Gold prices hurt by less investment demand

Some investors bought gold for protection against potential inflation and paper currencies. But deflation is more a threat. And gold has drawbacks.

Gold is trading at US$1,318 an ounce. This is far below the peak price of $1,908 an ounce it reached on August 22, 2011. Less ‘investment demand’ has likely reduced the price of gold.

We believe that gold’s lower price largely reflects selling by investors who now feel less fearful. It was thought that very loose monetary policies around the world would lead to galloping inflation. But inflation has declined. In 2013, it’s estimated consumer prices will rise by only 1.1 per cent in both Canada and France. In Japan, consumer prices are expected to rise by 0.4 per cent. Greece and Switzerland are dealing with deflation (falling consumer prices). With inflation mild in many countries, demand for gold is down. In fact, some investors sold their gold.

Demand for investing in gold is down

A second reason to hold gold was a distrust of paper currencies. With lower budgetary deficits in Canada and the U.S., there’s less risk of a debasement of the North American dollars. Germany in fact runs a budget surplus equal to 0.1 per cent of the size of its economy. This could give the euro more staying power. As a result, some investors need not hold much gold to protect against paper currencies.

The International Monetary Fund may need to sell some of its gold to raise money to bail out countries. This adds to the supply of gold and, all else being equal, depresses its price.

The price of gold is notoriously cyclical and unpredictable. An easing of geopolitical tensions could hurt the price of gold. So could a bumper crop by gold-producing nations such as Russia. They wouldn’t need to sell gold and buy food. The opposite is also true in terms of raising the demand for gold. The price of gold usually moves in the opposite direction of the U.S. dollar. The recent rise in the U.S. dollar is likely to keep the price of gold down.

Other factors tend to raise demand for gold. One is the popularity of gold jewelry, particularly in countries such as China and India. As middle classes in emerging markets grow quickly, the demand for gold could start to outstrip the supply of gold.

A second positive factor is higher demand by what’s known as the ‘official sector’. That is, many central banks would rather hold reserves of gold instead of reserves of dollars or euros.

Lower gold prices make it less profitable to produce the yellow metal. It can also make it unprofitable to work marginal mines. And lower prices tend to depress gold scrap recoveries. Lower supply usually leads to higher prices.

At present we have three buys: AuRico Gold, Centerra Gold and Eldorado Gold. Alternatives to gold stocks are gold exchange traded funds or bullion itself. Just remember that given gold’s drawbacks, it’s best to hold only a little gold to diversify your portfolio.

Gold’s drawbacks

One problem with gold stocks is that they often trade for more than they should. When the price of gold is high, gold stocks often trade at excessive price-to-cash-flow per share and price-to-earnings ratios. In most industries, investors would walk away from high multiples.

The poor outlook for the price of gold has hurt the price of gold on stock markets.

There’s more than one way to buy gold

You can buy gold itself. This will avoid the problems of any given gold stock—a sudden jump in taxes, a drop in ore grades, strikes, floods and so on. But holding physical gold means you’ll earn little, if any, income. More likely you’ll have to pay for its safe-keeping. One way around this is to buy gold exchange traded funds.

A third drawback is that unforeseeable events can affect the price of gold. For instance, geopolitical instability can drive up the price of gold. The trouble is, how can you plan for unforeseeable events?

More important, gold has a terrible long-term record as an investment. For more than 200 years, gold has delivered very poor total real (inflation-adjusted) returns. Jeremy Siegel, a professor of finance at the University of Pennsylvania’s Wharton School, studied the returns of different classes of investments from 1802 through 2006. One was gold.

Say one of your ancestors had invested a U.S. dollar in gold in 1802. At the start of 2007, it would’ve risen to only $1.95. That’s a real return of just 0.3 per cent a year. True, the number would now be higher due to higher recent prices for gold. But for most of that time, that dollar in gold was worth less than a dollar. By contrast, had your ancestor invested a dollar in stocks, it would’ve turned into an inflation-adjusted $755,163 at the start of 2007.

Professor Siegel concludes, “In the long run, gold offers investors protection against inflation, but little else. Holding these assets will exert a considerable drag on the return of a long-term investor’s portfolio.” Indeed, after a run-up in the price of gold to a record high in 1979 and 1980, gold subsequently fell and languished at low prices until after 2000.

Even so, some investors worry that the poor finances of European and the U.S. governments will lead to higher inflation. The printing of paper currencies is no longer held back by the old gold standard monetary system. Higher inflation lightens the debt burdens of governments. They get more taxes from higher nominal salaries and profits. Inflation lets them repay debt in depreciated currencies. Indeed, higher inflation is likely to eventually return.

If you’re worried about inflation and paper currencies, buy ‘hard’ assets, such as gold. It’s best used to reduce the risk of your portfolio. But given its poor long-term record, limit your holdings of gold to a small part of your portfolio.

The Investment Reporter, MPL Communications Inc.
133 Richmond St.W., Toronto, ON, M5H 3M8. 1-800-804-8846

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