Revisiting Gold: Food For Thought

“Having behind us the commercial interests and the laboring interests and all the toiling masses, we shall answer their demands for a gold standard by saying to them, you shall not press down upon the brow of labor this crown of thorns. You shall not crucify mankind upon a cross of gold.”

Former Rep. William Jennings Bryan of Nebraska addressing the Democratic convention, 1896

“Deficit spending is simply a scheme for the ‘hidden’ confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights.”

Former U.S. Federal Reserve Chairman Alan Greenspan

As the two contrasting quotes above indicate, evaluating gold is truly a challenge. I have written before about gold, primarily focusing on some brilliant analyses from some of Twitter’s Finest.  I highly recommend checking out some of the links from that post featuring some wonderful authors.

As we begin the second half of 2013, I thought it might be a worthwhile time to re-evaluate the current state of affairs for gold, as it intertwines with my recent discussion on U.S. Federal Reserve (Fed) monetary policy.

There are many different ways to approach assessing gold.  I personally feel it requires a comprehensive analysis of the history of and philosophy behind money, as well as a more contemporary contextual assessment of gold relative to other potential assets an investor or speculator might consider.

Accordingly, here are just a few of the issues (primarily highlighted with the related charts) that might help shed some light on some issues to consider when assessing gold during its current turbulence.

Why consider gold in the first place?  Here are a few common responses:

  • Some may feel it serves as insurance (or as a less-correlated fellow asset among others in one’s portfolio) against a major financial system breakdown (e.g. 2008)
  • Others may believe it serves as an alternative currency which may be worth considering because many central banks are attempting to depreciate its currency (but is it a currency or a commodity?!)
  • Some may conclude that low rates stemming from accommodative monetary policy makes gold more attractive (e.g. lower opportunity cost than if bonds yielded higher rates)

Let’s take a look at the past year for gold.  Please note that this chart is of the $GLD exchange-traded fund (ETF) – often used as a proxy for gold’s performance.

Chart forSPDR Gold Shares (GLD)

As you can see, it has been a rough ride lately.  Before we take a look at where we might be going, let’s take a look at where we’ve been over almost a decade.

Chart forSPDR Gold Shares (GLD)

As you can see from the second chart, gold had a nice run for a while, which also happened to be seductively smooth.

However, as we saw in the first chart, gold isn’t necessarily poised to consider seeing such smooth success going forward.  On that note, if you know of any investments that plan to have a smooth and successful decade feel free to let me know!

Seriously though, here are some key issues in my opinion when considering gold for the short-to-intermediate term.

Is gold a legitimate diversification tool in most people’s portfolios? Again, perhaps a couple of charts could provide more insight into that question than any particular thoughts.

An important key in assessing diversification value is considering whether different assets are not heavily correlated with each other.  For many folks, when composing a traditional portfolio, one goal may be to have relatively uncorrelated assets because when one of them goes down the others may not be as heavily hurt.

As you can see, gold’s correlation with the Standard and Poor’s 500 (S&P 500) decreases based upon the time period reviewed.  However, correlations among assets have been quite fickle this century.  My personal favorite phrase that seemed to touch everyone lips during the 2008 troubles was “the correlation to the downside is 1!”

Next, $GLD vs the S&P 500 over almost a decade:

Chart forSPDR Gold Shares (GLD)

Again, it appears that there is a bit of a divergence between $GLD and the S&P 500.  But past performance is not necessarily representative of future results.  Moreover, I think there is a more important issue to ponder.

If gold is meant as “insurance” against a financial system problem and/or a currency debacle, then it is important to assess the health of the banking system in question, as well as the relevant currency.  As to the latter, the U.S. dollar ($USD) has been much stronger of late, relative to the $USD weakness from last decade that arguably helped fuel the prior smooth gold rise.

Historical Data Chart

As you can see, the $USD had a rough ride from 2003-07.  Was that the reason gold did well last decade? Perhaps.

So, let’s take a look at the $USD more recently:

Historical Data Chart

As you can see, the $USD has not had as much difficulty lately, which is a legitimate reason why one may want to think twice before assuming continued expansionary monetary policy will fuel gold.

The history, philosophy, and current context of gold in the investment world are issues about which I enjoy conversing but, in an effort not to make this post overly-long, perhaps it would be more efficient to now summarize a few final issues for your consideration.

Historically, gold has been “the people’s choice” as the monetary metal to keep up with inflation/currency concerns.

“For more than two thousand years gold’s natural qualities made it man’s universal medium of exchange.” –Hans F. Sennholz

However, with a current lack of concern as to inflation (with which I don’t necessarily agree), that argument may prove futile for gold bulls in the short run.

I addressed the currency issue with the chart above, and with a lack of any other countries likely ready to take the baton from the $USD as the world’s reserve currency, it may be challenging for gold to excel in the short run based upon the alternative currency rationale.

The one longer-term “fundamental” issue which I do think could prove to help fuel gold moving forward would be larger and longer-than-consensus expansionary monetary policy (i.e. low rates and a growing Fed balance sheet).

Graph of 10-Year Treasury Constant Maturity Rate

Since I do believe the Fed will keep rates low for a long time, and that the Fed balance sheet will continue to grow larger, I can theoretically envision gold ultimately recovering its significant recent losses.

Moreover, recent comments by New York Fed Reserve Bank President William C. Dudley last week appear to indicate that the Fed may not be done with its expansionary monetary policy as quickly as some people may have thought following current Fed Chairman Ben Bernanke’s comments from a couple of weeks ago that roiled the markets.

Graph of All Federal Reserve Banks - Total Assets, Eliminations from Consolidation

However, the ride appears to be much bumpier for gold than it was last decade.  Time horizon, liquidity, and risk management are important issues that folks often seem to forget when getting caught up in the dreams of making mad money on an investment/speculation.

Accordingly, while gold may ultimately prove not to be done with its longer-term secular bull move, it may be worthwhile to focus more on downside risk and proceed with caution.