Regular readers of my analysis pieces may be familiar with the fact that I am not generally an enthusiastic advocate of direct investment exposure to gold. I am a pragmatist, and not ideologically nor evangelically anti-gold. I have just always felt that as a ‘safe haven’ investment, gold is not especially reliable. Or at least not in a way that allows it to be an effective hedge for a broad-based investment portfolio.
As a direct investment in the value of the metal itself, gold offers no income nor the same kind of capital appreciation potential as a growth company. Gold advocates refer to its quality as a ‘store of value’. I personally find the suggestion that gold has inherent value that makes it a safe haven against collapsing financial markets or fiat currency values baffling.
Gold’s only claim, as far as I can tell, to inherent value is a long history as a commodity. Otherwise, it has little practical use outside of being a ‘precious metal’, used in jewellery or to otherwise display wealth. Or as a store of value commodity in the form of bars and coins.
But that value is entirely, again as far as I could personally ever see, completely reliant on abstraction. I honestly see little difference between gold as a store of value and bitcoin as one. Yes, gold has a physical form but its security of ownership also relies on the security of its storage and, if not in personal possession, trust in the rule of law, accuracy of (digital) record keeping and trustworthiness of the custodian.
You could of course keep your gold in a safe at home or bury it in the back garden. Or in some nearby woodland and keep a treasure map rolled up in a secret compartment of your desk. But I am personally slightly sceptical of how useful that piece of ornamental metal of abstract worth would really prove to be if modern society ever breaks down to such an extent that’s what is left to be relied on.
But, as I said, I am not fundamentally opposed to any kind of exposure to gold as part of a balanced investment portfolio. The commodity is an established part of our financial markets. Its value rises and falls over time as demand ebbs and flows with the influence of external market forces.
I see no practical point in debating whether or not gold has more or less ‘intrinsic’ value than fiat currencies or any other financial instrument. I don’t see the logic of any argument that says it does, but that’s not how financial markets work. The value of any financial instrument is based on collective societal agreement backed up by legal frameworks and a working judiciary system.
Philosophical debates on the details of which financial instruments might deserve their status to a greater or lesser extent than others on qualities of ‘objective’ or ‘intrinsic’ value are, in my humble opinion, at best mental or academic exercises. They change the practical outcome for financial markets and investors as much as philosophical debates on ethics and morality change the outcome for security markets and individuals considering their personal security.
Nobody with any common sense doesn’t install a home security system or take out content insurance on their possessions because they think people shouldn’t break into other peoples’ homes and steal from them. In the same vein, I wouldn’t cut off my nose to spite my face by never investing in gold because I don’t personally understand the logic of gold bugs.
Financial markets still, to an elastic extent, believe in gold as both a store of value and safe haven asset. Which, I think, means it would be foolish to completely ignore gold as an investment option, or opportunity.
Does Record High Gold Prices And More Volatility On The Horizon Mean A Gold Hedge Makes Sense?
Which brings us to the current question of whether investors who have little or no exposure to gold should now be reconsidering that position? Traditionally, gold prices have shown anti-correlation to equity markets. That’s why investment exposure to gold is often used as a hedge to lessen the blow of stock market downturns.
That’s not been the case in 2020. The chart below shows the movement of gold prices between the beginning of 2020 to the end of July 2020. Gold prices dropped in mid-February before recovering and then slumping in March. Since then the price of gold has been on a steady ascent towards new record levels.
The chart below tracks the MSCI World index, which tracks international equities across developed stock exchanges from London to Wall Street and Asia. Other than February’s volatility being less pronounced, it looks almost exactly the same.
Gold price is not moving in anti-correlation to equity markets. Over the coronavirus crisis, gold price and stock markets have shown close to perfect correlation. A gold bar can’t grow into a bigger gold bar over time, like a growing company expanding its business. Nor does it produce little gold coins for its owner, like dividend payments from stocks.
Source: Business Insider
If gold is not showing the kind of anti-correlation to stock markets that make it a strong hedge, what’s the point in owning it? The simple answer would be if there is a reasonable argument that will change in coming months and equities and gold will stop following the same direction. Will their paths diverge again and recent correlation fade?
Otherwise, the only other reason why an investor might bet on gold would be a reasonable chance its gains will significantly outstrip those of the stock market. If both asset classes were to keep going up, but gold by 20% to the end of the year and equities by 5%, then investment exposure to gold would be worthwhile.
Are there reasonable arguments either of those two scenarios is likely to unfold over coming months?
What Value Might Gold Reach Ahead Of The Post-Coronavirus Economic Recovery?
Over the week to the end of July, the price of gold climbed to a record $1954 an ounce. Back in June, when prices hit $1783 oz. there was a significant outflow of capital from gold ETFs, which, according to markets data company Morningstar, had attracted £4.4 billion in capital over the previous three months. £262 million was withdrawn, with profit taking the presumed motive.
Investors were clearly doubtful about whether gold could continue to climb. Less than two months later and gold is within touching distance off $2000 oz. If there were doubts in June about how much upside was left in gold, those doubts should presumably now be intensified. Especially in the context of equities markets also continuing to rise.
Ordinarily I would be tempted to point to gold’s 2020 correlation to equities as evidence investing in gold makes little to no sense. But right now, I am more inclined to lay the blame for correlation at the door of equities. I just don’t think the extent of the recovery in stock markets since March makes any sense.
It’s now obvious that the two to three-month lockdowns seen around the world from spring into summer were not a one-off sacrifice that would get the Covid-19 pandemic under long term control. Something approaching normal life isn’t, it has become clear, going to consistently be the case internationally for many more months to come.
Current stock market valuations, especially on Wall Street, seem to reflect a level of optimism for a ‘V-shaped’ economic recovery that it’s hard to reason does not appear misplaced. The relative robustness of revenues generated by the biggest tech companies, that account for up to 25% of major indices such as the S&P 500, has helped prop the stock market recovery up.
But even their income generating powers will not remain immune to months of on-off lockdown measures over the months ahead. Especially as aggressive government moves to protect employment are tapered off. And even if they did, are the fortunes of a handful of tech giants, even as dominant as they are, enough to compensate for all of the sectors and economic activity that will continue to struggle to survive?
The stock market looks poised for a second downturn. Quite possibly a big one. If it comes, it’s unlikely that the recovery will be so fast again. I think another serious drop, which I personally expect, will instil a greater degree of realism. The stock market will come back but it will be a longer road ahead.
The extent of quantitative easing from major central banks around the world is another factor that could be in gold’s favour. And that trend isn’t flattening, with the Federal Reserve, European Central Bank, Bank of England and Bank of Japan all expected to announce new money printing programmes soon. The dollar is already losing value quickly against other major currencies, despite the fact their printing presses are also hot. With gold priced in dollars, that’s a trend in its favour. If the dollar’s comparative value drops, gold’s is likely to gain.
One of my biggest gripes about gold, already mentioned, is that it doesn’t do much. It’s a commodity for which demand is purely based on sentiment, as it has no industrial application. And as also already mentioned, it earns no income like fixed income assets or cash, nor can grow like stocks. But bonds and cash are moving into negative interest rates. Which makes gold’s no income status actually seem like an attractive alternative.
How High Could The Gold Price Go?
One way of forecasting the potential upside left for gold’s price is to compare previous peaks in 2011 and 1980. Adjusted for inflation, gold still has another 16% in dollar terms to rise before it matches its 2011 peak. To match its inflation-adjusted 1980 high, prices would need to rise by another 29%.
Gold’s value relative to stock markets hasn’t moved since March, despite rising by over 30% in dollar terms over that period. Some analysts argue that means it makes sense for it to record further gains. Another way of looking at it would be to say stock markets are overvalued, rather than gold being undervalued. As I’ve done. That could see balance restored not by gold gaining more than equities over future months but by dropping by less. Which would make an investment in gold now a losing investment.
I’m still not a big fan of gold. I don’t think I ever will be. But despite the pros and cons and the fact much of the upside may well have been missed already with gold looking expensive after recent gains, I do see reasonable arguments why it may prove to be a decent bet as a stock market hedge at the moment.
That’s more because I see troubled times ahead for stock markets than because I have suddenly changed my mind on gold. And the negative returns of investment grade bonds and cash likely over the next couple of years at least don’t leave many alternatives.
I still wouldn’t, personally, go heavily in on gold. But for the first time in my own investing career, I am seriously considering using it as a hedge.
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