Gold prices warrant caution

Not all that glitters is gold. There are a number of reasons why you should invest in gold, but advisors need to be wary of the meteoric price of the metal, which could be the result of over-hype.

According to a report recently issued by Windsor-based Dan Hallett & Associates, gold investors need to be aware that, potentially, much of the demand for gold is being driven by the financial markets rather than substantial shifts in supply and demand.

Gold has a unique position with an almost 1:1 inverse correlation with the U.S. dollar, so institutions and retail investors alike have loaded into the asset class for a number of diversification reasons.

According to Dan Hallett,CEO of the firm and the author of the report, this does not necessarily make gold a great investment from a valuation perspective.

“If you’re buying gold today, (at around $1,000 an ounce) you have to have some view at least in broad terms about how far the commodity is going to go above that,” he says. “One of the risks that you run, particularly with a popular hot asset class, is valuation risk at the time you buy. You’re reasons for investing in gold could be well thought out but if you’re buying at a very high price, you’re going to suffer some downside.”

Hallet says data from the World Gold Council, an industry that tracks gold usage, shows more than a doubling in demand from investment instruments like exchange traded funds (ETFs gold during the second quarter of 2009. Meanwhile there have been actual decreases in some physical supply channels, like jewelry demand.

Subsequently, Hallet points out Canadian investors in un-hedged bullion products have seen nearly a 50% diminishment of returns, due the drop in the U.S. dollar versus the Canadian dollar.

“True, buying gold at the height of fear last year would have worked well, but a falling U.S. dollar would have clipped gains. Buying stocks (as we advised) has worked out much better. So, we present this analysis to warn of the irrational trends we are noticing that could disappoint today’s gold buyers,” Hallet says.

Hallet also points out that investors may not be willing to stomach the volatility that gold investing has historically exhibited. Back in March he conducted a study that looked at gold prices over the last four decades.

“I looked at gold in the context of why people recommend it. One is as an inflation hedge, another is to diversify portfolios and a third reason is to have it as kind of disaster protection portfolio insurance,” he says. “I found that it delivered on all three of those goals, but it did so in a very volatile fashion. You’re looking at 19% to 20% a year in annualized volatility. That is well above what you’ll get with most stock markets.”

Paul Vaillancourt, senior vice-president and director of portfolio strategy for Franklin Templeton Managed Investment Solutions, says it’s very hard to put a valuation on gold because of its special status as pseudo-currency.

“I would say that a true valuation of gold is something difficult to come up with,” he says. “You can look at the ratio of the price versus oil. The way we look at gold these days, is the inverse correlation with the U.S dollar. Days in which gold prices seem to fall, it’s basically because the world is threatening to return to a riskier investment environment.”

Vaillancourt says supply and demand is difficult predictor of gold price.

“We’re not going to get hung-up on the valuation,” he says. “There are other $1, 000-dollar-per-ounce metals that are for industrial use that don’t trade at that same sort of level. There are metals in greater demand and shorter supply that are not trading at anywhere near the price of gold.”

Vaillancourt outlines that there are a number hard commodities that have pretty close correlations to inflation. Oil and copper tend to rise in price with the U.S. dollar.

Gold has a privileged position of being a physical asset that protects against deflation.

“Gold has actually been a better hedge against potential deflation than inflation,” he says.

For this reason, Vaillancourt says some sector exposure to gold is probably necessary if a portfolio has some relationship to the U.S. dollar. The Quotential portfolios that Vaillancourt helps run are actually examining the use of gold ETFs, to manage the dollar relationship.

“The correlation between gold and the dollar is pretty solidly entrenched. There is a proliferation of the view now that commodities are real asset classes. We see that,” he says. “Anytime a [government] expands their money supply, and ultimately you pay for that. That may create inflation or devalue your currencies, both of those work for gold.”

Advisors have to determine which is the best way to get gold exposure — through equities or bullion?

The benefit of equities is they give you leverage to the gold price. Gold producers generally have a fixed cost of production, so large increases in gold price drastically increase the earnings margins for gold producers.

Hallet says if the price of gold is your benchmark, than bullion exposure is probably the best route.

“You get the best diversification with the bullion. If you’re buying gold for portfolio insurance, then bullion is the way to go,” he says. “If you’re buying it as a portfolio diversifier, you could probably go either way, but the bullion is a better diversifier. With equities getting exposure to the general stock markets independent of the price of gold.

(09/28/09)