Investing in Gold: 5 Things You Need to Know First

Investing in Gold: 5 Things You Need to Know First

Gold holds a special place in investors’ hearts; coveted for both its value and beauty. The precious metal has been a part of history – not just in the United States, but throughout the world. It has sparked migrations through gold rushes and inspired artists dating back to antiquity who used the shimmering metal to romanticize their works.

In modern times, gold is pointed to as a valid monetary base with talks of returning to a gold standard. Until the mid-seventies, the U.S. dollar’s value was directly backed by a reserve of gold and that image of the commodity maintaining its value still drives investment markets today.

In many circles, gold is considered its own asset class. Financial advisors recommend that gold be a part of every portfolio with weights ranging from 1% up to 10%. Investor interest in gold even prompted the creation of gold-specific mutual funds and exchange-traded funds (ETF’s) just to meet the public’s demand.

A quick glance at any Wall Street headline will show you how the major indices performed and right underneath it, gold prices. Gold is so common that many investors hop into it without really thinking about why gold fits their portfolio. For such a popular commodity, there are a surprising number of mysteries surrounding it.

Gold myths abound in the market drifting from investor to investor until they’re taken as actual facts. The truth, however, is that these so-called facts might surprise you.

Physical Gold Is Not The Same As Paper Gold

This might be one the biggest misconceptions about gold by investors and can lead to poor investment decisions. There’s a big difference between holding physical gold and investing in gold companies like mining stocks or ETF’s. The divergence stems from your portfolio objective for including gold: growth or hedging. Before buying, you need to understand what your goal is and what type of gold investment is appropriate.

As a hedge, there is no more popular investment than gold. It’s a natural store of value and refuge in times of economic uncertainty. Typically this means hedging against inflation, but it can also be a hedge against systemic risks as well as simply through diversification. Physical gold reacts to economic activity very quickly and is a reflection of overall sentiment unlike equity-driven gold plays like mining stocks and gold funds which will be primarily influenced by general market behaviors.

Keep in mind that holding actual gold may appreciate in value, but not in a growth-driven sense. Gold bullion doesn’t pay dividends, doesn’t manufacture anything, and doesn’t reinvest itself. Physical gold is the safety net for falling equities and a declining dollar.

If you’re interested in gold as a growth investment, then mining stocks, mutual funds, and ETF’s are your best bet. These types of gold investments often pay out dividends and are driven to grow profits. Unlike simply buying gold coins or bars, you’re buying actual shares of a company, and like all equity investments, stocks are driven by internal fundamentals as well as external forces. As gold prices rise, so too will gold mining stocks, but some companies will always be more competitive than others and grow at a much faster rate.

Gold’s Volatility Makes It An Ineffective Defensive Investment

Gold may be the go-to hedge against economic fears, but it doesn’t have a very good track record as a stable defensive play. In the past year alone, gold prices have been to a low of $1,195.00 back in December ’13 and spiked as high as $1,420.60 earlier in August ’13. That’s a difference of $225.60 – about 19% from its 52-week low. Looking back 5 years, the difference is even more pronounced with a spread of more than 100% from low to high.

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Gold tends to trade in a somewhat negative correlation to equity markets which is what gives it the reputation of being defensive. It tends to keep pace with, albeit lag, the general market when equities are rising, but rises rather quickly during market downturns and corrections. Despite gold’s volatility, it can be used as an effective hedge against stocks or short-term value investment when it’s out-of-favor.

Gold’s True Value

Gold’s volatility is often attributed to the difficulty in properly valuing gold prices. In other words, determining its intrinsic value. Detractors of the precious commodity will point to its lack of intrinsic value as the basis of their bearish sentiment and argue that it’s traded on technicals only rather than fundamentals. Gold’s worth it seems, depends on whom you ask.

As of 2011, over 2,500 metric tons of gold is mined every year globally. Out of it, only 34% is used for investments and central banking purposes. The majority of gold (52%) goes to jewelry which leaves around 14% to be used for industrial applications.

Gold is a great conductor of electricity and is used in virtually every form of electronic device on the planet. The amount of gold found just in cellphones worldwide is worth hundreds of millions of dollars. Space satellites frequently use gold as a radiation shield and temperature stabilizer.

While the actual intrinsic value of gold is still hard to pinpoint, we can be certain that it is not zero. Simply put, gold is valued like anything else; by supply and demand. Forces like inflation and market sentiment play a big role in gold prices which need to be factored in when analyzing whether gold should trade at a given level or not.

Gold As An Inflation Hedge, With A Twist

Arguably the most common characteristic investors attribute to gold is its value as a hedge against upcoming inflation. Investors attribute historical reliance on the precious metal as a backer to currencies, as evidence that gold will hold its value regardless of inflationary pressures. It’s a persistent myth that is only partially true.

Let’s take a look at how gold performs over a long period of time to see how well it maintains purchasing power. The 80’s and 90’s were a period of time plagued by sky-high inflation and interest rates and many investors flocked to gold as a safe haven asset. Here’s a table that shows the value of gold from 1980 to 2006:

1980

$615.00

1990

$383.51

2000

$279.76

1981

$460.00

1991

$362.11

2001

$277.90

1982

$376.00

1992

$343.82

2002

$309.73

1983

$424.00

1993

$359.77

2003

$363.38

1984

$361.00

1994

$384.00

2004

$409.72

1985

$317.00

1995

$384.18

2005

$444.74

1986

$368.00

1996

$387.69

2006

$603.46

1987

$447.00

1997

$331.00

  

1988

$437.00

1998

$294.21

  

1989

$381.00

1999

$278.76

  

The results clearly don’t support the theory that gold effectively hedges against inflation. For gold to have kept up, it should have been worth $1547.52 by 2006; instead it fell short of breaking even with the original amount after 26 years. Anyone who bought gold would’ve realized a considerable loss with inflation taken into account.

The reason gold fell short of expectations is because real rates were still positive. Inflation may have been high, but so were interest rates. Investors could have realized greater gains investing in safer assets like bonds and treasuries. For gold to prosper, inflation must be higher than interest rates resulting in negative real rates.

Here’s how this relationship works using recent data:

Date

5-Year Treasury Yield

Inflation

Real Return

Price of Gold

March 2013

0.88%

1.50%

-0.62%

$1,614.00

December 2013

1.74%

1.20%

0.54%

$1,187.00

March 2014

1.53%

1.60%

-0.07%

$1,350.00

Gold performs well in inflationary environments only when real rates are negative. Investors should remember that gold is not a capital appreciation asset class unless invested in via stocks and other equities classes. As a hedge, gold is appropriate in a portfolio keeping in mind that it should not constitute a heavy weight in it.

Mining Stocks Key Fundamentals

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If you’re investing in gold miners, then you should be familiar with how fundamental analysis works in order to find quality companies. Mining stocks however, require looking at different items than other types of equities. One big mistake investors make when analyzing gold miners is judging them based on their P/E ratios. Gold companies should be compared by their assets, not their earnings. Because they carry large amounts of gold on their balance sheet and gold is seen as a currency of last resort, P/E ratios will typically be quite high in comparison to other stocks.

Before investing in a gold miner, the first thing you should identify is whether it is a junior mining company or not. Junior miners are largely exploratory companies and own few, if any, producing mines. Senior mining stocks are the ones that generate revenues on production from established mines. As a rule, junior miners are riskier and more volatile than senior miners.

The single most important piece of information investors should know about a mining stock is its cost of production. This is the cost the company essentially pays in order to pull the precious metal out of the ground and produce it. All-in-cash costs are what you should be looking at. This is the cost of production plus operating costs, depreciation, taxes, and exploration expenses. Once you figure out what the cost is for a company, it needs to be compared to the price of gold. If All-in-cash costs are higher than the price of gold, then you know that the company is losing money. Gold miners with the lowest cost of production can withstand downturns in commodity prices and stay ahead of their peers.

Gold Investing Practices

The inherent volatility in commodity prices make gold an attractive investment for value investors and growth investors alike. Short and long term opportunities can be found in both bull and bear markets making gold one of the most heavily traded commodities in the world. When used as a hedge, gold is purchased in its physical form and left alone, making it valuable if economic conditions deteriorate. As an appreciation purchase, gold can be quite lucrative.

During long bull markets, gold tends to lag in its performance relative to other equity classes as investors chase higher returns elsewhere. Savvy investors can take advantage of this by selling puts on gold stocks and generate income while potentially taking advantage of unforeseen dips by buying shares of a stock at a low price if the put is called. Calls are cheaper as well and investors can speculate on higher gold prices at a reduced premium.

During bear markets, gold usually performs well. Investing in high quality, dividend paying stocks and selling calls will keep your portfolio profitable during recessions. Puts can be sold as well, although premiums won’t be as high as they would be during bull markets. Also, there’s an additional risk to investors that get called into a put because gold companies could drop precipitously. Hedging by buying a put will limit your downside risk.

Gold based ETFs give investors a broad exposure to the precious metal but come with pitfalls of its own. Buying and selling these ETFs generate additional volatility in gold stocks due to the basket of companies owned in the funds. Products like ETFs are great for traders, but don’t work so well if you want to hold gold as an inflationary measure.

Shares of ETFs are not redeemable for physical gold and come with little transparency; you never know exactly what’s held in these vehicles. It won’t help you to hedge against stocks because ETFs trade as stocks. Furthermore, they are often subject to leverage, making them risky assets to own.

Used correctly, gold can be a powerful addition to any portfolio. Understanding your objective is key to determining whether physical gold should be bought vs. gold equities. Inflation alone isn’t enough to lift gold prices, but the current low interest rate environment could be a boon for the commodity. The long bull market has depressed prices to attractive levels for value investors. As long as interest rates stay low, gold could be just one small correction away from breaking out.

Fariba Ronnasi
CEO, Elite Wealth Management

Full Disclosures: http://elitewm.com/disclosures/
This article is not intended as investment advice. Elite Wealth Management or its subsidiaries may hold long or short positions on the companies mentioned through stocks, options or other securities.


 

 

 

 

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