Many prominent investors, including Warren Buffett, have recently raised doubts about gold as an investment. Dominic McCormick questions their views.
It’s been a wild ride for investors in gold-related areas recently. After peaking at around $US1925 in September last year, the price has since gyrated between $US1500 and $US1850.
Meanwhile, many gold mining stocks are trading at the same levels they were several years ago when gold was around $US1000. In addition, some prominent investors have declared the gold bull market dead or questioned gold as an investment, with Warren Buffett the most prominent of these.
This all creates a very confusing environment for those investors considering gold exposure in their portfolios. Is the gold bull market really over? Or is this a good buying opportunity? Why are the gold mining shares languishing? Is Buffett right?
Buffett’s comments in an article in Fortune and his annual shareholder letter have received extensive coverage and, as one of the world’s most successful and sensible investors, his views should be taken seriously.
But he is far from infallible, and a valid question is whether he has ventured outside his own ‘circle of competence’ with these comments.
Buffett discussed the characteristics of investments he disliked and those he liked. Specifically, he divided the investment world into three major categories.
Firstly “currency based” investments including cash and various debt instruments; secondly “unproductive” investments, with gold supposedly the most representative; and thirdly his preferred avenue – “productive assets” in businesses, farms or real estate.
Ironically in Buffett’s discussion of the first category covering cash and bonds, he seems to totally understand the damaging impact of currency debasement by inflation, which is one of the major factors supporting hard assets like gold.
“Governments determine the ultimate value of money, and systematic forces will sometimes cause them to gravitate to policies that produce inflation.
"From time to time such policies spin out of control. Even in the US, where the wish for a stable currency is strong, the dollar has fallen a staggering 86 per cent in value since 1965”. It takes no less than $7 today to buy what $1 did at that time”.
Surprisingly then, Buffett fails to connect the dots that these are the very reasons one should have some gold as part of a diversified portfolio.
Interestingly, one of Buffett’s least successful plays over the years has been investing in foreign currencies as a hedge against concerns he has had about debasement of the USD.
If he had understood gold as money and chosen it as his currency of choice, he may have a very different view of gold today.
Instead, he views gold through the prism of conventional investment analysis only. Gold isn’t “much use nor is it procreative”. If you own one ounce of gold for an eternity, you will still own one ounce at the end.”
Isn’t that the point? Gold is unchanging, and its supply expands only very slowly with annual production. Meanwhile, central banks can create unlimited new paper money at whim.
Ultimately, gold is not really an asset or investment but is a currency or money. Gold’s primary attraction centres not on its own characteristics (although these – scarcity, density, malleability etc – allow it to be seen and used as money) but in the level of confidence in the various forms of paper or fiat money. That confidence is still arguably entrenched in a multi-year bear market.
James Grant of Grant’s Interest Rate Observer probably says it best.
"It is the nature of gold that its valuation must forever be a mystery. It earns nothing. It pays no dividend. No conference call, no management to call up and complain to.
"What I do think is gold is simply the reciprocal of the world's faith in the institution of managed currencies. It is one divided by T, where T stands for trust. And trust is a shrinking number and will continue to shrink. Therefore, I am still bullish on gold."
Buffett equates the interest in gold to the tulip bubble. This is a terrible comparison. The tulip mania was a particular irrational bubble (of which many have occurred through history) that occurred in a small part of the world for an item that one can easily grow and which doesn’t last.
Gold cannot be grown, basically lasts forever and has been a prominent part of global monetary systems for thousands of years. Buffett totally discounts this history.
Buffett says that those investors purchasing gold need the ranks of the fearful to grow to support it. Perhaps he’s right, but there are strong grounds that the fearful will continue to grow in coming years. The US debt situation is unsustainable.
Reigning in central bank ballooning balance sheets will be no easy task. The euro could implode. In this environment there is plenty to be fearful of, particularly since the likely response to these challenges is to accelerate currency debasement via policies that are eventually inflationary.
These are legitimate fears. Buffett seems to have that fear himself. You don’t need Armageddon to justify seeking ways of protecting your savings from debasement.
Buffett brings his thoughts down to a discussion about two “piles”. Pile A contains the world’s estimated gold stock valued at around $US9.6 trillion, and Pile B contains all US crop land (400 million acres with output of about $US200 billion annually), plus 16 Exxon Mobils (each one earning $US40 million annually).
It’s an interesting game but one that has little to do with building a properly diversified portfolio capable of preserving value in a range of macroeconomic environments with widely varying levels of currency stability.
No sensible investor approaches investing with this concentrated either/or approach. Most real-world investors could never handle the volatility and drawdown risk of a farmland plus Exxon portfolio. And no sensible investor would put all his money in gold.
Of course, the productive assets Buffett describes should be the majority core of a sensible portfolio when they can be purchased at reasonable prices in areas without excessive political risk.
But why does this preclude an exposure to areas like gold that have proved themselves throughout history as a preserver of wealth during periods of instability and flawed or unconventional economic policy.
One shouldn’t hold physical gold to achieve a specific investment yield or return. Rather, it should be held because one is concerned about the debasement of money and the need to preserve its value. Buffett is concerned about that too, but believes other areas are better defenders against that debasement.
However, the record of the stock market preserving real value in periods of unexpected inflation is a poor and unpredictable one. And even great companies can produce poor performance – even over the long term – if the price paid is too high.
James Grant highlights the case of Buffett’s beloved Coca Cola, which has dramatically lagged gold – as well as other ‘non-productive’ assets like sugar – since 1996.
Despite Buffett’s talk of the gold “bandwagon”, it is still largely ignored by the bulk of the investment industry. In a recent Barons’ survey of 51 of the US’s best financial advisers, only two had specific allocations to gold. Negative views like Buffett’s are prominent, and very influential.
Even locally, The Australian recently (14 April) had an article quoting a prominent stockbroker saying gold would halve and should be avoided. These are not the symptoms of a bubble just about to bust.
Meanwhile, official holders such as a number of the world’s central banks are buying more gold. As holders of a country’s foreign exchange reserves they would be crucified if they invested all or even a significant proportion of assets in volatile oil shares or farmland.
Their choices are primarily currencies and government debt and increasingly the yields on the latter are approaching the zero yields on gold, but with increasing credit and debasement risk that gold doesn’t have.
Having a modest proportion of their holdings in gold makes sense.
The bubble is not gold – the bubble is certain central bank balance sheets, money supply and the miniscule sovereign bond yields of certain countries that cannot possibly pay back their debt without serious currency debasement.
The line between a “safe haven” and a major credit risk is a thin one. The US 10-year bond is effectively on a Price Earnings ratio of 50, with no growth and next to no chance of beating inflation over the short or long term. Shares are more reasonably priced and have a chance of matching or beating inflation.
Gold does too. Why shouldn’t investors have some of both in a diversified portfolio (as well as other diversifying investments such as inflation-linked bonds and alternatives)?
This is not to say that those holding gold exposure can be complacent. The endgame for the gold bull market will almost certainly be some form of bubble.
When the gold rise accelerated in the middle of 2011 we became cautious and reduced our exposure to gold bullion considerably.
However we have seen the consolidation since as a healthy development and arguably a buying opportunity.
It is true that gold seems to have become more correlated with other risk assets, so its value as a diversifier may have reduced somewhat.
However, this is also true of many assets in the risk on/risk off world we live in today.
Meanwhile, the gold mining stocks have struggled in recent years, underperforming the gold price significantly since 2009.
There are a range of reasons put forward for this – the ease of accessing gold via other means such as ETFs, cost pressures, operational risks and the like.
These are all valid reasons.
However, I suspect a major reason is simply the widespread scepticism – encouraged by Buffett and others – that gold prices can maintain current high levels or even go higher in coming years.
Analysts, and by implication markets, typically have forecast long-term gold prices considerably below current levels. If they are proved wrong, gold stocks could outperform gold dramatically, and produce very good returns in coming months and years.
Further, their increasingly attractive dividends nullify the “no-yield” criticism of gold by Buffett.
Of course, if the US economy does recover strongly, the US dollar becomes stronger and interest rates rise much earlier than currently expected, then gold may struggle.
But this scenario is by no means certain, and does little to solve the US longer-term debt issues that are key factors supporting gold in the longer term.
Europe’s debt issues certainly are not yet solved.
Moreover, even if gold struggles in response to an improved global outlook, a well-diversified portfolio should still do well as the majority balance of the portfolio – much of it consisting of Buffett’s “productive assets” – responds to a better economic and earnings outlook.
Holding 5-10 per cent gold exposure is simply a hedge that may or may not be required.
There will be a time and environment where the case for holding gold exposure is definitively much weaker. That will be when real interest rates in many countries are positive and when debasement of the currency is not seen as the proper policy response to ease a debt burden and promote growth.
It will be when the expansion of central banks’ balance sheets has been reversed – perhaps in response to growing inflationary problems.
It will be when the major developed markets, that currently can still get away with record-low bond yields despite record government debts, experience their own sovereign debt crisis.
It will be a time when belief in gold as part of a portfolio is almost universally accepted rather than something many actively argue against. My guess is that this time is still at least a number of years away.
Buffett’s comments, in my opinion, are just another brick in the ‘wall of worry’ for the 11-year gold bull market. It may even have created an excellent buying opportunity as it contributes to a temporarily lower gold price (and even more depressed gold shares) than would otherwise have been the case.
Taking advantage of this opportunity in the current climate of volatility as well as scepticism and recent disappointment in gold is difficult, but that is the nature of contrarian investing.
Dominic McCormick is the chief investment officer at Select Asset Management.
