Friday, October 9, 2009

The Rush to Buy GOLD, GOLD, GOLD!

(Editor's Note: Paul Schatz, President of Heritage Capital, LLC, in Woodbridge, will be contributing to Fi$callyFit every Friday. Read his biography here)

Now that gold has exceeded its all-time high set in March 2008, it’s become headline news. The media is just fascinated with the yellow metal. Gold bugs, whose answer to every investment question is “gold”, are screaming the virtues of owning gold from the rooftops, with prices north of $1000 an ounce. But let’s remember that as of today, the price is only up 17% year-to-date, roughly the same as the stock market.

So why all the fuss with gold? Why are investors so hypnotized by it? Does it belong in everyone’s portfolio?

First, let’s discuss how to own gold. For decades, investors were limited to the futures market to speculate on its direction. If people wanted to take possession of the metal, they typically bought coins from private dealers. While both methods are still used today, the explosion of exchange traded funds (ETFs) has allowed individual investors to act more like institutions by purchasing instruments that trade on the New York Stock Exchange with the State Street Global Advisors Gold Trust, GLD, being by far the most popular. It essentially represents 1/10 of the price of gold and trades like a stock on the exchange.

But there are inherent problems with each of the instruments listed above. Futures require a margin account and often trade at a premium to the spot price. That premium is based on the cost to carry the metal, i.e. interest rates and storage fees. Gold coins purchased through dealers also can trade far above the intrinsic or “real” value. When demand is high, like it’s been, some dealers will mark up prices 10-30% above what they are really worth. That’s their commission. And the GLD supposedly holds actual gold bars in safes, but there’s been speculation that it may not be 100% accurate - a topic for a different discussion.

Gold, like other hard assets such as copper, real estate, and oil does not pay interest or dividends. And as history has shown, owning these assets long-term has been a terrible investment. But tactically or more short-term, they have provided some outstanding opportunities.

In 1980, during the last bout of inflation, gold soared very quickly to $900. It then spent the next 28 years collapsing to $250 and rallying to $1000. So holding the metal all that time yielded you basically nothing in absolute terms. If you adjust for inflation of the past 28 years, gold needs to hit $2300 before it breaks even from 1980!

Many textbooks teach that gold is a great hedge against inflation. While it may have worked during a period in the 1970s, that is certainly no longer the case. If you are skilled in math or engineering, feel free to run the correlation between gold and the Consumer Price Index (CPI). You will be surprised to see the failure. Gold has also been viewed as a safe haven in times of crisis. The problem is that too many people never actually researched that theory to see how the metal actually performed. In 2008, a year in which no one on earth can argue we didn’t have a crisis, gold was a safe haven but still lost 5.8% in value.

So the $64 million question then is: Why is gold going up now? Seeking answers from the gold bugs is pointless since they always have reasons to own gold, even as it collapsed from $900 to $250. To begin with, gold does tend to perform well when there is lots of liquidity in the financial system. Liquidity is basically the amount of money available for investment. The more liquidity, the better the investing climate. With so much liquidity, the secondary instruments, like gold, silver, platinum, lumber, etc. end up receiving more dollars than normal. And because those aren’t usually large markets, it doesn’t take a sea of money to move price, like it does in treasury bonds or blue chip stocks.

Since early 2008, the U.S. Federal Reserve rammed short-term interest rates to essentially 0%, making money “free” to banks to borrow. As the crisis worsened they began running the printing presses 24/7 to flood the system with money, along with constructing some of the most creative and cutting edge programs in history to unclog the bowels of the financial system. The U.S. Treasury, not wanting to feel left out, also chimed in with a bevy of programs of their own.

This all led to a tsunami of liquidity in the global markets, which helped establish the market low in March. With the rising tide lifting all ships, gold certainly saw its share of the money. Additionally, many investors, myself not included, saw the torrent of free money in the system as very inflationary. I laughed when I heard people comparing our economy to that of Weimar Republic in Germany post World War I or Zimbabwe where hyperinflation was the order of the day with citizens using wheelbarrows of money to simply go grocery shopping.

I am on record on CNBC, WTNH and in my weekly newsletter that Ben Bernanke and his band of merry men would light up his best cigar, open a bottle of his favorite wine and do a celebratory dance if the Fed could somehow engineer some inflation, which my 6 year old daughter could fix. Bernanke & Co. is terrified of deflation, not inflation and that’s a topic for a different day.

What we’re seeing now is a wave of liquidity, not real, threatening inflation. For me to worry, we would need to see wages growing, not falling as they’ve been for some time. The average hourly workweek is down to roughly 33 hours per week and has been falling for years. That would need to be on the steady to worry about inflation. Global capacity utilization is only at 70%, not even at neutral levels let alone inflationary ones. And unemployment has more than doubled and is about to hit 10%, even by the government’s questionable calculation methods.

There is no real threat of inflation now or in the near future. Those who are buying gold to hedge against it will be disappointed. As I’ve said, gold is rallying along with most other instruments because there is so much money in the system. It’s also been strong because of the weak U.S. dollar. Gold is priced in dollars so currency weakness acts as a tailwind to global commodities priced in dollars, like the metals, energy and agriculture products.

History has shown that the best times to buy gold are when no one wants to own it, usually after a significant decline, like we saw in late 2008. That also coincides with market sentiment showing very few traders positive on the metal. For the past month, the sentiment surveys have consistently shown more than 90% bulls, not usually the time to initiate a position as the end tends to come sooner than later.

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