It’s time again to return to the topic of gold. It comes at an interesting time when, at least at the time of writing, gold is confounding many critics by rising in price when the US dollar is also rising.
Although arguably still in a long-term downward trend, the US dollar has rallied sharply, particularly against the Euro — the currency seen, at least until recently, as the alternative ‘reserve’ currency.
Foreign currencies
Many had come to see gold’s high inverse correlation to the US dollar as a given, and used this relationship to argue that gold was not required in a portfolio because one could get the same benefit simply by selling the US dollar for other currencies.
In today’s global markets, if investors were concerned about the US dollar, they could simply shift money to other currencies with the press of a button. This is what many investors have recently done, including the most famous investor of all, Warren Buffet, who now holds around $US20 billion in foreign currencies.
It seems the Euro had been the target of most of these foreign currency purchases. Perhaps it is not that simple, and attempting to preserve value by moving into other currencies is the wrong strategy. Perhaps they should have bought some gold?
Some take the recent market action as signalling the next leg of the bull market in gold. While the future is always uncertain, a serious bull market in gold would require it to rise in all currencies — not just in US dollar terms. From this point of view, the recent strong move in the Euro price of gold is quite significant.
Gold under-performance
My return to the gold story was also sparked by a recent piece by Eugene Fama of Dimensional Fund Advisers (DFA) entitled Nowhere to Hide. I have much respect for what DFA do and have long believed that if you are going to invest passively, their approach is the way to do it. However, I do sometimes struggle with their exceptionally strong belief in efficient markets. This belief comes through clearly in this recent piece on gold.
The thrust of the piece by Fama is that gold offers no protection to “scary” markets, pointing out that gold has under-performed on the S&P 500 (with greater volatility) over the last few decades.
Since January 1970, Fama writes, gold has had an annualised standard deviation of 19.64 per cent versus 15.41 per cent for the S&P 500.
In spite of its greater volatility, gold returned only 7.48 per cent per year, versus 11.29 per cent for the S&P 500.
Omitting the 70s paints a bleaker picture: over the past 20 calendar years, gold has returned 1.77 per cent per year versus 13.23 per cent for the S&P 500.
Portfolio construction
While the numbers are no doubt correct, this is history and misses the point about why gold should be part of a portfolio. Gold is a form of insurance and can perform and help preserve capital in exactly the types of environments where equity markets perform poorly, although it comes with no guarantees.
However, there are also no guarantees that equity markets will perform anything like they have in the last 20 to 30 years. Indeed, starting from much higher valuation levels and lower levels of interest rates, we are almost certain to achieve lower returns. Investing is about assessing probabilities, and history shows that capital market returns can be very disappointing, even over long periods.
Fama is most correct when he states: “Maybe they [gold supporters] see gold itself as de facto currency. After all, gold has been used on and off as money across many civilisations through history, sometimes surviving other local coins.”
Gold does best when confidence in the currencies of the day are reduced through inflation or financial instability and interest turns to harder assets for a store of value.
However, I don’t agree with his comment that “currencies don’t produce anything; and though they fluctuate relative to each other, the fluctuation is unpredictable. There’s no economic reason to expect any currency to be worth more tomorrow than it is today”.
Currency fluctuation
In the short-term, currencies clearly fluctuate and are largely unpredictable, but in the longer-term (and we know DFA push the long-term view), the above statement is clearly wrong with respect to gold.
Over the very long-term, all paper currencies have depreciated versus gold — there are no exceptions. In many cases, such as pre-war Germany, the currency became worthless.
Therefore, there is indeed a valid reason to expect one, or all, paper currencies to be worth less relative to another currency (gold) over time. That has been the case throughout history.
This occurs because governments tend to, at least eventually, print too much currency simply because they can.
However, simply creating more gold out of thin air is not an option — it needs to be mined or sold out of existing private and official reserves.
And in times when there is significant mismanagement of the so called ‘reserve currency’ of the day (the US dollar), one’s confidence that it will depreciate versus gold looking forward should be greater.
Fama also says: “But modern finance suggests that, like metals and other commodities, currencies are not investments with expected return.”
Ignoring gold for the moment, he is also wrong about other commodities such as metals.
When one invests in commodities through collateralised futures indices (the standard way to invest in them), they do have an expected return related to the interest earned on the collateral, any storage premium and long-term inflation. Commodities, more generally however, are a topic for another day.
Alternative investments
The DFA argument against has some flaws when it comes to gold mining stocks.
Well-managed mining companies with good reserves can make good money digging up and selling gold.
However, if you set up a company printing and selling US dollars you will be put in jail. Of course, gold stocks come with additional risks and effective leverage to the gold price that gives investors a volatile ride, but these risks can be well worth taking.
Of course, no one knows the future with any precision, but it is this uncertainty that makes having some exposure to gold (among other alternative assets) a sensible strategy.
Alternatives such as gold don’t come with guarantees, but if you question whether markets are efficient, neither do mainstream asset classes.
The one thing you can be sure of is that in the course of any bull market there will be plenty of sceptics along the way.
Dominic McCormick is chief investment officer of Select Asset Management .
