The Golden Rule means one thing to most of the country. But on Wall Street, it's a cheeky axiom that the Golden Rule means “the people with the gold make the rules.” That has certainly seemed true for the last decade or so, as gold outperformed other types of investments.
Recently, and in the past few weeks in particular, however, the price of gold has been doing considerably worse than other investments. The precious metal, which peaked in September 2011 at more $1,900 an ounce, traded below $1,400 this past week and has fallen about 16 percent since the beginning of 2013. By contrast, the S&P 500 was up close to 8.5 percent for the year as of April 18.
That so few people could see gold's recent slide coming, and the general disagreement as to what's going on with the price of gold, make it timely to scrutinize the claims for and against gold as an investment.
Reasons for, against
Proponents of gold as an investment cite many reasons for owning gold, each of which essentially fits into one of the following categories:
Gold's reputation as a protector against inflation;
The purported benefits of diversifying a portfolio with gold;
Fear of political and economic instability;
Supply and demand.
What about these claims?
Gold is said to protect against inflation by maintaining its purchasing power against a declining dollar so that, for example, a certain unit of gold continues over time to be sufficient to purchase a certain item even while the item becomes more expensive in dollars.
It is true that the price of gold increased significantly during the inflationary years of the 1970s and 1980s. In addition, mere expectations of inflation may be enough to cause gold to rise in value — note how the price of gold has seen large increases subsequent to the financial crisis of 2007-09. Even though actual inflation has remained very low in the last few years, some investors have had expectations of inflation due to the Fed's monetary policy of low interest rates and quantitative easing.
But stocks of large, dividend-paying companies may be equally good or better as a hedge against inflation over long periods. One popular measure of the purchasing power of large cap stocks versus gold, known as the Dow/gold ratio, describes how many bars of gold it would take to buy the Dow Jones Index if the index were a dollar number. With the Dow at 15,000 and gold at $1,500, for example, the ratio would be 10.
The Dow/gold ratio has gone lower from 2000 to the present, but is considerably higher now than it was in 1981. So a comparison of the value of gold and stocks depends on what time period one is looking at, and provides inconclusive results.
What about diversification? As a separate asset class, gold is thought to provide some diversification in a portfolio. But common sense tells us that the more widely owned a type of investment becomes, the more “correlated” it becomes with other types of investments that are widely owned. So that when a price shock happens in stocks, for example, margin calls there should lead to selling across other widely owned asset classes to pay for losses in stocks. More correlated means less diversified.
We know that gold has become far more popular as an investment in recent years. Exchange-traded funds that track gold have proliferated in the last 10 years or so, which has made it easier to invest in gold. According to recent filings with the SEC, the SPDR Gold Shares Trust, one of the best-known gold ETFs, had more than 1,100 institutional holders, not to mention individual holders. According to the World Gold Council, an industry group, gold demand coming from investments (including both physical gold and ETFs) was 16 percent of total demand for gold in 2004 (the first year ETF numbers are available), but almost 35 percent of total demand in 2012. Gold's wide ownership means that it may not provide the benefits of diversification that one might expect.
Fear of political and economic instability does lead to buying of gold, and may explain some of the run up in price since 2008. Many companies that deal in gold as an investment point to hard times in their sales pitch. Some even advertise on syndicated talk radio shows and scandal type TV shows, both breeding grounds for pessimism regardless of their political posture. At this extreme, gold has an almost survivalist appeal.
Warren Buffett has been famously critical of this aspect of gold's appeal, stating that gold purchasers depend on the notion that “the ranks of the fearful will grow” creating a self-fulfilling prophecy that increases the price of gold — for a while. Buffet himself prefers to own what he calls productive assets, such as farmland and companies that pay dividends. Gold is better for fondling, as he puts it.
Supply and demand
What about the supply and demand argument? Proponents of gold as an investment point out that the supply of gold is limited while demand for the metal has grown. This is accurate: annual gold production has increased little even as the price of gold has gone higher during the last decade.
But supply and demand is a tricky pitch by itself because, like the fear trade, it also works until it doesn't — “for a while,” as Buffet says. If the demand side of the equation dries up, for whatever reason, the price of gold is apt to go lower. Economic growth in China or India might slow down, Cyprus and other governments might have to sell gold reserves, the U.S. economy may improve, other assets may become more attractive, expectations of inflation may recede. Take your pick.
Many smart investors buy gold. But gold should be viewed as just another investment option. Recent events show it is not the “safest” asset class, as some might proclaim, even if there are legitimate reasons to own it. As with any investment, claims made by people selling gold should be researched — and met with a healthy dose of skepticism.