We have been asked recently about whether we would recommend buying gold.
What follows is a summary of Graham Bentley’s excellent article on the subject.
Graham Bentley: Fool’s gold. – Allure depends on demand
In spite of the constant reminders that we are in a ‘low return environment’, investors may find themselves looking back over the last eight years and wondering what all the gloom was about.
We are enjoying a “bull market” i.e. one where everything seems to be going up. It is now more than 100 months since the Bank of England introduced quantitative easing (QE) in March 2009 and remarkable annualised returns have been enjoyed by every fund sector. At the same time, fund volatility (or risk) has been way below historic averages.
Bull markets do not die of old age – they die of fright. Increasing political tensions are clearly evident but there is a growing recognition the driver of asset price inflation – QE – may be about to be reversed. The word ‘correction’ is increasingly featuring in investment commentary and the sense of nervousness is characterised by the column inches devoted to gold.
We would counsel investors not to be fooled into adoption of the glittery stuff and, to support that warning, perhaps a brief reflection on its investment attributes – or lack of them – is in order.
Despite thousands of years of mining, the total amount of gold ever brought out of the ground is around 183,000 tonnes, according to the World Gold Council. This is roughly equivalent to a 21 cubic-metre block. There remain around 55,000 tonnes yet to be mined.
Gold produces no income – its price is purely driven by demand. Historically, it has been accepted as the universal store of value, being rare enough but not too rare, malleable but virtually indestructible, and not too shabby to look at.
Until relatively recently, gold was used as the standard by which most currencies were valued, where the central bank promised to redeem paper money for gold. Since 1971, however, when US President Richard Nixon told the Federal Reserve to stop honouring the dollar’s value in gold, it has not had that function. Not a single country in the world now uses it that way, and that has fundamentally changed how the gold price behaves.
The gold price was settled upon by Isaac Newton in 1717 at £4.4sh.11.5d per ounce of fine gold and, 77 years later, the price remained unchanged – the dollar equivalent being a little under $20.
As the graph below shows, with occasional and brief exceptions – Napoleon’s escape from Elba in 1815 and the 1864 Gold Hoax – the gold price was virtually static until 1933 when President Franklin D Roosevelt banned the ownership of the precious metal (yes, really), and the following year forced all owners of gold to hand it to the US treasury in exchange for paper money.
This was the 1930s equivalent of quantitative easing – allowing the supply of paper dollars to increase by owning the gold against which that money was secured. Gold was revalued at $34 an ounce, where it stayed with little fluctuation for more than four decades until Nixon finally decoupled the dollar and gold, allowing both the dollar and gold prices to ‘float’ feely.
The dollar was now not backed by anything, creating what is known as ‘fiat money’ – legal tender by government decree, printed (or in the modern era digitally introduced) with no physical constraint (unsupported by any physical asset).
Some commentators draw attention to gold’s inflation-proofing characteristics but there is little evidence for that. The price was fixed for literally hundreds of years. At a floating price, we have less data than we do on equities as it only runs from the mid-1970s. On that data alone, on an inflation-adjusted basis, gold is worth less today than it was in 1975.
Essentially, gold’s allure depends on demand, driven by a shared belief – or myth – with nothing fundamental to support it. Equities rise through demand, for sure, but there is a calculation involved: a cashflow is being purchased – that is to say, earnings translated into a company’s book value and ultimately growing dividends. Gold, on the other hand, advances because of nothing more substantial than the shared belief the price will rise in a crisis.
At the extreme, prophets of doom suggest the reliance on debt supported by fiat money will lead to a complete financial collapse, when gold will be the investment of last resort. But if the world does go to hell in a handcart, you might prefer a plentiful supply of canned food, barbed wire and machine guns.
Graham Bentley is managing director of gbi2