Gold: Is NOW The Time To Buy?
Jeff NielsonI was asked by a reader yesterday if now was a good time to buy gold. This is always a deceptively simple question with any investment. After writing a fairly lengthy reply, it struck me that this was probably a topic worthy of a commentary, itself.
October 9, 2009
The starting point with such a question is to note that there are two types of investors. One group prefers buying into investments where prices are already rising. Depending on how you choose to characterize such investors (or how long they wait to buy-in), these are either investors who like to "go with the trend" or "jump on the bandwagon".
The second type of investors are much more focused on buying things while they are "cheap" than in looking for already-established trends. These "value" investors typically buy their investments while prices are falling. The reasoning being that if you want to try to buy something at its cheapest point that this will never be possible if you wait until the price of that asset has already established an up-trend.
Many financial advisors fall into the first group, for a couple of reasons. First, since they are managing other peoples' money, they often are more conservative with their buying and selling. Secondly (and more cynically), if the investment goes sour, it's much easier to justify buying something on the way up than on the way down.
Personally, I belong to the second group. While I've taken a number of puncture-wounds from "catching falling knives" over the years, this is still the philosophy with which I'm more comfortable. It is not so much a matter of saying that one approach is better than another. The most-famous and most-successful contemporary investors fall into both categories.
Instead, this is largely a matter of investor comfort. I have a very difficult time "pulling the trigger" with a purchase when the price of that investment has been moving steadily higher. Put another way, I have a greater fear of purchasing something just as it is making a short-term top than my fear of purchasing something where the price is falling - and then seeing it go even lower.
Many investors have the exact opposite "comfort zone". Again, it's not a matter of one approach being proven better, but rather choosing a strategy which will minimize the inevitable stress which comes from investing (which, ultimately, is simply another form of gambling).
Putting aside personal philosophy, the next point which must be determined before it's possible to answer the question "is now the time to buy?" is to determine whether this is an investor seeking to enter a market, or an investor looking to add to an existing position.
The reason why the decision to invest will vary between these two categories of investors relates to "opportunity cost". In this case, the opportunity cost in question is what does an investor stand to lose if he/she does not buy today, the price of the investment continues to rise, and there is never another opportunity to buy at this price?
This is not a prediction that this is what will happen. It is, however, the only scenario where the issue of opportunity costs arises. If the investment should go down in price in the future, then the "opportunity cost" is zero - and thus a moot question.
In this scenario, the opportunity cost is different between those investors who already hold some gold, and those who hold none. For those with no gold, the opportunity cost is 100% of the profits they could have realized if they had invested all they wanted to invest in this sector - at current prices. For those with existing holdings, their opportunity cost will only be a fraction of that total (depending on what percentage of their maximum holding they have already purchased).
What this means from a purely mathematical standpoint is that the investor who already holds some gold can afford to be more patient and "choosy" about if or when to make their next purchase. Having established that there is a lot more pressure on an investor with zero gold holdings to buy today, does this equate to answering the original question with a simple "yes"? No.
Assuming that the investor is looking to purchase gold for the specific virtues of this investment (wealth preservation and protection from significant "shocks" to the economy), with gold currently setting new (nominal) highs, a second question must be asked: is there an alternative to investing in gold bullion which offers equal or similar virtues?
The answer to this question is "yes". There are two, obvious alternatives to buying gold bullion today. One is to buy a different precious metal, and the other is to buy shares in the producers of this commodity (or other precious metals).
The most-obvious alternative to buying (real) gold bullion today is to buy silver instead. While silver has actually outperformed gold in this most-recent rally, silver began its latest run from a position of being extremely under-valued versus gold.
As regular readers know, for roughly 5,000 years the gold/silver price ratio has averaged roughly 15:1. Today, despite the larger move higher for silver, that ratio remains close to 60:1. This historically lop-sided ration exists despite the fact that roughly 90% of the world's stockpiles of silver have been consumed - and with current inventories (the amount of silver available for sale today) also still near historic lows (see "Your ETF-silver is for sale").
Thus, while the price ratio is still severely skewed in favor of gold, the supply ratio dramatically favors silver. Obviously, over the long-term the complete disconnect between price and supply must be resolved by a strong move higher by silver versus gold. As a result, while we never know for certain whether the price of a good will move higher over the short-term (whether we are talking about gold or silver), we do know that over the longer-term that silver will significantly outperform gold. This offers people buying silver today some "downside insurance" which does not exist if they buy gold today.
The other attractive alternative to buying gold bullion today is to buy into the producers of gold (or silver). There are both powerful short-term and long-term arguments for favoring the miners today over bullion.
As a shorter-term argument, many if not most precious metals stocks have yet to recover to their 2006 highs - when gold was trading below $700/oz and silver was trading at less than $15/oz. This is despite the fact that gold is now roughly 50% higher in price, while silver is roughly 20% higher. Even after the impressive rally which the precious metals mining sector has recently experienced, these companies remain inexpensive versus the price of bullion.
The longer-term argument which favors the miners is the historical observation that when bullion ultimately reaches some sort of medium- or long-term top that the miners have always greatly outperformed bullion. This is not simply some market idiosyncrasy, but rather an expected behavioral pattern.
To begin with, as I have pointed out in previous commentaries, precious metals producers (and all commodities producers) provide investors with natural leverage - as a basic component of their business model and not dependent on taking on large amounts of debt (see "A Novice's Guide to Precious Metals, Part II: the miners").
When this market approaches a top, this also implies the peak of greed amongst investors (whether it's a "top" in precious metals, or any other sector). Obviously, when greed is at its maximum, this is the time when the leverage offered by the miners will have the greatest appeal to the most investors.
The second reason why the miners historically greatly outperform bullion (especially toward the "top" of a cycle) is because of the tiny size of the precious metals sector. Just one of the trillions of dollars being thrown around by the U.S. government could buy-up every ounce of gold and silver on the planet - with enough left over to buy most or all of the miners, as well.
Thus, with a market this tiny, there simply is not enough bullion in existence to satisfy total demand. With many investors unable to sate their appetites for this sector through buying bullion directly, they choose instead to buy the best proxy for bullion: the precious metals miners.
For investors who have not yet entered this sector, and are worried about "missing the boat", there is no need to panic and feel that you must buy gold today. Personally, I have no doubt that anyone buying gold at $1000/oz will look back a couple of years from now and consider that a "cheap" purchase. However, as I have pointed out, investing is also about being able to sleep at night between the time you purchase an investment and the time you sell it.
As of this minute, my suggestion is that buying silver, or buying shares in quality, precious metals miners is more conducive to a good night's sleep than buying gold - at the current, nominal record-high.
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