Now that gold has tumbled, is it a viable investment? Is it ever?
A few years ago, when gold was still on its tremendous run, it seemed gold was the only thing people wanted to talk about. Between December 1999 and March 2012, gold returned over 15% a year – far more than U.S. stocks or bonds. Gallup polls from 2011 and 2012 found that a third of respondents picked gold as the best long-term investment over stocks, bonds, or real estate -- and surveys of professional analysts were bullish too. But then, as often happens when expectations are high, gold started to disappoint.
The contrarian in us likes looking at things when interest in them evaporates. But we approach gold with caution because we know we can’t put a fair or intrinsic value on it. We believe assets have an intrinsic value that can be estimated by looking at cash flow. But gold doesn’t generate cash flow, and it doesn’t have a lot of industrial uses where supply and demand dynamics can help us understand its value. Only 12% of the world’s above-ground gold stock goes toward technology or fabrication. Of the remainder, 50% is in jewelry, 18% is held by central banks, and 20% by investors. That means gold isn’t terribly productive or much consumed. It is simply held for different reasons by different owners, many of whom aren’t motivated by valuation or investment return.
10 Year Gold Price in USD/oz
In recent years, gold has been held as protection against disaster and the fear that even cash and U.S. Treasury Bills could become unsafe. It has been a bet on other people becoming more fearful. It also has been a hedge against central banks wreaking inflation and currency debasement with easy money.
A 2013 article in the Financial Analysts Journal by Claude Erb and Campbell Harvey studied six rationales investors claim for owning gold:
1) Gold is an inflation hedge.
2) Gold is a currency hedge.
3) Gold is an attractive alternative to assets with low real returns.
4) Gold is a safe haven in times of stress.
5) Gold should be held because we’re going back to a de facto gold standard.
6) Gold is “under-owned.”
After ploughing through the data, the authors could draw very few conclusions about how well these arguments held up. They didn’t find any evidence that gold was an effective hedge against unexpected inflation or currency devaluation, and they couldn’t draw any conclusions about where gold prices were headed. Instead they likened gold to the parable of the six blind men and the elephant: “Different perspectives and different models lead to different insights. Depending on which rationale or combination of rationales one embraces, gold is either very expensive or attractive.”
That is how slippery the slope for gold is – it is driven by sentiment. And that is why Warren Buffett suggested in 2012, when gold still was immensely popular, that investors forego gold in favor of productive assets like farmland or Exxon Mobil. Owning crop or dividend-producing assets, he said, would be far more sensible than investing in the hope that the sentiment of others would come through for you.
The corollary is that if there is any way to own gold sensibly, it is to do so in small amounts. Seth Klarman, a contrarian investor we admire, recently said at a conference that gold was getting interesting because sentiment was so bad and it wasn’t crazy to imagine gold going through the roof if people ever started questioning the solvency of the U.S. and stopped buying its bonds. But he is not sure. “We’re not sure about lots of stuff,” he said, “so we don’t create a gold-backed fund. We don’t bet the ranch on gold . . . we have 1.5% of our assets exposed to gold. If gold goes through the roof, that will be worth five, 10, 20 times what we have in it. And if gold doesn’t work, it doesn’t work, and hopefully our portfolio will be okay without it.”
That seems highly reasonable. Matthew McLennan of First Eagle Investment, another investor we admire, has said that a small gold holding as a disaster hedge is perfectly rational. A large gold position, however, amounts to taking a directional bet, and that is no better than guessing.