What’s Driving Gold

March 09, 2012
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What’s Driving Gold?
by Cathy Pareto, MBA, CFP® – March 2009

Much attention has been given to the rise in the price of gold in recent weeks, leading investors to wonder, what are the current factors driving gold? The easy answer to that question is –fear. We have already witnessed an eight year bull run in gold, but many believe that it’s bull run is far from over. What is gold’s role in the credit crisis? Is buying the metal a better investment than investing in gold mining companies? Is it too late to cash in on the growth?

Before we can answer these questions, let us first review what role a gold investment might play in your portfolio. Investors buy gold for a number of reasons, including:

  • To hedge against inflation.
  • To hedge against a declining dollar.
  • As a safe haven in times of geopolitical and financial market instability.
  • As a store of value.
  • As a portfolio diversifier.

Falling under the precious metals asset class, gold is a monetary metal whose price is determined by various factors. Among these factors are: inflation, fluctuations in the dollar and U.S. stocks, currency-related crises, interest rate volatility, global geopolitical tensions and increases or decreases in the prices of other commodities.

In the credit crunch of deflation, gold and currencies are hoarded and the purchasing power of both rises. But, gold also thrives in inflationary environments. That is because of gold’s unique property with a dual role as both money and acommodity. Think of gold as money, and money is hoarded in deflation so gold naturally tends to go up. The point here is that gold does well during extreme economic environments. Let’s dissect some of the benefits of owning gold in the paragraphs that follow.

Inflation

As inflation goes up, the price of gold goes up. Since the end of World War II, the five years in which U.S. Inflation was at its highest were 1946, 1974, 1975, 1979, and 1980. During those five years, the average real return on stocks, as measured by the Dow, was -12.33%; the average real return on gold was 130.4%. The environment in the 1970’s was not unlike the environment today. The common denominators in both periods are huge budget deficits, loose monetary policy, soaring oil prices (2008) and the open-ended costs of war (Vietnam vs. Iraq/Afghanistan).

Store of Value

According to the World Gold Council, gold has maintained its value in terms of real purchasing power in the very long run in the US, Britain, France, Germany and Japan. Despite price fluctuations gold has consistently reverted to its historic purchasing power parity with other commodities and intermediate products. Gold is tangible, it’s a physical asset that brings a sense of comfort when intangible assets, like stocks, are evaporating. But, while they do maintain a store of value, it is worth noting that gold, like stocks and other investments, is also subject to price fluctuations.

Safe Haven

Many investors are diversifying away from traditional equities and into gold because of the continued uncertainty surrounding the financial markets. Gold has long been considered a safe haven, or “crisis commodity”. Of course, as investors flock to safety investors the price of gold is pushed even higher. Historically, as people begin to distrust their paper assets (ie. Currency), this positively influences the price of gold too, as we’ll discuss in the next paragraph.

Currency Hedge

Not all citizens have full faith in their local currency, at times, this might even include the U.S. Dollar. So, what do they do? They buy hard assets like gold (a tangible and physical item or object of worth). Although it’s no secret that U.S. Dollar is world’s reserve currency and the main medium for global trade, the U.S. Dollar, like the Euro, Yen or other global currency, is really nothing more than paper, or fiat money. Fiat money is money that is intrinsically useless and is used only as a medium of exchange. There is no physical asset that backs the U.S. Dollar today (or other global currencies for that matter) since its gold backing was stripped in 1971. But since gold is purchased using your local currency, in this case the dollar, then any decline in the value of the dollar causes the price of gold to rise.

Diversification

While all the other rationales for owning gold are viable, perhaps the most important reason to consider gold in your portfolio is for its diversification benefits. Gold, like many other commodities, typically has an inverse relationship to the market. Assets with perfect negative correlation to other assets in a portfolio help investors hedge away their risks, in effect they reduce volatility while enhancing performance. Gold and other tangible assets have historically had a very low correlation to stocks and bonds. Because the price of gold increases in response to events that erode the value of traditional paper investments like stocks and bonds, it’s worth considering a fair allocation to this asset as part of a diversified plan. The “right” allocation will depend upon your specific circumstances and risk tolerance, but a good gauge might be between 3% to 8%.

Owning Gold

The gold market is highly liquid and there are many ways that investors can own gold. The most traditional way of owning gold is via gold bullion like gold bars and coins. When buying the physical asset, many people buy gold coins, considering the potentially higher storage costs or risks associated with owning gold bars. Gold coins can be easily purchased directly from the U.S. Mint or from authorized dealers and precious metals firms. Depending on where you purchase the coins and the current demand levels, you may have to pay a premium (above the current spot price of gold) to acquire the coins.

Another way to access gold is through futures contracts or products like gold ETF’s (ie. Ticker: GLD) which offer investors a relatively cost efficient and secure way to access the gold market. A Gold ETF is an exchange traded fund with gold being the principle and only commodity being traded. Gold ETFs are listed and traded on the stock exchange and investors get units for their holding in the gold ETF. The returns on gold ETFs are more or less same as that of the spot price of physical gold. It’s worth noting that the IRS treats gold as a collectible for long-term capital gains tax purposes, therefore, gains recognized by individuals from the sale of gold ETF’s are subject to a capital gains rate of 28% if held for more than a year.

Finally, investors can also consider having gold exposure through gold mining stocks and funds. Some argue that this is more tax and cost effective, in that, there are no storage fees, theft concerns and gold mining stocks also benefit from lower capital gains rates. On the flip side, owning stocks in a mining company is really not the same as owning the actual gold.

In closing, gold’s recent rise is really no surprise given the recent financial uncertainty in the global markets. As fear and investor trepidation permeate the markets, investors look to physical assets to help them preserve their wealth. Times of crisis help fuel the demand for gold and, arguably, the easy access allotted by gold funds or ETF’s has further pushed up gold’s price in recent years. To a certain extent, the demand for gold, mostly by investment funds, is feeding on itself. While some analysts suggest that the price of gold is being inflated by a flood of new investment money (implying it might be overvalued), others predict even further price growth down the road. Either way, the argument can be made that gold offers sufficient benefits (inflation protection, currency hedge, portfolio diversifier) to warrant at least some representation in your collection of assets.