Is Gold’s Bull Run Over?
Since the turn of the century, the spot price of an ounce of gold has increased by 392 percent while during the same time period the Dow Jones Industrial Average Index has risen by 27 percent.[i] This large percentage difference is in spite of the pull back of over 20 percent in gold since it hit its nominal (not inflation-adjusted) high of $1917.90 in August 2011. Gold’s allure lies in the belief that it is a safe haven asset that investors turn to in times of economic and stock market downturns and that it is an investment that protects against the costs of inflation. Since 2000, both the internet and housing bubbles collapsed and the central banks in many developed countries (U.S., U.K., Japan) have resorted to increasing their money supplies in order to combat their economic hardships. Unlike stocks though, gold is not a productive asset since it does not produce any earnings. As a result, gold cannot be valued in the same way that traditional asset classes are. While we believe in the same thesis as supporters of gold, we believe that stocks provide a better long term outlook than gold.
Decline of the Dollar
One of the major reasons that people purchase gold is because of the decrease in the value of the dollar over time because of persistent inflation. The Federal Reserve explicitly targets an annual inflation rate of 2-2.5 percent, and it attempts to accomplish this goal through the increase in monetary reserves aka through printing money. Since 1900 U.S. inflation has averaged 2.9 percent annually and since 1933 – one of the last occurrences of major deflation – inflation has averaged 3.5 percent annually.[ii]
Why does the Federal Reserve want moderate inflation? The Fed fears deflation – a decline in the prices of goods and services – because it can cause a spiraling downward of prices. If consumers believe that prices are going to decline, then they could delay purchases of goods. This could cause companies to have excess inventory and could cause companies to decrease prices even more in order to attempt to attract consumers. With a decline in prices confirming their suspicions, consumers might again choose to delay purchasing goods. This deflationary spiral was exactly what occurred during the Great Depression: from 1928-1933, prices and output in the U.S. fell by approximately 25 percent.[iv] Does a deflationary spiral always transpire when deflation occurs? Over the past couple of decades, Japan has experienced gradual deflation with prices declining only 0.1-0.3 percent per year. Despite this slow decline, the Japanese central bank is trying various ideas in order to attempt to kickstart inflation.
By guding inflation expectations, the Federal Reserve is more than willing to allow the dollar to decline in value. For example, by comparing the purchasing power of money, a dollar in 1900 would now only be worth 3.7 cents.[v] For a more historical example, George Washington was paid a salary of $25,000 annually for his two terms as President from 1789-1797. His salary would correspond to a salary of $615,000 today (President Obama’s salary is $400,000).[vi]
The Federal Reserve currently alters the monetary supply by setting a target rate for the Federal Funds Rate (the interest rate charged on overnight loans between banks). Then, in order to lower (raise) the Fed Funds Rate, it purchases (sells) Treasuries. By using the money that commercial banks have on deposit on the Fed as excess reserves, the Fed does not even need to print money in order to accomplish its goal of increasing the money supply. When the U.S. operated under the gold standard, the price of an ounce of gold was set to a particular dollar amount. At the start of the Great Depression in 1929, the price of an ounce of gold was set at $20. Since the dollar was set to a particular amount of gold, the Federal Reserve could not attempt to use monetary easing to deal with the high unemployment. When Britain decided to drop the gold standard in 1931, credit conditions tightened more in the U.S. as individuals hoarded gold on the belief that the U.S. was going to devalue the dollar in order to break the current gold standard conditions. In 1933, those beliefs were fulfilled when the U.S. devalued the dollar to $35 per ounce of gold and FDR issued Executive Order 6102 which declared that all individuals holding gold needed to exchange the gold for dollars at a Federal Reserve branch.[viii]
As a result of this devaluation, the price of gold in dollars increased and therefore was a good short-term investment at that time. A separate, but somewhat related question is did the dropping of the gold standard and the loosening of monetary conditions work? If it did work, it would be justification for the reason that the Federal Reserve chose to loosen monetary policy significantly during the most recent recession. Furthermore, it would make a case for economic recoveries occurring because of monetary easing, and therefore a case for investing in stocks because of monetary easing. During the Great Depression, the major economies went off the gold standard in the following order: Japan, Britain, Germany, U.S., France. How did their economies respond to the conditions of the time? The following chart shows the industrial output of these economies:
Which economies recovered the fastest? Japan, Britain, Germany, U.S., France. The exact order that the countries abandoned the gold standard.
Gold as an Investment
While the previous chart was condemning of gold as a currency – at least in response to unexpected economic shocks – it proved to be a good investment during this time as the price increased from $20 per ounce to $35 per ounce (however, holders of gold were not able to take advantage of this appreciation as as Executive Order 6102 stated that the Treasury demanded all individuals to sell their gold to the Treasury for $20.67). During periods of unexpected inflation, stocks have not performed well. Research by three economists from the London Business School verify this point: after studying the performance of stocks, bonds, bills, currencies, and inflation in 19 different markets since 1900, they concluded that equities gave a real (after-inflation) return of -12 percent during times of unexpected inflation.[x] Therefore, research also showed that gold and other commodities performed well during these same times.
With this knowledge, should each investor own gold (or a derative of gold) in his or her portfolio? Not necessarily. Earlier, it was stated that a dollar in 1900 would now only be worth 3.7 cents.[xi] In 1900, the price of gold was $20 per ounce while the price of the Dow Jones Industrial Average was 68.13.[xii] Today, the price of gold is $1477 per ounce and the Dow is at 14708.[xiii] Although the dollar lost most of its value during this time period, stocks still outperformed gold handily. Over the long term, stocks have historically done well during times of moderate inflation (2-5% inflation was the norm during the 20th century in the U.S.). While one thesis for gold is that the printing of money could cause the value of the currency to decline, history has shown that this does not necessarily mean that this will cause gold to be the best performing asset class.
If the thesis of increased money printing can be beneficial to both gold and stocks, then the question of in which asset class to invest turns to valuation. For stocks, many investors use discounted cash flow models to project their current intrinsic values or analyze price-to-book or price-to-earnings ratios relative to industry averages or stock benchmarks. Historically, stocks with low price-to-book ratios or with low price-to-earnings ratios have outperformed the market averages.[xiv] Since gold does not create anything it cannot be valued in this same manner. If you purchase an ounce of gold, you will never have more or less than an ounce unless you decide to purchase or sell an amount. Another issue with gold is the increasing supply of gold. Currently, there is approximately 167,000 metric tons of gold in the world. Recently, approximately 2500 metric tons are produced per year. Of that new supply, 52 percent is used for jewelry, 12 percent is used for industrial purposes, and 34 percent is used for central bank holdings and retail investments.[xv] Therefore, there is an ever increasing amount that can be used for investment purposes. Imagine a company that increasingly issued new stock each year. All other things being equal this would not be good for the stock since earnings would be spread out among more shares.
Despite the increase in supply, gold has soared over the past decade as fears over economic troubles and central bank printing increased. Since gold does not produce anything and cannot be valued by any earnings, gold is purchased by an individual with the hope that he or she can sell the gold to someone else at a higher price. By this regard gold cannot be thought of as a traditional investment, but must be thought of as speculative investment. Is the current price of gold pricing in 2 percent inflation or 4 percent inflation over the next decade? While analysts can back out the growth rate of earnings or cash flow that a current stock’s price is projecting, they cannot do the same with gold. As a result even if inflation increases to 3 percent annually over the next decade this does not mean that gold will appreciate in price because the current price might be forecasting a higher level of inflation than 3 percent.
When Warren Buffett contemplated the argument between stocks and gold in an article in Fortune in February 2012, he stated that at the time all of the gold (priced at $1750 per ounce) in the world could purchase the following:
…all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge).. A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops — and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything.[xvi]
Because most stocks are backed by companies that can produce goods and services, their value is derived from the demand for their goods and services. Over the long term because of this production stocks will most likely be a far less risky asset than gold. There almost certainly will be periods of time that gold will outperform stocks. This occurred in the 1970s and the first decade of this century and could occur again at any time. Yet, for investors seeking long term appreciation as well as the ability to receive distributions for dividends or for compounding with their previous holdings, stocks are the main asset class in which to invest. Because of its speculative nature, gold can be used in some portfolios to hedge against unexpected inflation increases but should not constitute more than 3-5 percent of an individual’s portfolio. Instead, investors should focus on the long term and for many that means investing their assets in a productive asset class – stocks.
*The opinions and forecasts expressed are for informational purposes only and may not actually come to pass. This information is subject to change at any time, based on market and other conditions and should not be construed as a recommendation of any specific security or investment plan. The representative does not guarantee the accuracy and completeness, nor assume liability for loss that may result from the reliance by any person upon such information or opinions.
*Investments in precious metals such as gold involve risk. Investments in precious metals are not suitable to everyone and may involve loss of your entire investment. These investments are subject to sudden price fluctuation, possible insolvency of the trading exchange and potential losses of more than your original investment when using leverage.
[i] Historical Prices. 22 April 2013. Yahoo Finance. 22 April 2013. <http://finance.yahoo.com/q/hp?s=^DJI&a=00&b=1&c=2000&d=00&e=1&f=2000&g=d.>
[ii] Sajal. The Dollar’s 20th Century Decline. 12 May 2009. Seeking Alpha. 24 April 2013. <http://seekingalpha.com/article/137051-the-dollar-s-20th-century-decline.>
[iii] US Inflation Rate. 19 April 2011. Wikipedia. 24 April 2013. <http://commons.wikimedia.org/wiki/File:US_Inflation.png.>
[iv] Siklos, Pierre L. Deflation. 1 Feb 2010. Economic History Association. 24 April 2013. <http://eh.net/encyclopedia/article/siklos.deflation.>
[v] Manuel, Dave. Inflation Calculator – 2013. 24 April 2013. 24 April 2013. <http://www.davemanuel.com/inflation-calculator.php.>
[vii] Sajal. The Dollar’s 20th Century Decline. 12 May 2009. Seeking Alpha. 24 April 2013. <http://seekingalpha.com/article/137051-the-dollar-s-20th-century-decline.>
[ix] Krugman, Paul. Modified Goldbugism at the WSJ. 9 Oct 2009. The Wall Street Journal. 26 April 2013. <http://krugman.blogs.nytimes.com/2009/10/09/modified-goldbugism-at-the-wsj/.>
[x] Investing Error: Don’t Use Stocks as an Inflation Hedge. 9 Mar 2012. Daily Finance. 26 April 2013. <http://www.dailyfinance.com/2012/03/09/investing-error-stocks-not-inflation-hedge/.>
[xi] Manuel, Dave. Inflation Calculator – 2013. 24 April 2013. 24 April 2013. <http://www.davemanuel.com/inflation-calculator.php.>
[xii] Dow Jones Industrial Average (1900-President Monthly). Stock Charts. 26 April 2013. <http://stockcharts.com/freecharts/historical/djia1900.html.>
[xiv] Market Anomalies. Murray State. 26 April 2013. <http://campus.murraystate.edu/academic/faculty/lguin/FIN333/Anomaly.htm.>
[xvi] Buffett, Warren. Why Stocks Beat Gold and Bonds. 9 Feb 2012. Fortune. 26 April 2013. <http://finance.fortune.cnn.com/2012/02/09/warren-buffett-berkshire-shareholder-letter/.>