May Newsletter: The World's Most Interesting Asset-Class

Posted by Alex Frey (@alexhfrey )

The stock market is rallying again, the Fed again seems poised to raise interest rates, China is still teetering on a “hard landing”, and Donald Trump is really the Republican nominee. Those were the headlines that mattered this month. But periodically it makes sense for us to step back from the headlines, which, as momentous as they seem to be in the current day, may after all be judged by history to be mere random noise, and take a look at the intermediate and long-term movements within a market. This month we do so with a very special asset-class, one, if forced to pick, we would classify as our “favorite.”

We don't give it this title because we are the most bullish about it over the long-term, or because we think it is the most currently undervalued relative to its fundamentals, or even because we own more of it than anything else. We have a rules-based and systematic approach to investing, so we don't actually have to care about any of these things. Instead, we call it our favorite asset class for the simple reason that we find it to be the most enigmatic, provocative, interesting, and opinion-dividing of all of them. The best analogy that we can think of to the current time is that it is kind of like the financial equivalent of Donald Trump – love it or hate it (and it's probably one or the other), you can't help but watch it, as “it” attracts attention and polarizes opinions like nothing else in its field.

Also like the Donald, our favorite asset class has its share of nuts and conspiracy theorists in its camp – there's a cottage industry of people on the internet predicting economic collapse and touting it as the way of surviving the cataclysm, and they've been doing so for the last twenty years (all the while our favorite asset class has been handily underperforming nearly all of the others, but that's a different story). Others consistently contend that it has zero instrinsic value in a modern world, and that anyone buying it for investment value is simply foolishly playing the greater fool's game (i.e. hoping that you will find someone even more foolish than yourself willing to buy it for a higher price).

If it's not obvious yet, the asset we want to talk a bit more in detail about this month is gold.

What makes gold so interesting and divides opinions so sharply? Let’s start by acknowledging that it is objectively very different from most other investments. There is really no good way to quantitatively value gold. Bonds can be valued by the interest they pay and the financial health of the issuer. In principle, stocks can be valued by the expected stream of future earnings. Most commodities have specific uses in commerce, and in principle, they can be evaluated by considering supply (including the cost of adding additional supply) and demand (including the cost of substituting another commodity for the one under consideration).

But gold is different. About half of the supply is used in jewelry, and a small amount goes to industrial uses, but a significant amount goes to central banks and investors. They buy it because they think it is valuable, and they think it is a store of value, but there is no quantitative analysis that explains its value. In short, gold is valuable because and only because people think  it should be valuable. This gives the price of gold a disturbingly reflexive quality – if the gold price is going up, it means people are finding it more valuable, so perhaps it should be more valuable. Similarly if the gold price is going down, people are finding it less valuable, which in turn justifies a lower price. Put differently, since the price is so deeply rooted in psychology, it is very hard to predict what the price should  be at any time.

Erb and Harvey (reference 1) put academic analysis around this very point. They noted that the demand curve for gold has an unusual form. Figure 1 is taken from reference 1 and shows how the demand for gold varies with the price. Of course, normally one would expect that higher price reduces demand. The jewelry component of demand behaves in the normal manner and decreases as price increases. The technology (or industrial) component is almost independent of price, but it accounts for a very small amount of the total demand. However, the demand by central banks and investors goes up as the price goes up, a complete reversal of the normal trend. Why should this be so? Erb and Harvey suggest several reasons, but it is quite likely that the higher price is associated with times of economic trouble or high inflation, and it is in times like these that people put a premium what they assume is the stability of gold. The real importance of figure 1 is to show that the investment demand for gold doesn’t obey the normal economic rules.

Fig1 Gold

Figure 1: Demand for gold as a function of price. Taken from reference 1 (Erb and Harvey).

So how has gold performed as an investment in the past? Over long periods of time, it’s clear that  gold has not been a good investment. This is shown by Figure 2, which comes from Jeremy Siegel’s book, Stocks for the Long Run. It shows the performance of stocks (with dividends included), treasury bonds, treasury bills (short term bonds), gold, and the dollar over the period from 1801 to 2001. All returns have been adjusted for inflation. Stocks are clearly the long term winner in this analysis. They have some volatility, but if one ignores short term fluctuations, they show strong growth throughout the period. Bonds are the second best performer.  Gold only barely beats inflation. Of course, the dollar decreases in value rather sharply, so holding gold is certainly better than keeping dollars under the mattress.

<Fig2 Gold

Figure 2: The real (inflation adjusted) total (including dividends) return of stocks, treasury bonds, treasury bills, gold, and the dollar from 1801 to 2001. Taken from Siegel’s Stocks for the Long Run.

Gold's long-term performance looks abysmal next to bonds and stocks, but there is an important caveat we should note. For much of the time from 1801 to 2001, the value of the dollar was tied   to gold under a fixed ratio, which is called a “gold standard .” The point of a gold standard is to limit the ability of the central government (or the central bank, meaning the Federal Reserve under the US system) to use its control of the currency in order to fund government obligations. Essentially, under a gold standard it becomes difficult to impossible to “print money” and de-base the value of the currency, since if there is a massive increase in currency people will start turning it in to use gold instead, and this will deplete the government's reserves of gold.

 The monetary history of the United States is quite complex, but U.S. currency was based on gold for much of its history. Many other countries also based their currencies on gold. This means that the price of gold was fixed by government action, not by markets.

The U.S. went off the gold standard in steps between 1933 and 1974, but the country was completely off the gold standard by the beginning of 1975. So by the beginning of 1975, gold was a market commodity, and it makes sense to look at what has happened to the gold price since then. The earlier history may be irrelevant to the present circumstances.

Figure 3 shows the performance of the S&P 500 Index ( NOT  including dividends), gold, and the consumer price index from the beginning of 1975 to the end of 2015. Even without including dividends, the S&P easily outperforms gold.

So given its poor performance relative to other assets, why do we continue to recommend that investors hold a small allocation to gold within an IvyVest balanced portfolio?

If you take a look again at gold's performance since the 1970s, the figure also shows that gold has some interesting counter-cyclical properties, meaning it holds up well when little else is. During the inflation of the late 70’s, gold increased in value while the stock market decreased. From about 1981 to 2001, the stock market was trending sharply up, and gold trended down. After the market collapse of 2001, gold started trending up again and continued trending up through the Great Recession of 2008. This was also a time of great worry about terrorism. Gold turned down only as the stock market was showing a strong recovery from its 2009 lows. It seems clear that people turn to gold when they are worried about economic or geopolitical events.

Much like a good insurance policy, the virtue of gold seems to be in preserving value, not increasing value. In both the 1801 to 2001 period and the 1975 to 2015 period, gold did only slightly better than inflation.  Truly severe economic problems, such the hyperinflation that occurred in Weimar Germany, would make gold look much better. Still, we like the insurance analogy – gold functions a bit like an insurance policy against a financial market collapse. By buying some of this insurance, you can reduce the overall fluctuations in your portfolio while also holding up better in the hopefully unlikely event of a kind of “financial armageddon.”

Fig3 Gold

Figure 3: The S&P 500 Index, the price of gold, and the CPI are plotted from 1975 to the end of 2015. The values are normalized (divided by) the values in January, 1975.

What of the argument that gold has no “intrinsic value” since it's value is only what someone else will pay for it? This is true – but you could say the same thing about the US dollar. And indeed, part of the “insurance policy” gold offers is that in a world where a future Federal Reserve created too many financial dollars and the price of the dollar tanked against scarce assets, gold might again come to be an internally accepted basis for currencies, and its value (in real terms and even more so in dollar terms) could actually increase substantially.

So is there any way to assess the price of gold at any given time? Over long periods of time, the price of gold seems to track with inflation. Over long periods of time, the price of gold seems to track with inflation. This is apparent from figures 2 and 3. Of course, one should note, especially from figure 3, that gold does not closely track inflation in the short term, and in the short term its real (inflation adjusted) value may increase or decrease rather significantly. Nevertheless, Erb and Harvey (reference 1) suggest that the tendency of gold to follow inflation can be used to assess the price at any given time. Using the period from 1975 to 2012 as a baseline, they compute that the average ratio of the gold price to the consumer price index is 3.2. As we are writing, this ratio is about 5.14, indicating that gold is overpriced. Erb and Harvey also point out that the price of gold in the 1997 to 2012 time period exhibited an inverse correlation with interest rates. This makes sense, since low interest rates reduce the cost (foregone interest) of holding gold. Figure 4, taken from their paper, shows the correlation that they observed. The time period for this observation is very short, but it indicates that the price of gold might go down if interest rates rise from their present historically low levels.

Fig4 Gold

Figure 4: Price of gold versus interest rates. Taken from reference 1 (Erb and Harvey).

However, there are other people who give reasons why the price of gold might increase significantly. They would argue that the period from 1975 to 2015 is too short to draw conclusions and that earlier periods were influenced by government actions. One argument is that the gold standard might get reinstated, and if so, the price of gold would have to increase markedly to support the current money supply. Of course, there is a big issue as to what the money supply is, but Erb and Harvey note that if one accepts the monetary base as a measure of the money supply, then the price of gold would have to be about $10,000 dollars per ounce in order for the current U.S. gold holdings to support that amount of money. (It’s clear that Erb and Harvey were not arguing that gold should have this price; they were merely noting the consequences of this point of view). Another argument is that investors currently own less gold than they should if they are trying to a hold a “market portfolio” (i.e., if they are trying to duplicate the allocation of investments in the broad market of investable securities). If investors collectively decided to build a market portfolio, it could lead to significant upward pressure on the price of gold

We tend to believe that the gold price in the long term is controlled mostly by inflation and interest rates. In our view, the main reason for having gold in a portfolio is to provide some protection in the case of severe economic disruption or hyperinflation. If this is true, in good times you shouldn’t expect much of a return from the gold portion of your portfolio. In fact, you should probably hope that you don’t get much return from gold, because that will mean that the rest of your portfolio is probably doing well.

Right now, we are overweight (relative to neutral) in gold. The reasons are three-fold: 1) Real interest-rates are extremely low, which reduces the opportunity cost of holding gold relative to other “defensive” assets like TIPs, 2) Stocks appear very strongly / aggressively valued on long-term measures, which pushes us slightly more into comparatively “defensive” assets, 3) Traditionally moment investors that have bought gold when it is going up and avoiding it when it is going down have been rewarded in the gold market – since the beginning of the year gold appears to be in an up-trend, so we are willing to make a bit of a bet and play along.

One of the advantages of following a rules-based approach to investing is that we don't have to get emotionally attached to the performance of a particular asset-class. Whether gold goes up or down does not make much difference to us emotionally, but we nonetheless do enormously look forward to seeing what the future for the “most interesting” of the asset classes holds.


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By Alex Frey