November 2010
All That Glitters
Can you relate to this situation: the struggling U.S. economy experiences severe unemployment, and a falling dollar spooks investors. The stock market seems to be in a protracted tailspin, and the situation in Afghanistan is increasingly alarming. So you look for an alternative investment, and find...gold, which is generating impressive returns after a long dormant period. In fact, the precious metal has been testing all-time highs, and there are plenty of financial bloggers, touts and analysts that see a lot more legs to the rally.
As familiar as this sounds, it's actually a pretty good description of the latter months of 1979 and early 1980, when the price of gold rose from $400 an ounce in November 1979 to $850 by the middle of January 1980. Investors poured in, expecting more of the same, but were sorely disappointed. By the end of March 1980, gold was back to selling at less than $500 an ounce, leaving investors who bought at the peak holding a stunning 40% loss for the quarter. Holding on didn't help; by the end of the stock market runup in early 2000, an ounce of gold was selling for under $300 an ounce on the spot markets.
Today the shiny metal has been testing all-time highs almost monthly, most recently leaping from a little over $1,150 an ounce in late July to its latest all time high of just over $1,365 in the middle of October. Is it time to jump on this bandwagon and ride the gains up to (according to some bullish newsletters) $2,000 an ounce or higher? Or is gold an overpriced investment ready to go bust?
One of the interesting problems with gold in your portfolio is how hard it is to get a handle on what its price should be. You can't compare its price to its earnings, like a stock, because when you put gold in your safe deposit box, there are no earnings. But there are ways to help decide whether the current price is being driven by fundamentals or yet another mania.
The first is to look at where the demand is coming from. Back in January, the Commodity Online website interviewed Miguel Perez-Santalla, vice president of marketing at the German precious metals producer Heraeus Precious Metals Management. Heraeus is one of the companies who fabricates precious metal products for industrial use. Perez-Santalla said that physical consumption of gold by industrial users has fallen dramatically due to the high prices (which have since gone higher). "The gold investment market is the main demand driving the price up," he said in the interview.
What about the influence of supply? If there is a worldwide shortage of gold, this could justify a dramatically rising price. According to the World Gold Council website, mine production and recycling (including people selling their gold jewelry) together account for roughly 3,500 tons of gold coming into the marketplace every year. How does that compare to demand? Jewelry demand, by far the largest market for gold, consumes 2,436 tons a year. That means more gold is coming onto the market than industry and manufacturers appear to need. There is no supply-demand imbalance.
Another way to look at the reasonableness of gold’s prices is to look at the cost of extraction and refining – in other words, the cost per ounce of getting gold out of the ground and into the hands of jewelry makers, industry and investors. This information is not always easy to find, but an article on the MineWeb website back in April 2007 estimated that gold mining companies were spending $401 an ounce in overall costs. At that time, gold was trading for around $650 an ounce. In October of this year, an article suggested that today’s extraction costs run between $500 and $600 an ounce – or a little less than half of what you would pay today on the spot market. In general, new mines are replacing old ones, so there has been little significant expansion in global output. It can take up to ten years to get a new mine started, which means that gold mining companies can’t take instant advantage of today’s higher prices.
Many investors look to gold as a reliable hedge against inflation, but is it? From January 1974 (when the U.S. officially went off the gold standard) through September 2010, gold has returned an inflation-adjusted performance of 2.5% per year. The S&P 500's inflation-adjusted return for that period was 5.7% a year, a far better inflation buster. Contrary to what many think, there is only a weak relationship between the rate of inflation and the price of gold.
While gold hasn’t served well as an inflation hedge, it does appear to be a pretty good “crisis hedge.” That is, when people are frightened of events like the Soviet invasion of Afghanistan, as they were in 1979-80, or when they are concerned about the global liquidity crisis and its economic hangover, as they have been for the past couple of years, gold takes off. Fear is a powerful motivator, and we’re seeing a lot of it being used by news networks, financial shows and political commercials these days. Unfortunately, we can’t predict the timing that these events will start or end, but when the panic eventually subsides, so too does the price of the precious metal. Kitco has historical and live gold and other precious metals charts.
Separate from the investment side of gold, many people are comforted emotionally knowing they have a supply of gold and silver coins and cash on hand in case the financial system completely collapses. This behavior is valid and can be a prudent piece of a financial plan. A reliable local source for purchasing and selling coins is Columbia Coin. They will sell American Eagle gold and silver coins at spot price plus 7%, and buy them at 99% of spot price. You can also buy gold and silver coins issued by other countries such as Canada, South Africa, and Australia.
Some people have asked about buying gold and silver coins inside their IRA accounts. There are very specific regulations regarding what type of precious metals are allowed in an IRA account (with regards to purity, base metal, originating country, etc.). Additionally, you need a special self-directed IRA custodian to purchase and hold them (Charles Schwab does not provide this service). The annual fees for the special custodians can be expensive, and care needs to be taken in selecting a reliable vendor.
As with any investment decision, it is critical to understand the history of an asset like gold and how it can fit into a broadly diversified portfolio. In addition, investors must understand their own motivations and attempt to separate emotion from the process. Markets are moved by fear and greed, and today’s gold prices are reflecting both in strong supply. Contact your Silver Oak advisor if you have questions or would like source information from this article.
Year End Tax Planning
Please be sure we have copies of your 2009 income tax returns. We often refer to these when making investment recommendations, and especially when doing year end tax planning for your portfolio. Call Linda if you are not sure we have current copies.