Fools’ Gold?

One of the ways you’ll know that something has reached a peak is when everyone starts climbing on the bandwagon.

This was true of commodities in the late spring of 2008; especially the oil market, where crude was sailing towards US$150 per barrel. Folks were falling all over each other trying to get on board for fear of missing out on a run to $200. By the end of the year, oil had fallen more than $100, reversing all the gains since 2004.

A year earlier, Canadian banks offered the same enticement. After several years of a booming economy and strong housing market, bank earnings were firing on all cylinders. And so were their share prices. By May, most of the big-6 banks in Canada had reached record highs, prompting a raft of new products geared to bank performance. Unfortunately, many of these came with plenty of leverage attached, thus magnifying the eventual collapse in valuations through 2008.

The point here is not that we should magically be able to time the tops and bottoms of the market, but that there are times when we shouldn’t be following the herd – especially when it’s being led to the abattoir.

Fast forward two years and another mass gathering is forming. This time it’s a metallic herd. The price of gold broke above US$1,200 an ounce this month, as it did back in December. Predictably, retail investors are again asking if they should be adding gold to their portfolios, sometimes to the exclusion of other asset classes. And just as predictably, the question comes in the same context. If gold is going to US$2,500, isn’t this a great time to get in?

Maybe it is, and maybe it isn’t. If you knew the answer you wouldn’t be reading this and, if I knew, well okay…I’d still be writing!

For a commodity that is carried at book cost of $35/oz on the balance sheets of central banks around the world (a leftover from the post-WWII gold standard), the escalation in market price is nothing short of amazing. I remember back in the days of “Investor On Line”, having chat room discussions with viewers over the direction of gold, which was trading down near $250/oz. Despite the capital market instability brought on by the Asian financial crisis and then the Russian debt dive, gold was steadily losing value.

The problem was that gold had lost its three main reasons for existence in one’s portfolio. These are simply to provide (A) a hedge against rising inflation, (B) a store of wealth (in uncertain times), and (C) a hedge against a weakening US dollar.

Well, in the second half of the last decade, inflation was fairly static, even though global economic growth had been strong for several years. In the US, inflation fell below 2% in 1998, while Canadian inflation was rarely above 2% throughout the period. The staunch anti-inflation monetary policies of the previous decade had worked in forcing down inflationary expectations by both businesses and households to the point where 3% wage hikes were almost luxurious. As for uncertainty, there was plenty – from an Asian financial crisis to Russia’s debt collapse. However, equity markets didn’t seem to mind and, with the exception of some minor hiccups, stocks kept pushing higher right into the next decade. Why own a lump of gold when your favourite stock is not only paying a dividend, but appreciating in value too?

Now, gold makes for a decent store of wealth especially when other alternative forms of investment are tumbling – like the US dollar. Again, this wasn’t the case in the late 1990s. In fact, the US dollar index gained close to 50% in value from its lows in 1995 to late 2000. But that was then and this is now.

Where are these fundamental drivers today? Due to the spike in commodity prices in late 2007 and early 2008, inflation was looking a little ominous then but, thanks to a global recession, deflation quickly became a household word again. Things have improved a little with the recovery, but this week’s surprise report of a decline in US consumer prices in April pushed the deflation (or at least disinflation) chatter back to the forefront. At the same time, the US dollar is refusing to cry ‘uncle’ and is climbing towards levels we saw at the height of the financial crisis of 2008, when there was an insatiable appetite for safe-haven investments. This week the DXY dollar index broke above 85 for the first time since April of last year, thanks to continued erosion in the value of the euro. Seems like the only major currencies winning these days are the Loonie and Japanese Yen.

This leaves us with the third and final driver – market stability, or lack thereof. There is certainly a lot of angst in equity market these days – some of it real, some of it perceived. Volatility, as measured by the VIX index, has jumped in recent weeks and global equity markets are nearing a 10% correction. And, indeed, gold prices have leapt towards the $1,250 mark amidst this volatility. But the ride ended quickly last Friday and Wednesday’s $30 plus correction in gold certainly shook investors thinking the opposite might happen, with equities still venting value. What makes the choice of jumping into gold today tough is that recent events could reverse and still be ambiguous as to direction. If the European fiscal fiasco is seen to be stabilizing, then risk appetites could increase and draw flows away from safe havens, such as the US dollar and US government bonds. That might allow gold to advance, but what if equity conditions also stabilize and show improvement? Investors may elect to move straight from safety to risk and by-pass gold.

It should be clear that there is an absolute vacuum of certainty today. So, the decision to have gold in one’s portfolio must look beyond this current vacuum to the longer-term fundamentals.

Is there an inherent reason for gold to extend to these lofty targets above $2,000? Well, gold doubled from 2001 to 2005, and then again to 2009. Maybe it doubles to $2,400 by 2015, or maybe it gets chopped in half. The critical take away for investors is not to bet the farm on just one horse, especially gold. For one, gold doesn’t pay a dividend (unless you own a gold company that does). It can be volatile. And it changes hats between the fundamentals that drive it more frequently than the average investor has the ability or willingness to follow.

So, here’s my advice for this week: when someone tells you to buy gold today, ask why. Then ask what it is you should buy – gold bars in your safety deposit box, gold exchange traded funds (etfs) or gold shares? Then take a look at your portfolio (or ask your adviser to) and figure out how much exposure to gold you already have. You might be surprised. But, let’s assume that you are not exposed at all to gold at all. You could try to time this market and wait for gold to find support at $1,150 or maybe even way down at $1,050. Or, you could take a balanced approach and incorporate gold into your portfolio by means of a general commodity investment, which could be an exchange-traded fund or mutual fund.

Just keep in mind why you’re putting this investment in your portfolio and whether it fits with your overall objectives and risk tolerance.

http://ca.finance.yahoo.com/personal-finance/article/yfinance/1608/fools-gold

I Believe that when the likes of Peter Munk make a decision about whether to make an acquisition, they use a far more conservative figure than the current POG. Our potential with this company to a great extent depends on the size of the resource and cost of extraction. If it is calculated that it costs say $350/oz to mine our gold then even at a POG of $800 there is good money to be made. The question that remains is even at a profit of $450/oz, is there enough there to earn back the capital investment of building a mine and make real money thereafter.

I'm very positive on this stock but also realistic. Sure a SP of $20 would be very nice but even if it only goes to $5 it would not be a kick in the nuts.

The last junior I was in, (CTQ) a large copper play in Equador that was taken over, sold at $8.60/share.

Cheers.