Gold fever

Posted by on July 27, 2011 @ 8:35 am in Investing

This morning I saw on a website that the spot price of gold had soared to $1,600 an ounce, up over 30% in the past year. What can we as investors say conclusively say about gold? Two things, I think: First, now seems exactly the wrong time to be thinking about gold as an inflation hedge. Second, now is probably not a good time to be buying gold jewelry, if such is your passion.

Among “gold bugs,” the standard argument for buying gold is the risk of financial Armageddon: If the Federal Reserve mismanages the money supply, the United States will be engulfed by hyperinflation and the dollar will be debased. Only real assets like gold will preserve their purchasing power.

Yet despite the recent stimulus that the Fed provided—whether through traditional means (low interest rates) or nontraditional approaches (asset purchases like QE1 and QE2)—inflation is not surging. The shorthand macroeconomic reason for this is simple: Consumers are still reducing debt, corporate demand for borrowing is low, and unemployment is still high. Under such circumstances, the chances of out-of-control inflation are quite remote. (What’s more, if there is an inflation hedge to be had, it looks like much of it is behind us.)

A second argument for gold is the structural change that is underway in investing. Gold is just one of numerous commodities that have surged in value as investors have moved into commodities as an asset class. So, part of the $1,600 price may be the consequence of a long-run shift in investor demand. “Why not get on the bandwagon?” is how the thinking goes.

This is the “greater fool” argument—the argument that you’ll be able to sell for $2,500 or $3,000 an ounce gold (or some other asset) you acquired at today’s prices. This would be a good rationale if your timing skills were perfect. But in a world where timing skills are quite imperfect, building a portfolio on these types of bets is like building on quicksand—dangerous.

A third argument for gold is what you might call the industrial commodities view. Gold is used in various industrial and consumer applications—jewelry, electronics—and you might believe worldwide demand is on the rise. But to believe this, you’d somehow have to argue that industrial demand will accelerate beyond what’s already reflected in the large surge in gold prices. This seems implausible.

The last time there was a surge in gold prices like today’s was the 1970s. Gold jumped from around $65 an ounce in early 1973 to $850 an ounce in early 1980—a 13-fold increase, equivalent to earning more than 40% a year on your money.* This increase occurred in an environment with actual surging inflation, as opposed to today’s scenario, which is merely the chance of surging inflation. When inflation fell in the early 1980s, spot prices fell by 55%. The price of gold returned to the $300–400 range, where it languished for decades.

Today, gold prices have moved from the low $400s in 2005 to today’s price of $1,600—a quadrupling, equivalent to a return of about 23% per year over six-plus years. My guess is that many investors have been drawn to this asset class simply because of the headline-making short-term performance. Had you bought gold six-plus years ago, you would have made more than 20% per year on your money.

Surging prices, investor regret about missing the bandwagon, a theory of why prices “must” go higher—these are the necessary elements of a bubble. A true bubble could have an even larger exponential price rise. But we won’t know until after the fact.

My own theory is that if you’re buying lots of gold today at $1,600 an ounce, you are playing to a greater-fool theme. It’s a gambler’s bet. If you do proceed on this course, make sure it is money you can afford to lose. The risk is that you could build up a position in gold at today’s prices—only to discover that it was the investor selling to you who made the right call.

* Source: Vanguard estimates from spot prices in nominal (non-inflation-adjusted) terms.

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