Date: 03-11-2013
Source: The Wall Street Journal
The Precious Metal has Lost its Luster as Stocks Have Regained Center Stage
To its fans, gold is an inflation-fighting, economy-hedging, dollar-busting superhero asset class.
Lately, it has just been a dud.
The precious metal this year is on track to record its first yearly fall since the year 2000. On Friday, it closed at $1,313.10 an ounce, down 22% for 2013.
According to the International Monetary Fund, global central banks, which had recently been big gold buyers, in the past year have reduced their purchases.
So should investors throw gold on the scrapheap?
A small allocation to gold won’t kill an investor’s portfolio, but experts say you should think twice before leaning on it heavily to hedge against inflation, economic collapse or any other specific fear. Most stated goals of gold investors can be accomplished with other, potentially cheaper, asset classes.
The performance of other assets during gold’s recent slump just makes the sting worse. Large U.S. stocks are up big time so far this year, with the S&P 500 returning 25%, including dividends, through Thursday. Small-company stocks, as measured by the Russell 2000, have done even better, returning 31%.
Even U.S. bonds, which are vulnerable to the threat of rising interest rates, have lost only 1.1%, as measured by the Barclays U.S. Aggregate Bond Index.
That has left gold nearly alone in its misery.
John Pierce, an 80-year-old retiree in Haddonfield, N.J., bought a few thousand dollars’ worth of American Eagle gold coins in November 2011, hoping they would protect him from inflation and potential disruptions from continuing squabbles in Washington over the debt ceiling and spending cuts.
Mr. Pierce, who has belonged to stock investment clubs for a quarter-century, had never before invested in gold.
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“I heard all the stories about how gold has gone up in the last 10 years,” he says. “I thought it was time to get my feet wet.”
Since then, Mr. Pierce’s investment is down about 20%.
Adding to the anguish, the concerns that drove many investors toward gold have been validated.
Since Mr. Pierce bought gold at $1,700 an ounce, Washington gridlock has led to severe spending cuts, a debt-ceiling debacle and a government shutdown.
The only thing Mr. Pierce—and many of his fellow investors—got wrong was how gold would react.
‘Somewhat of a Chameleon’
For decades, gold’s behavior has defied attempts to define it. At times, investors have said they hold it to protect against inflation, a poor economy, and a decline in the U.S. dollar.
Depending on the time period, each argument has been upended, says Michael Cuggino, president and portfolio manager of the Permanent Portfolio Family of Funds. The company’s $11 billion flagship mutual fund, Permanent Portfolio, keeps about 20% of its holdings in gold and charges annual expenses of 0.69%, or $69 per $10,000 invested.
Instead, gold seems to play different roles at different times, Mr. Cuggino says.
In the early 2000s, gold acted like other commodities, such as copper and oil, and rose amid demand from fast-rising emerging markets and a weak dollar, among other factors. In 2008, gold provided a haven when other risky assets plummeted. The metal is still up 68% since Lehman Brothers Holdings collapsed on Sept. 15 of that year.
Now, Mr. Cuggino says, it is acting as a hedge against potential interest rate rises, slowing economic growth and other uncertainties.
“Gold is somewhat of a chameleon of an asset because investors tend to value it as a function of something else, and it’s sometimes tough to tell what that is,” Mr. Cuggino says.
That is partly because no one knows how to value gold. Unlike stocks, which have dividends and earnings growth, and bonds, which pay interest, gold doesn’t generate cash flows.
That makes the shiny stuff quite literally worth only what the next investor will pay for it. Even more so than stocks, gold’s price is driven by investors’ perceptions of its allure and scarcity.
Gold’s remarkable run since the turn of the century brought lots of conservative, investors into the asset class who never considered it before. Between the end of the year 2000, when gold closed at $272 an ounce, and August 2011, the precious metal’s price increased nearly sevenfold.
One driver: the advent of gold exchange-traded funds, such as State Street Global Advisors’ SPDR Gold Shares, which made its debut in 2004, and BlackRock’s iShares Gold Trust, which launched the following year. The ETFs, which charge annual expenses of 0.4% and 0.25%, respectively, trade throughout the day like stocks, which makes it easier for small investors to move into and out of gold quickly and cheaply.
Since its debut, SPDR Gold Shares, the larger of the two, has collected nearly $16 billion, which, when combined with price gains, has brought the fund’s total assets to about $37 billion, according to research firm IndexUniverse.
Gold’s rise led even so-called value investors, who typically rely on earnings fundamentals to pick stocks, to dip their toes in the water.
In his main portfolio, William Peterson a 65-year-old retired information-technology professional in Phoenix, picks stocks based on standard metrics such as price/earnings ratios and earnings-growth projections.
But in 2003, as the dot-com bubble finished deflating, he and his wife bought more than $1,000 worth of collectible gold coins.
“The price was going up relatively rapidly, so we thought we ought to be in that area,” he says. “It felt like I was protecting myself from another downturn in stocks.”
Asset managers also jumped on board.
In its 22-year history, Leuthold Weeden Capital Management in Minneapolis had never held gold in a mutual fund or separate account. But after a decadelong run that saw gold’s price more than triple to about $900, the firm decided to work the asset class into its traditional mix of stocks and bonds.
Some clients were relieved.
“We had a client base that seemed to say, ‘These guys are finally getting it,’” says Doug Ramsey, the chief investment officer at Leuthold, which manages $1.6 billion.
The firm has since backtracked. At one point, it held as much as 7% of its typical portfolios in gold, but now its allocation is merely 1%.
Professional money managers disagree over the cause for gold’s recent drop.
Eric Sprott, CEO of Toronto-based Sprott Asset Management, says gold’s price has recently dropped because faulty statistics underreport demand and overestimate supply.
In October he wrote an open letter to an industry group, asking them to change the way they calculate supply and demand for gold in a way that would make the metal seem like a hotter commodity.
“This lack of quality information has certainly been one of the driving factors behind the lack of investors’ confidence towards gold as an investment,” he wrote.
In an interview, Mr. Sprott called gold’s recent drop in price “bizarre.”
Inflation Protection
Two of the most-cited reasons for owning gold are to protect against inflation and to hedge against plummeting stocks.
The first, inflation, has been rumored for years. So far, it hasn’t arrived.
On Wednesday, the Labor Department said that prices rose only 1.2% in the year ended September.
But even if an investor is worried about future inflation, he might be better served somewhere else.
Indeed, even over long periods, gold has failed to keep up with prices.
Consider the 1980s and 1990s. In those two decades, gold’s price fell from about $533 an ounce to $289, according to SIX Financial, even as overall prices more than doubled. Even now, gold is still below its 1980s inflation-adjusted peak of more than $2,300.
“It’s one of those things that makes intuitive sense but turns out not to be true,” says William Bernstein, an investment manager at Efficient Frontier Advisors in Eastford, Conn.
Gold bought at other times has sometimes done a better job keeping up with prices. But if inflation protection is really the goal, there are other options that address the problem much more directly, Mr. Bernstein says.
For example, 10-year Treasury inflation-protected securities—which are Treasurys whose principal rises and falls with prices—are back in positive territory after spending some time delivering negative returns after inflation. TIPS currently yield 0.31% annually after inflation.
Small investors who don’t want exposure to interest-rate risk can look to I-Savings Bonds, sold at TreasuryDirect.gov, which right now are paying interest equal to the rate of inflation plus a small fixed rate. Such bonds can be redeemed, with a small penalty, after only a year, but have a very low annual purchase limit of $10,000 per investor.
Though they can go through stretches of declines, stocks actually have done a fine job beating inflation over time. While inflation has run at about 3% a year between 1926 and 2012, large U.S. stocks have grown by about 9.8% a year, according to Ibbotson Associates.
To be sure, stocks are more volatile than TIPS and I-bonds, but over the past five years, the S&P 500 has been less volatile than SPDR Gold Shares, according to Morningstar.
Hedging Stocks
Gold’s other oft-cited role—as a hedge against falling stock prices—carries a little more weight, at least when markets drop sharply. According to a Leuthold analysis, from 2006 to 2012, when the S&P 500 dropped by 1% or more, gold tended to rise sharply.
That is one reason Charles de Vaulx, chief investment officer and portfolio manager at International Value Advisers, keeps a small 3.25% allocation to the metal in the $9.5 billion IVA Worldwide Fund. If stocks perform well and gold drops, the tiny position won’t have a big impact on his fund. But if stocks plummet, gold has the chance to double or triple, which could offset significant losses, he says.
“Within the context of a portfolio, something that can go up a lot when the rest of the portfolio goes down is a wonderful thing,” he says, adding that he thinks gold can also protect against currency debasement and deflation. The IVA fund’s A shares charge annual fees of 1.28%.
But experts warn that investors shouldn’t go overboard. Mr. de Vaulx, for instance, views gold as a tiny part of his cash position, to defend against stock-market declines.
Following that approach, an investor with an allocation of 60% to stocks and 30% to bonds would have only the final 10% of cash out of which to carve out a gold allocation.
One percent, Leuthold’s current allocation to gold, “is not a whole lot of portfolio diversification,” Mr. Ramsey says. “An allocation of zero probably isn’t that much different.”
Instead, if an investor fears a sharp market drop, there are other options besides the obvious bonds and cash. He can set up a “stop loss” order to sell stocks when they fall by a set amount, say 10%, says Chris Cook, president of Zero Commission Portfolios, which manages $450 million.
That limits losses without relying on gold to behave as expected, he says.
“Gold has a personality disorder. You don’t know what you’re going to get,” Mr. Cook says. “That creates a problem for anyone trying to use it.”
