Gold has been in a bull market for the best part of a decade but, as Dominic McCormick writes, it still provides an excellent base for those looking for a solid diversifier.
Although most asset classes have been struggling recently, gold has been flirting with new highs in virtually all currencies.
Even gold mining equities have done well, outperforming other sectors and producing positive returns through this period of sharemarket weakness.
The media coverage of gold’s performance has been sporadic, with still plenty of sceptics suggesting gold is a bubble and the last place investors should allocate money today.
This is leaving many investors and advisers confused. Should they have gold exposure, or is it too late? If they should, how do they get that exposure? And how much?
Before we get to these questions, it seems some commentators are totally missing the point on gold — and this includes some of its most vocal proponents.
Gold’s primary merits as an asset derive not from its inherent, standalone characteristics but rather from the flipside of the level of confidence in the financial system generally, and paper currencies specifically — particularly those that are (or aspire to be) reserve currencies.
Gold has played both an official and unofficial monetary role for thousands of years, and is more highly valued when the stewards of the world’s major currencies undermine their current or future value.
Gold’s own direct fundamentals (new production each year, jewellery demand, etc) are secondary, especially at times when confidence in the financial system is tenuous and/or fading.
Critics, meanwhile, get obsessed with arguments that gold doesn’t have an income stream, cannot be valued easily and relies heavily on speculative buyers/investors.
It is therefore crucially reliant on “confidence” — something they argue is very fickle. This is true, but confidence affects the return on all investments.
Even a stock or a market with a known dividend can fall 50 per cent if sentiment sours and its price/ earnings ratio falls from 20 to 10 without any change in the underlying fundamentals.
Further, there are other investment assets or strategies that have no reliable income stream and are difficult to value, but still have a role in a well constructed, well diversified investment portfolio.
Examples include managed futures, commodities and volatility focused hedge funds.
Rigid valuation approaches that work reasonably well with conventional assets are next to useless in assessing such areas.
But it is these areas — including gold — that are often the best diversifiers in portfolios, performing well in a range of scenarios that are less positive for mainstream assets.
The ability to think from a macro perspective about various scenarios for the investment world is vital for assessing the prospects and suitability of such investments.
I also have little time for the ‘analysis’ of some of the gold bugs who seem focused in outdoing each other in providing specific-point forecasts of gold prices at US$2500, US$5,000 or US$10,000 at various dates in the future.
It’s not that very high prices are not possible by the time this bull market (bubble?) peaks, but these assessments often neglect the actual factors driving the bull market and the reasons for holding some gold.
Gold is not heading to any specific valuation driven by finite fundamentals, but is responding to the loss of confidence of investors and savers in the financial system generally and paper currencies specifically.
It will be how pronounced, pervasive and extended that loss of confidence is that will be the primary determinant of the level that gold reaches and the time frame it does it in.
Any end of the current gold bull market is therefore more likely to be defined by sentiment indicators than any particular price target.
It is true that a dramatic improvement in some of the current factors affecting confidence in the financial system could create a less gold friendly scenario, but this does not seem likely in the near term.
Gold’s peak is therefore more likely to reflect an increasingly wide acceptance of gold’s role in a portfolio, a broad-based panic/mania to get exposure and a belief that the world’s financial problems are insoluble.
When these bubble/mania elements are clearly in place, it will make sense to consider significantly reducing or exiting one’s gold investments.
If some of gold’s critics actually thought about and understood these dynamics, they might not be so quick to write off gold’s role in a portfolio.
One speaker at the Portfolio Construction conference in February this year said that gold is the one asset he would definitely not have in a portfolio (assumedly because it does not fit a rigid valuation approach).
The nature of gold means it will always attract critics.
Around five years ago when gold surpassed $US500, I was admonished by the head of one of the research houses for writing an article suggesting that investors continue to participate in what he saw then as a gold bubble.
Ultimately, I could be wrong and gold’s bull market could roll over tomorrow.
However, if so, there is a good chance that the majority of the rest of a well diversified portfolio not invested in gold (equities, property, bonds etc) will do well, as it will likely reflect a greater degree of overall confidence in financial stability.
However, even if one thought gold would not do well in their core investment outlook, it may still make sense to hold some now (although perhaps less than you would with a more positive view) simply for insurance and because there is almost always a number of possible alternative scenarios that could develop where gold is likely to do well.
Contrast this with the arrogance of those who casually dismiss gold as having no role in portfolios.
Perhaps they know for sure that paper currencies won’t be debased, that inflation won’t be a problem in years to come or that investors will not lose confidence in governments.
Or perhaps they are just in denial, blindly seeing only the sunny side of any situation (despite the global financial crisis showing how badly things can go wrong) and risking poor diversification and their clients’ wealth in the process.
Others justify staying away on the basis that gold is already in a bubble/mania and imminently vulnerable. While we could be in the early stages of such a bubble, we are far from a mania.
So far gold’s bull market has been very orderly, and while gold is up almost five times over a period of 10 years, this compares to the last great gold bull market of the late 60s/70s when gold rose 18 times (albeit from controlled and depressed levels).
Despite being the best performing asset over the decade, the level of widespread investor interest remains subdued.
It is true that the gold bullion ETFs have attracted significant support as they have become the gold vehicle of choice for those wanting exposure.
However, the total value of gold ETFs, at around $US60 billion, is still a fraction (less than 1-2 per cent) of the assets held in money market accounts.
The value of gold equities as a proportion of total market capitalisation is minute.
For an asset that has proved a much better store of value than other cash type investments for a decade now (in US dollar terms) these numbers hardly represent the frenzy associated with an advanced bubble.
Some talk about the increasing number of gold-related advertisements and gold shops/ stands appearing, but many of these are about buying your gold rather than selling some to you.
Still, gold is now being recommended widely (despite still numerous critics) and the number of vehicles to access gold continues to grow.
This suggests we are now likely closer to the end of gold’s bull market than the beginning, but we are also in a phase where gold’s diversifying role is increasingly apparent in an uncertain world and where price blow-offs with further spectacular (albeit, perhaps, short lived) gains are possible.
Some have jumped on (but misunderstood) the comments of George Soros earlier this year, who said that gold was the “ultimate bubble asset”.
He wasn’t saying that gold was a bubble about to burst, but that the characteristics of gold and gold bull markets (some described above) mean that gold was more likely than other financial variables to develop into a fully fledged bubble/ mania.
At their last disclosure, Soros’s funds continue to hold significant exposures to gold, as do a number of highly respected hedge funds and fund managers.
The big question for investors and advisers who are still largely on the gold sidelines is: do they jump in now, or do they stay out? At this stage of the bull market, it’s a difficult question.
As a manager of multi-asset, multi-manager portfolios our core view and position is that gold and gold stocks remain in a bull market that has now been going a decade.
Both the key fundamental and speculative drivers remain in place.
Gold offers valuable diversification benefits in an increasingly uncertain world, although on a standalone basis, gold will be volatile and major setbacks should be expected along the way.
We believe that many portfolios should have 5-10 per cent exposure to gold-related investments for insurance purposes, as well as to participate in a bull market that may have significantly further to go.
That exposure should be a combination of direct exposure (eg, gold bullion, gold ETFs) and gold equity funds/mining stocks, with more of the latter as one moves up the client risk scale.
At the margin though, our view is evolving. We do think we are now closer to the end of the bull market than the beginning (but that still suggests it could run for several more years).
It is a time to be thinking about the factors that would encourage one to reduce gold exposure significantly. We also do not underestimate the difficulty of being able to time these moves appropriately.
Ultimately, it is up to advisers/researchers to understand the nature and history of gold to consider its role as a diversifier, to consider whether the key drivers of gold’s bull market are still intact and to consider whether there is evidence it is already a well developed bubble.
To the extent that one is then comfortable, one could use periodic weakness to build some exposure.
A key development in the recent period is that the behaviour of gold-related areas and general markets is creating a different mindset from earlier years in the gold bull market.
On days and during weeks when gold and gold stocks rise, you can almost feel the angst amongst those investors, advisers and fund managers who dismiss gold and have little or no exposure. Why is this angst so palpable now?
For much of the gold bull market over the last 10 years, gold-related assets have displayed a reasonably high correlation to growth assets (ie, they have tended to move with the “risk on” crowd).
Thus, even when gold and gold stocks were doing well, most of the rest of the market usually was too. Now gold has been moving more in line with the “risk off” assets and there aren’t many of these highlighting gold’s roles as a diversifier.
This is the type of behaviour that could accelerate the rush to gain gold exposure dramatically (and therefore truly bring on the mania stage).
The other key change recently is that gold has ceased to be just an inverse US dollar play.
Indeed, as the US dollar rose as holders of Euros rushed for the exits in recent months, gold was a significant beneficiary.
This suggests that the gold bull market is no longer just heavily driven by scepticism of the world’s reserve currency but about all major paper currencies.
Now, there are no guarantees that these relationships will continue, but in a world of uncertainty looking for diversification that recent behaviour has clout.
In the context of Australian equity portfolios the looming merger of Newcrest and Lihir creates some interesting pressures.
The combined entity will represent almost 4 per cent of the S&P/ASX 200 index and my guess is most benchmark oriented managers will be under enormous pressure not to stray too far from that weighting given the contribution of such a volatile and lowly correlated area to tracking error.
Even managers who hate or don’t understand gold may be forced to hold it.
Having said this, people who are relying on their Aussie equity exposure to get sufficient exposure to gold are likely to be disappointed.
At index weighting an investor with 35 per cent in Australian equities is only getting just over 1 per cent exposure in their portfolio.
Gold stocks as a proportion of the global index are minuscule. In our view at least 5 per cent gold exposure is needed to have a meaningful effect.
Still, the decision whether to purchase and hold gold exposure at this point will be a difficult one for many.
However, in many respects I think a decision not to hold gold-related exposure now will prove more difficult and ultimately costly for many investors.
Not just because they will miss out on further gains I believe are likely (of course I could be wrong) but because they will experience enormous emotional frustration in not participating in one of the few major bull markets in place. In some cases investors will ultimately give up in frustration and seek significant gold exposure at the riskiest point of the bull market, and ultimately experience big losses.
Allocating even a modest amount now (ideally on corrections) and therefore participating to some degree is likely to reduce the emotional pull of this financial rollercoaster at a more dangerous time.
Having said all this, some gold is just one element of building well diversified portfolios and it is vital to build those portfolios and ‘size’ the gold exposure appropriately with an eye to the effect gold exposure will have on returns and risks during periods of weakness — and (more importantly) when the bull market is ultimately over.
In the meantime, however, recognition of the value of gold exposure in recent broader market weakness is likely to help accelerate a developing bubble.
On the other hand if advisers have made a decision to steer clear of gold for their clients, a continuation of gold’s behaviour in recent months is likely to prompt more media coverage, more questions from clients and more pressure to include gold in portfolios.
If the bull market continues and a fully fledged bubble does develop it will become increasingly hard to resist.
For both supporters of gold investment and its critics, an interesting and challenging time lies ahead.
Dominic McCormick is chief investment officer at Select Asset Management.
