Merits of Investing in Gold

Posted on May 17, 2011 by David Laidlaw 

The price of gold is trading at all time highs recently topping over $1,500 per ounce.  Ten years ago this precious metal was only trading for about $270 per ounce.  Buying gold and holding it for 10 years has produced a compound rate of return of 19% per annum.  As the investing public is aware, these returns dwarf those produced by common stocks and bonds which have returned 2.8% (S&P 500) and 6.3% (Barclays Aggregate Bond Index) per year respectively.

Gold is also one of the few assets where its returns are not correlated with common stocks.  Using the gold Exchange Traded Fund (GLD) as a proxy for the price of gold and comparing its price movements to the change in stock prices (S&P 500), we found that the correlation between these price changes has been only  0.07 over the past six and one-half years.  This result suggests that these price movements are basically uncorrelated.

Even though gold has performed spectacularly and is basically uncorrelated with stock returns, we do not invest in gold as part of our portfolios.  The main reason for this policy is that gold does not produce any cash from the purchase of the metal.  Unlike a bond, gold does not provide interest payments.  Similarly, gold will never pay a dividend or divert its cash flows to invest in a productive enterprise as does a publicly traded company.  All of the investments that we manage for our clients are valued according to the cash flows provided by that investment.  Since there are no cash flows associated with gold, we do not have any tools at our disposal to determine what gold should be worth.

It is also impossible to determine where supply and demand intersect regarding gold.  The supply part of the equation is relatively straightforward.  There are about 30,000 tonnes of gold that have been mined and are in circulation throughout the world.  Each year, gold miners add roughly 2.5 tonnes to this worldwide supply.  However, the demand side of the equation seems impossible to predict.

Gold has very few commercial uses other than jewelry, dentistry and electronics.   Therefore, the majority of demand comes from speculators in the financial sector.  Demand for gold tends to be high when confidence in paper currencies such as the US Dollar are low.  Demand also rises when inflation is expected to increase since the metal has provided protection to portfolios during periods of higher inflation in the past.

It is very difficult to predict how gold will respond in a falling market due to the emergence of financial ETFs which hold significant amounts of gold.  The largest ETF is GLD issued by State Street’s SPDR division.  GLD holds 1,192 Tonnes of gold worth almost $58 billion in its trust.  This amount pales in comparison to the 8,000 tonnes held at Fort Knox and the NY Federal Reserve; however, if holders of GLD and other financial instruments wanted to exit the commodity at the same time, the price would fall drastically.  The impact of this financial leverage has never been tested since gold has only risen since the widespread presence of liquid ETFs in the market.

While gold may play a role in portfolios, we do not believe that we have the tools to predict whether or not gold is selling above or below its intrinsic value since gold does not produce cash flows.  The main factor that influences the price is psychological; investors hold gold since they believe that someone else will pay more for their gold in the future.  Investors in gold must also have faith that the market for gold will remain orderly so that they will be able to sell without the price falling dramatically; however, this faith has not been stress-tested in a declining market.