Why All the Interest in Gold?

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Why All the Interest in Gold?

Larry Swedroe Aug 04, 2015

Last week, we examined the accuracy of Peter Schiff’s financial predictions. His track record, we discovered, served to underscore Warren Buffet’s sage advice to ignore all forecasters.

Because so many “gurus” who appear in the financial media make predictions focusing on the direction of gold prices, today we’ll discuss some more commonly held beliefs about this precious metal in an effort to determine whether or not they hold up under closer scrutiny.

Belief: Gold is an Inflation Hedge

The most common reason for buying gold is probably the belief that it acts as an inflation hedge. Despite this widely held conviction, historically, gold has been a poor hedge of inflation in the short run, and even for periods lasting as long as 20 years or greater.

For example, on January 21, 1980, the price of gold hit what was at the time a record high of $850. On March 19, 2002, gold was trading at $293, way below where it had been more than 20 years earlier. The inflation rate for the period from 1980 through 2001 was 3.9%. Thus the loss in real purchasing power was about 85%. How can anyone claim that gold is an inflation hedge when, during a 22-year period, it lost 85% in real terms?

And while we’re being selective in choosing our period start date, it’s now been more than 35.5 years since gold first hit $850 an ounce. With gold today trading at about $1,100 an ounce, that’s an increase of just 29%. In other words, gold has increased about 0.7% per year in nominal terms since that date in January 1980. During this period, inflation has increased at a rate of about 3.2%. That means gold has now provided negative real returns for the past 35.5 years, losing about 2.5% a year, producing a total loss in real terms of about 60%.

As further evidence that gold isn’t a great inflation hedge, Goldman Sachs’ 2013 Outlook contained a report that found that in the post-World War II era gold underperformed inflation during 60% of the episodes in which inflation surprised the upside. With that said, gold has been a good hedge of inflation in the very long run, such as a century. Unfortunately, that’s a much longer investment horizon than that of many investors.

Belief: Gold is a Currency Hedge

There are two other explanations often offered by investors for their interest in gold. The first is that gold acts as a currency hedge. A study by Claude Erb and Campbell Harvey entitled The Golden Dilemma found that the change in the real price of gold seems to be largely independent of the change in currency values. In other words, it’s not a good hedge of currency risk.

Belief: Gold is a Safe Haven

Erb and Harvey also looked at whether gold serves as a safe haven, meaning it is stable during bear markets in stocks. They found that gold is not quite as good a hedge as some might think. In fact, 17% of the monthly stock returns they examined fell into a category where gold prices were decreasing at the same time stocks posted negative returns. If gold was a true safe haven, then we would expect very few, if any, such observations.
With these facts in mind, it’s hard to see how gold can be viewed as the “safe haven” many investors believe it to be. It’s also hard to see how an allocation to gold could be made with what we might call “sleep-well money.”
Remember, gold prices have risen due to concerns over loose fiscal and monetary policies, and have been supported by negative real interest rates. There is certainly the possibility that the inflation many fear will not materialize, the U.S. economy will get back on track, the Fed will end its current policy and that real interest rates will revert to their mean. And for gold, perhaps that would lead to a repeat of what happened from 1980 through 2002. Or perhaps today’s price already reflects that expectation.

The Cost of Gold

There’s another important point to note about gold. While the laws of economics can be defied in the short term, history demonstrates that investors ignore them at their peril. The principle involved here is that, over the long term, prices tend to move toward the marginal cost of production. In their 2013 Outlook, Goldman Sachs estimated that the marginal cost of producing gold was less than half of what was then the current price, about $750 an ounce.

They also noted that more than 80% of gold production costs less than $1,000 an ounce, about 10% below the current price. It is possible there’s validity to the claim by gold bugs that gold is under-owned by investors (such as central banks) and that even a small shift in demand could lead to a significant rise in the real price of gold, assuming supply is inelastic (a big assumption).

However, we must also keep in mind that almost all the gold ever produced is available for sale. And, as Dimensional Fund Advisors’ Weston Wellington, pointed out: “It’s also conceivable that a significant real price increase would encourage development of electrochemical extraction of the estimated 8 million tons of gold contained in the world’s oceans, dwarfing the existing gold supply.” That’s a lot of supply that could potentially hit the market.

The Bottom Line

As always, my crystal ball is cloudy. So, I don’t make any forecasts, other than that the markets will go up and they will go down (though not necessarily in that order). If you’re thinking about buying gold because of fear stoked by forecasters such as Peter Schiff, I’d urge you to think again.

On the other hand, if you’re considering making a strategic investment in gold as part of your long-term plan, and you are a disciplined buy, hold and rebalance investor willing to accept the risks that gold could collapse and stay down for a decade or two, then gold might merit a small allocation.

Image courtesy of Boykung at FreeDigitalPhotos.net

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