Investing in Gold

I personally don't invest in gold but I know quite a few readers are interested in it (based on comments I've received.) Hence I'm running this guest post from Marotta Asset Management that contains their thoughts on gold investing. I'm looking forward to your thoughts on the same topic.

Last week gold broke $1,000 an ounce. Gold advertisers and gold investment newsletters are touting their wares as though gold only goes up in value. Nothing could be further from the truth. Gold may glitter, but it is still better to own the mine.

Keep in mind that investing in hard asset stocks is not the same as investing directly in commodities. Buying gold bullion or a gold futures contract is an investment directly in raw commodities or their volatility, whereas buying a gold mining company is a hard asset stock investment.

Over time, dollars lose their buying power, and the goods and services we buy cost more. Commodities as an asset class generally maintain their buying power in terms of dollars. Stocks as an asset class, in contrast, generally appreciate over inflation after factoring in dividends. And recently, hard asset stocks such as precious metal mining companies have been appreciating nicely.

Jeremy Siegel, author of the book "Stocks for the Long Run," analyzes investments over the past 200 years. Gold, on average, maintains its value over time. If you bought a dollar's worth of gold 200 years ago, after adjusting for inflation, it would be worth $1.07 today. Because of inflation, a dollar today would only have had the buying power of about 7 cents back then! However, the stock market, on average, has been appreciating about 6.5% over the long-term rate of inflation. Hard asset stocks give you the best of both worlds: the stability of a real asset plus higher market returns.

The beauty of hard asset stocks is that they are not highly correlated to U.S. large-cap stocks as a whole. The correlation between the Goldman Sachs Natural Resources Index and the S&P 500 Index is only 0.49. Importantly, the correlation between the Goldman Sachs Natural Resources Index and the Lehman Aggregate Bond Index is even lower at 0.26. A negative correlation means that bonds and natural resources, as separate asset classes, are often moving in opposite directions. Balancing a bond portfolio with hard asset stocks can help hedge the risk that inflation poses to a bond portfolio.

Natural resource companies sell valuable tangible commodities. Thus their earnings are tied to inflation because their resources are worth more as the dollar declines in value. This situation can occur in times when the supply of money and credit is increased to fund government spending and budget deficits.

Consider a gold mining company in 2001 whose expenses and overhead allowed it to pull gold out of the ground for $290 per ounce and sell it for $300 per ounce, making the company a $10 per ounce profit. As the price of an ounce of gold rose 3.3% from $300 to $310, the company's profit doubled from $10 an ounce to $20 an ounce--a 100% jump--which caused the company's earnings and stock price to soar. Now that gold is more than $1,000 per ounce, the current price level of gold stocks is much higher than it was in 2001.

Therefore, we segment hard asset stocks into their own asset class because they have a unique set of characteristics. First, the movement of hard asset stocks generally correlates less with the movement of other asset classes such as bonds. Second, hard assets react in a unique (and positive) way to inflationary pressures. And third, in certain periods in the longer term economic cycle, including hard assets helps boost returns.

Direct investments in gold react a little differently, however. The correlation between the price of gold and the S&P 500 is nearly zero, lower than hard asset stocks at 0.02 instead of 0.49. But the correlation between the price of gold and the Lehman Aggregate Bond Index is also nearly zero at 0.09 instead of 0.26. In truth, the price of gold does not fluctuate with investments because it is simply holding its value.

But although it is true that gold generally holds its purchasing value, it still fluctuates wildly based on other factors of supply and demand. While it does so, the part of these movements that is not just random noise is simply an inverse reaction to the value of the dollar.

In January 1980, gold reached its high of $850 an ounce. The following year my wife and I became engaged and chose modest wedding rings that were still very expensive. Note that $850 in 1980 had the same buying power as $2,184 in today's dollars. Gold trading at $850 an ounce then was like gold trading at more than twice its current price. Those people who purchased gold in 1980 have lost over half their buying power during a 28-year investment.

In August 1998, gold reached its low of $356 an ounce. So those who had invested 18 years earlier at $850 an ounce had lost 79% of their purchasing power. By 1998, an ounce of gold should have been worth $1,682 just to keep up with inflation, but instead it had dropped dramatically.

A small percentage of your portfolio should be in precious metal mining companies. It provides a balance to your portfolio that you cannot gain by investing directly in gold.

Here are three mutual funds we have used for investing in precious metal mining companies. We look for a low expense ratio, a turnover ratio of under 50% and returns that capture the lion's share of the sector's returns.

Vanguard Precious Metals and Mining (VGPMX) earned 36.13% during 2007 and has had an annualized return of 35.28% for the past five years. It is up 12.74% for the first two months of 2008. It has an expense ratio of 0.35% and a turnover ratio of 24%. Although closed to new investors, VGPMX is probably one of the best funds.

U.S. Global Investors World Precious Minerals (UNWPX) earned 23.02% during 2007 and has had an annualized return of 36.66% for the past five years. It is up 15.05% for the first two months of 2008, with an expense ratio of 1.01% and a turnover ratio of 54%.

American Century Global Gold (BGEIX) earned 15.12% during 2007 and has had an annualized return of 20.53% for the past five years. Although it underperformed relative to other funds last year, it is up 16.52% for the first two months of 2008. It has an expense ratio of 0.67% and a turnover ratio of only 3%.

Because of the negative correlations, our firm uses these investments and others in this sector for a small percentage of a balanced portfolio. Diversified and negatively correlated investments can help your portfolio maintain its equilibrium when the U.S. markets are losing money.

Comments

[Ryan S]

With gold at a historical high, and the dollar at a historical low, personally I am very reluctant to start stocking away gold bars. In my OPINION, this is the time to be selling gold, not buying it. As for buying gold mining stocks, I have not thought about it enough to talk about it.

[Jake]

"A negative correlation means that bonds and natural resources, as separate asset classes, are often moving in opposite directions."

"Diversified and negatively correlated investments can help your portfolio maintain its equilibrium when the U.S. markets are losing money."

Huh? The natural resources index DOES NOT have a negative correlation with broad stock indexes or with broad bond indexes. Why is the article trying to make it sound like they do?

The sad part is that the article itself includes the facts that discredit the implication they repeatedly make above...

"The correlation between the Goldman Sachs Natural Resources Index and the S&P 500 Index is ...0.49. Importantly, the correlation between the Goldman Sachs Natural Resources Index and the Lehman Aggregate Bond Index is ...0.26."

Clearly not negative numbers.

[escapee]

Last week gold broke $1,000 an ounce.

And this is why it is NOT time time to buy gold.

Buy low and sell high. That is the rule of making money.

[jrf]

My 2c:

Commodities by definition are fungible. They offer nothing but speculation on price. Their value does not change --> it's still the same hunk of gold today that it will be tomorrow. As a result, I can almost never recommend that people buy commodities.

(There's an old saying in investing that gold takes the stairs up but the elevator down.)

[Curt at PennyJobs.com]

The gold debate is in full swing with everyone trying to call the top or the huge upside potential.

But the reasons for the gold rush today are different from the reasons in the 70's. The dollar is falling like a rock, forcing other nations to inflate their currencies to remain competitive with the dollar - or they risk losing their biggest customer - the US consumer. Therefore, all paper currencies are losing value, and the dollar is leading the pack. Some nations are beginning to drop the dollar as their reserve currency.

Article: Argentina, Brazil to drop U.S. dollar in bilateral commercial transactions
http://news.xinhuanet.com/english/2008-03/16/content_7800121.htm

The question is quickly becoming, "who will bailout the Fed"

Article: Will the Fed Succeed in Saving the Market?
http://www.pennyjobs.com/pp/public/Articles.aspx?aid=41

The only reason gold dropped in the 80's was because the Fed removed the dollar peg on gold and the dollar became the reserve currency of the world. But, this time we don't have a gold peg to remove - to prop up the dollar. Gold will likely continue to rise until something replaces the dollar as the world reserve currency. Perhaps a new monetary union with the four top currencies of the world - Japan, China, Europe and the US.

For these reasons, gold is likely to continue to rise for years – perhaps to $10,000.

[Mixer]

jrf - you are correct that the value of gold hasn't changed - only the value of the currencies used to purchase it. Gold's purchasing power has been essentially maintained over the last 100 years while the value of the dollar has declined. Gold is a lousy investment, but one of the top assets if you want to preserve wealth.

Curt - you're figures are a bit off. Nixon closed the gold window in 1971. The decline of gold in the 1980's was a combination of overspeculation and a coordinated effort between the IMF and various central banks to flood the gold market to depress the price. The US attained global reserve currency status in 1944 during the Bretton Woods Accord. The Bretton Woods system broke down in the late 1960's and was replaced with a three-legged system of the Petrodollar, exporting manufacturing (mainly to Japan, Taiwan and China) in exchange for rolling over investments in treasury bills and positioning to be the consumer of choice for the global marketplace through the "buyer of last resort" clause in almost all of our trade agreements. All three legs are pretty much removed at this point, it's worth noting; first the Petrodollar system was weakened, then Asian reinvestment (a bit more stable) and finally being the world's consumer - recent trade agreements have been signed that are shifting consumer output to India, China and the EU - hence all this talk in the financial realm of the end of the dollar as the global reserve currency in the next 5 years.

[snappyfrog]

Escapee has it right. Now I believe is the time to take my gains in gold. I try to find what I believe has made a good run-up, take my winnings and be happy- not greedy.

Now my money goes into something I think is near the bottom - financial stocks.

Buy low, sell high.

[bigj]

Just curious how that's gone for you in the past couple of months snappy frog???

Some people believe, including me although I am aware it's basically a bet, that buying gold at $1000/ounce is buying gold low. My money really is on Silver though. Much higher demand, very low supply, and is also backed by historically being a place to preserve wealth.