“When we have gold we are in fear, when we have none we are in danger”
Gold is often considered the ugly duckling of investing, we think, unfairly. Gold doesn’t generate cash flow; it exhibits some volatility with prices often moving in fits and starts. But, from a portfolio manager’s perspective, the reason for adding gold to a portfolio is the lack correlation to other asset classes. That’s just a fancy way of saying that gold reacts to a variety of risks in ways that are different from other assets. The price of gold responds to inflation, financial stress, and interest rates, to varying degrees depending on which of these factors is of the greatest significance at any particular time. At least one of those reasons exists virtually 100% of the time, which is why gold is a staple on our portfolio models.
Gold may no longer be the most misunderstood asset of modern times (crypto and non-fungible tokens have the lead on that score), but the value of gold has been confirmed for thousands of years starting with Kings and today by central banks. The role of gold in a portfolio has evolved over time and that might well be the most impressive quality of gold – it’s ability to transcend thousands of years of the evolution of civilization, yet still remain relevant.
Gold as an Inflation Hedge
At times gold acts as an inflation hedge and the price reacts strongly to changes in inflation, yet at other times it seems to not care about inflation at all. Case in point: if you look at price of gold, adjusted for inflation on the chart below, even adjusted for inflation, the price of gold has been quite volatile so there is more to gold than simply as an inflation hedge. But although the price of gold doesn’t consistently reflect inflation, over a long time, it often does. In 1930, a kilo of gold could buy you a new Chevrolet. Today, a kilo of gold will still buy you a new Chevrolet! Is gold an inflation hedge? Over the long term it has been a very reasonable inflation hedge, but over shorter time frames, it may or may not be an effective hedge, depending largely on which factors are influencing the price of gold at any particular time.
Gold as an Insurance Policy
There are times when gold acts as a financial insurance policy and reacts to financial stress in the economy as well as markets. World class investor Warren Buffett once said “Gold is a way of going long on fear”. We experienced a recent example of that as the COVID pandemic broke out in 2020 and gold held up much better than most other asset classes.
In times of stress, the value of stocks and traditional investments come into question. Gold has long been the reliable store of value when the value of other assets is questioned. As a result, when the world worries, the gold price tends to rise as the ‘cost of insurance’ increases. Yet at other times, that insurance appears to be unnecessary and the linkage to gold is broken — until the next round of stress. In our view, the need for insurance as global debt levels continue to rise to new heights is more pronounced.
Gold as a Speculative Asset
There are also times that gold acts as a commodity purely for speculative reasons. Unlike most other commodities, gold has few industrial uses. Its primary use is in jewelry, and even in that case, jewelry can simply be considered an alternative method of storing gold. As a speculative asset, gold competes with other assets for the attention of speculators and that implies that the level of interest rates and other cash on cash returns, like dividend yields, create a headwind for gold speculators because gold has no yield. The higher interest rates go and dividend yields go, the less attractive gold is to speculators. It’s simply easier to make a case to own gold when interest rates are near zero, as opposed to 6% or 7%. As a result, in the very near term, gold often trades based on changes in interest rates with higher rates pushing gold lower and vice versa.
Gold as an Asset Class
The great part about gold is that when all of the above are combined, we have an asset class with little correlation to other asset classes and over time, attractive positive returns. That makes a gold not only a strong asset for stressful times or inflationary times, but for all times.
“Gold is the money of kings, silver is the money of gentlemen, barter is the money of peasants – but debt is the money of slaves.” Norm Franz
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