Gold As An Alternative Investment
Thomas Z. Tan, CFA, MBA
November 8, 2007Gold has had a great run lately. As I indicated in one of my previous blogs, if you look at the long term monthly close chart of gold, $700 provides a major resistance, because gold had never stayed above $700 for over a month in its entire history, neither in 1980 nor in 2006, until now. This is the main reason why it had taken over a year to overcome it, and the reason of the current explosive upward movement. Now we have expanded the chart upward beyond the $700 line into the new uncharted territory, I feel that gold will possibly never go below $700 again.
If we compare gold with general equity market, since 1988 gold has had a negative 0.85 coefficient of correlation with the S&P 500 and R^2 of 72%, however since 1994, it rose to 0.94 with R^2 of 88%. In general, gold behaves negatively to equity market, and this is one of the reasons why I am bearish on equity now. Fundamentally from pure demand and supply point of view, as best described by Sun Valley Gold, a hedge fund, gold has "the elasticity of a positively sloped investment demand function overwhelms the inelasticity of supply". That is exactly what has happened during last 6 years of gold's bull market. I believe we are entering into a low return cycle for stocks and bonds. Monetary and investment demand for gold have turned around and will continue to be positive, and there has been a dramatic shortage of available precious metals with production flat or falling, which becomes the principal driver of gold's rise.
The same point is also mentioned in "Gibson's Paradox and the Gold Standard" by Lawrence Summers (former Secretary of the Treasury and President of Harvard) and Robert Barsky in 1988 at "The Quarterly Journal of Economics": "Gold is a highly durable asset, and thus, ....it is the demand for the existing stock, as opposed to the new flow, that must be modeled. The willingness to hold the stock of gold depends on the rate of return available on alternative assets. We assume the alternative assets are physical capital and bonds". Since 1982, the equity and bond bull markets have been the mainstream investment vehicle, and probably still will be, and gold was totally forgotten and not even considered to be alternative investment, which usually only designates to real estate, private equity and hedge fund.
In the not too distant future, gold and mining companies will become another category of alternative investment. Similar to private equity and hedge fund, globalization and wealth in emerging markets will bring much higher demand for gold and mining companies across the World than in the 1970s. From supply side, we are facing a more severe scarcity of gold supplies than 1970s. Globalization is a double-edged sword. It brings economic growth, prosperity and trades but also instability of paper currencies for all countries alike. It exports Western consumption and lifestyle, causing natural resource utilization and prices to increase exponentially for all commodities as we see today. It brings incentive and competition to devalue paper currencies of all countries alike to gain trade advantage. If the greenback, USD, as the dominant and strongest currency in the world, collapses in the future, all paper currencies will fall against gold, leaving gold as the last trusted and universal currency standing.
In 1970s, many central banks (CBs) had gold as their largest holdings, for example, central bank in Taiwan at that time had 98% of their reserves in gold. Pendulum has swung to the other side today when most of the holdings in CBs are in US treasuries however with falling values. As seen in some oil rich countries, CBs have started to diversify their holdings into other currencies and gold. Currently most of the developed countries have probably around 5-10% of their reserves in gold, while developing and emerging markets have 1-2%. In the near future, even they probably won't go back to the good old days of holding all gold, but I won't be surprised to see 10-25% of their reserves back in gold, developed and emerging countries alike. If true, pretty soon, instead of selling, CBs will have to compete with each other to increase their gold reserves. Developed countries won't be net gold sellers anymore as in the last 25 years.
There has been a lot of discussion among gold investors on gold manipulation by central banks, and there is an organization www.GATA.org making great efforts on this front. I am not quite into the old conspiracy story, but financially I see incentives and benefits for central banks to lease and loan gold to bullion banks during gold's bear market. It was a win-win situation for both CBs and big Wall St bullion banks. CBs can loan gold and get 1% interest otherwise gold is just sitting at their vaults doing nothing. For bullion banks, they can sell gold and use the proceeds to invest in equities and bonds to earn a return 5-6%, much better return than the 1% they need to pay CBs back. However, the key to success of this gold cross trade is under one condition, gold has to be in a flat or bear market (in the bear market, banks can make additional profit by recovering gold at lower price too). However if gold is on explosive move like right now, bullion banks will suffer heavy losses when they buy back gold in the open market. Whether this act can be called manipulation and conspiracy? Maybe, but it was probably more financial interest driven, and suppressing gold as secondary goal.
No matter what happened last 30 years, after gold enters into the current upward and volatile phase, it doesn't matter anymore, since it is no longer possible to engage such trades. We can see CBs running out of ammunition to suppress gold even if that is their real purpose. However, the existence of organization such as GATA is healthy and helps to keep government honest. For example, due to all this long period selling, leasing and totally lack of audit on US gold reserves, there has always been speculation whether and at what level Fort Knox actually has gold if taking all the leasing arrangements for all these years into consideration, since there has been no public audit since 1950s at Fort Knox and no transparency on gold leases. Do citizens and taxpayers have the right to know? Another logic question to ask is if someone has been a net seller of something for a long time, when and at what rate will it reach the depletion point if not already? Congressman Ron Paul has tried to find answers for many years but without success.
On the topic of CB selling gold, it is worth mentioning a very special event in 1999. Usually CBs announce the sale of gold and would slowly take 1-2 years to accomplish, so that they wouldn't suppress the physical gold market too much and sell into a downward spiral at fire sale price. However, there is at least one exception. According to Darryl Robert Schoon who authored a great book of "Time of the Vulture", in May 1999, the then Chancellor Gordon Brown (now Prime Minister) of Britain sold 415 tonnes of gold, almost 60% of its total reserves, leaving Britain with only 300 tonnes. 11 days earlier, Brown had requested the IMF to sell $10 billion of its gold on the open market too. So far no real reason has been officially offered for selling gold in such a hurry. When recently Prime Minister Brown was asked again the reason of such bizarre sale, his answer was simply a decision of money management at that time. But this act is totally against any common sense of money management and the normal approach by CBs to sell their gold. The only likely logic reason was to knock gold price down in a very short time by dumping so much gold at once. According to Mr. Schoon, it is rumored that British was acting probably in a joined effort with US Fed to save a large Wall St bullion bank which had a 1,000 tonne short gold position loaned by the US government. And it was at the brink of disaster when gold took an unexpected rise at that time in 1999 and the tide was turning against them. If true, this bailout is no different than LTCM and the current subprime bailouts, except the US government had absolutely no choice in this case since it had to rescue the bank and get its gold back.
Sir Peter Tapsall in the House of Commons commented and questioned about the price her Majesty had to pay in order to save a major US bank by fire selling majority of its gold reserves at rock bottom price below $300. Bank of England Governor Eddie George commented it is a necessary act otherwise "A further rise (in gold) would have taken down one or several trading houses". Imagine with the gold price today without this fire sale, Great Britain would have been much more solid, secure and stronger in its reserves. This question will come back and be asked again and again during Mr. Brown tenure being Prime Minister if gold keeps going up to remind people, and it doesn't seem to be the best timing to be Prime Minister at least in this subject. At the US side, when Greenspan was asked by Congressman Ron Paul how stupid Bank of England was to sell most of its gold at the absolute bottom, worst timing ever possible, he ducked the question by saying "The British knew what they were doing." This led people to believe that Fed might actually be involved too, an act of collusion as GATA has always suspected. No matter what happened then, today it seems: 1) Rise of gold is a nightmare for all CBs since they have been the net sellers; 2) All CBs have less gold than they claim to have, and will run out of ammunition to suppress gold and eventually be defenseless to protect their paper currencies; 3) At the end all CBs will have to turn themselves into net gold buyers from sellers.
With election year coming, Congressman Ron Paul, among all candidates, probably is the only one who many years ago, has already seen the monetary and double deficit problems we are facing today. He is probably the most honest politician with the most consistent voting records for the last 30 years in the Congress, and the only one has the courage to question both monetary and fiscal policies and provides painful but necessary medicines to solve them. Even few think he is winnable, his campaign policy proposal and his consistent messages for the last 30 years could be the direction of future policies considered and adopted by no matter who will be the next in the White House. His long time messages of balancing budget, paying back all US debt, eliminating individual tax, return to gold standard to keep monetary control, shrinking size of government and its spend by half, stopping acting as empire and policing the World, etc. etc. would be heard and echoed by more people through time, and would have been at least considered if Paul Volcker had been the Fed Chairman. It is also interesting that he has gained momentum and more support recently from young generation which normally wouldn't even consider voting for a 73 year old seasoned politician. Ron Paul is so unique and one of the kind who definitely can't be treated as another typical republican candidate from Texas. As gold becomes another alternative investment, Ron Paul, a long time gold advocate, will become an alternative candidate for more voters.
From analysis done by some economic cycle experts, gold should have bottomed in 1999 or earlier. The early 2001 bottom, according to GATA, is more a manipulation and collusion of CBs (such as the Bank of England's act) than real demand and supply driven in a free market. But this kind of manipulation, if true, plus the discontinued and explosive M3 supply and new CPI "adjustments" (the current PCE data shows almost ZERO inflation?!), will backfire in the future. Just as $250 is anomaly for gold at the low side, public dissatisfaction, anxiety and insecurity will cause anomaly at the high side, bringing gold to a higher level than its true economic value. I consider 2001 to 2007 period is the 1st phase of gold's bull market, lasting almost 7 years, a calm but steady rising market. From August this year, it has entered into the 2nd phase, we should see lots of more firework in the future. During this 2nd phase, I expect gold will enjoy a spectacular run but become more and more volatile. Near the end of this phase, we should see $100+/- movement in one day, while I am not surprised to see $50+/- in one day when gold reaches the 4-digit territory. On November 6th, we actually saw over $25 range in one day already.
If central banks should invest 10-25% reserves in gold, for individual investors, it would be more important to consider including gold in their portfolio. For corporate and government pension funds, endowment and foundation funds, if they can invest 20-25% in alternative investments of real estate, hedge funds and private equities, they should at least consider precious metals and mining sector to be another alternative investment vehicle, since I strongly believe that this particular sector will offer even better diversification, better future return, better protection from inflation, and especially better defense against falling US dollar.
Thomas Tan, CFA, MBA
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Disclaimer: The contents of this article represent the opinion and analysis of Thomas Tan, who cannot accept responsibility for any trading losses you may incur as a result of your reliance on this opinion and analysis and will not be held liable for the consequence of reliance upon any opinion or statement contained herein or any omission. Individuals should consult with their broker and personal financial advisors before engaging in any trading activities. Do your own due diligence regarding personal investment decisions.
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