notice the interest rate on the poster of the ABN window! http://www.youtube.com/watch?v=SA3GmB9Bxfc