Monday, January 5, 2009

All That Glitters is not Gold

During volatile economic times, investors and traders go back to conservative positions. If the stock market looks risky, money markets, government securities, and even commodities (“hard assets”) look attractive. The phenomenon is called a “flight to quality” and is common during bearish markets. Gold, one of the first stores of wealth, has received much attention as a way to guard against inflation and market volatility.

A friend and proponent of the new “Gold Rush” (having sold most of his stock to finance his investment into gold) explained, “Gold has intrinsic value and that’s why it will always be a valuable investment.” This couldn’t be further from the truth. In fact, no commodity has intrinsic value—stocks and bonds do: they are tied to the performance and potential dividends of a company. Commodities, on the other hand, being the fungible assets that they are, are linked to fluctuations in global supply and demand. And often, their market values are reflective of what investors think they are worth, not now, but in the future.

Yet the Gold Rush has caught on among the crowd that believes we should move back to the “gold standard,” where the American money supply is linked dollar-for-dollar to a store of gold. Our current system uses a floating money supply, or “fiat” system. American dollars are backed in part by foreign currencies but not hard assets. There is no intrinsic value to paper: the US Dollar is worth what we believe it is worth—or what we believe it can buy us. This may sound ridiculous, but collectively, it’s a system that works.

From what I’ve gathered, gold investments sound appealing for two reasons. One—there is a common misunderstanding about its worth, that as discussed above, gold has an intrinsic, even monetary, value. This commonly held view, in my opinion, has its basis in antiquity, when gold was the primary form of currency. The Bible commonly mentions gold as a standard measure of wealth. Gold back then had an almost supernatural quality to it—it was used in the building of religious artifacts and was also a symbol of majesty and grandeur. Today, gold has less utility in the way of building religious items but maintains its symbol of luster in the form of jewelry. The power of this symbolism and its subsequent perceived value is still a matter of faith; in other words, gold is fiat too.

The second reason builds upon the first. During economic downturn, doomsayers prophesize the end of the US Dollar. A common misconception is that gold is not as volatile as the stock market and has even out performed it. If you follow this line of thinking, what better way is there to safeguard your money then by putting it into something with hard intrinsic value? But even in a complete economic meltdown, few items maintain their value. As pointed out an article in The Economist, during such times, jewelry could maintain some value; however, totalitarian governments emerging from the crises are usually quick to snag such items. Think of the treasures taken by Nazi Germany or Saddam Hussein. In these cases, gold jewelry may be valuable as property—but not as an investment. And you’d better have a good hiding place for it too.

But even a careful look at the history of gold (since its value began floating in 1971) shows the stock market has greatly and consistently outperformed it. After reaching an incredible peak (yes, gold is also subject to wide speculation too) in the 1980s, it has yet to even come close to this high.

In 2001, gold yielded about as much as the US Dollar, making it a rather lackluster investment. Accordingly, $10,000 in gold invested in January 1980 would be worth $10,600 today. Conversely, $10,000 in the S&P would be worth $279,000

To those pushing for a return to the gold-standard: if the idea of an investment is to outperform inflation, then returning to gold-backed money would mean the end to gold as an ideal investment.

The reality is that declining prices make stocks a better deal. Diversification is important—including into commodities—but gold does not provide the protection against inflation and the stock market that the proponents purport. Don’t buy the hype.

Sources:
1. Zweig, Jason. “Why to Steer Clear of the New Gold Rush.” Money, v. 37 issue 4, 2008, p. 66-66.
2. “Apocalypse now?.” Economist, v. 386 issue 8572, 2008, p. 84-84.

4 comments:

  1. From the point of common sense and speaking as a Gringo, the US dollar is manna from heaven. Unfortunately for the naysayers of gold, there is a concept of "don't rain on my parade." Bull Markets go unnoticed or unliked by most until the end of one. Secondly, your chart is only valid to 2001 and the fireworks in gold begun after the fact. Third, Gold is a commodity that people save as insurance not as an investment such as the Dow, which therefore leads to a false comparison. Fourth, Gold has been regaining its luster from India, the Middle East, China, and individual investors, as shown by the the holdings of the GLD etf. Fifth, Gold speaks the universal language that everyone can understand when global currencies have been very volatile of late. Sixth, And as GATA.org brought to the public's attention, there is a shortage of government gold as it has been leased for several years. When the need to replenish their government stocks is recognized, it will create a short aqueeze on the metal. Already there has been rumblings of Gordon Brown's selling of half of Britain's gold in the late 90s, as proof.
    Seventh, a key argument for not owning gold is that it doesn't pay an interest rate, well, bank deposits don't either with Fed lowering rates to the 0 mark. It wasn't that long ago (Oct, Nov) that real fear of bank failures crept into our consciousness, so again, I ask, how much is good insurance worth and not the type you buy at AIG!

    Other than these points I brought up, I felt your thesis was strong and you gave the relevant facts as you saw them, but the fact remains, in this market environment, if gold goes down significantly then all assets should depreciate likewise. And I don't think anyone wants to see that, except maybe the people that like to hear Obama use the word sacrifice.

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  2. Eric I really liked your comments but shouldn't you have been less bombastic and just focused on bringing up queations for Jordan to consider?

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  3. You're correct, Eric, that it may have been bombastic, but I believe each point given was not answered in Jordan's original text and should be considered; since it is part and parcel of any gold bugs arsenal of responses. Also it is hard for Jordan to argue against the only thing that has been up the past 8 years without viagra.

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  4. Eric, the viagra joke is so used by now. Couldn't you think of anything wittier to put to print. Like the only thing up the past years except for gold is unemployment.

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