Should You Buy Gold Today?

Gold – among the most precious of all metals – has been on a tear, having gone up 18% in just the last three months.  Over the last decade, gold prices soared more than 300%.  Should you jump on this gilded bandwagon and attempt to capture possibly even greater returns in the future?

You have heard it said time and time again: There are no sure things in investing.  This year you cannot even count on death and (estate) taxes going together.  But, in general, you cannot win a race looking backwards.  Past returns are, well, in the past.

Background

There are several reasons why gold is bought.  There is an industrial demand for it, and manufacturers use it to make jewelry.  The recent high interest and demand in gold is because it is perceived as a better store of value and the ultimate insurance for really bad economic times, as in a depression or hyperinflation.  Furthermore, some investors now consider gold as an asset that can help diversify a portfolio comprised of stocks, bonds, and real estate.  (In my opinion, the addition of an asset class usually happens after a sharp rise in its price.)

Looking at not just the recent past but putting gold prices into the historical context of the last 30 years tells a much less favorable story.

The last time we witnessed such high interest in gold was back in November 1979, when the price of gold rose from $400 an ounce to $850 by mid-January 1980.  Investors who poured in – expecting more of the same – 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. Ouch.

Holding onto it didn’t help either.  By the end of the stock market run-up in early 2000, a single ounce of gold was selling for under $300 on the spot markets.

Today, of course, gold is hot; the shiny metal has tested all-time highs almost monthly, leaping from a little over $1,150 an ounce in late July to its latest all-time high, just over $1,365 in the middle of October.  Is it time to jump on this bandwagon and ride the gains up (according to some bullish newsletters) to $2,000 an ounce or higher?  Or is gold an overpriced investment ready to go bust?

Of course no one really knows. Obviously people disagree, as every time someone buys gold, someone else is selling it.

Things to consider

It isn’t real intrinsic demand driving the price of gold higher. Rather, it is investors (or speculators) who are buying at far higher prices than it costs to produce an ounce of gold.

There is no “shortage” of gold, as production over the past five years has been relatively stable at about 2,485 tons per year. In general, new mines are replacing the depleting production of current ones, so there has been little significant expansion in global output.

As prices rise, the market will probably see more recycled or scrap gold – a category which includes people selling gold jewelry. Between 2004 and 2008, recycled gold contributed 28% to annual supply flows.

There is no economic supply/demand imbalance, unless you count thousands of eager investors looking for more price run-ups or a hedge against inflation.

Is gold a reliable hedge against inflation? Since gold’s peak in the early 1980s, the annual inflation rate dropped, but cumulative inflation increased – just as gold was falling in value through the next two decades. According to InflationData.com, gold’s 1980 peak price on the spot market reached $2,250 if it were measured in today’s inflation-adjusted dollars, and the price fell to an inflation-adjusted $370 just two decades later. If gold had been an effective inflation hedge during that 20-year period, the price would have remained the same in inflation-adjusted terms.

So the numbers indicate that for long periods of time (but not always), gold can be a poor inflation hedge.   However, it does appear to be a pretty good “crisis hedge.” When people are concerned about a global liquidity crisis and/or an economic hangover (as they have been for the past couple of years), gold takes off. When the panic subsides, it is reasonable to expect that the price of the precious metal will decline.

Kenneth Rogoff is certainly not a “gold bug”, and he covers both sides of the argument in his article $10,000 Gold?

Pro

“In my view, the most powerful argument to justify today’s high price of gold is the dramatic emergence of Asia, Latin America, and the Middle East into the global economy. As legions of new consumers gain purchasing power, demand inevitably rises, driving up the price of scarce commodities.”

Con

“Gold prices are extremely sensitive to global interest-rate movements. After all, gold pays no interest and even costs something to store. Today, with interest rates near or at record lows in many countries, it is relatively cheap to speculate in gold instead of investing in bonds. But if real interest rates rise significantly, as well they might someday, gold prices could plummet.”

Conclusion

As Martin Feldstein wrote, “ Unlike common stock, bonds, and real estate, the value of gold does not reflect underlying earnings. Gold is a purely speculative investment. Over the next few years, it may fall to $500 an ounce or rise to $2,000 an ounce. There is no way to know which it will be. Caveat emptor.”

I certainly cannot predict whether the current fears will continue to drive gold higher. But history suggests that as soon as people start feeling more secure about the world situation, gold will suddenly lose its luster and leave its investors with significant losses.

If you buy gold now, are you investing or speculating? If you are speculating, is the best time to do it at near-record high prices?

About the author

Roger Streit, CFP®

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