It's All About Gold!

A Special Edition of Signature Update



January 21, 2010 Edition, Volume IV


Gold – a Commodity to Treasure

The run up in the price of gold over the past several years has been nothing short of impressive - perhaps even exciting - for those already holding the precious metal. Though a longer-term view of the commodity’s value may offer a different perspective, one thing is certain: Gold has been, and likely always will be, a commodity to treasure - if not for economic reasons, then for sentiment or perhaps even safety.

In recent months, as interest in gold has reached historic levels, solicitations to buy and sell gold in varying forms have become pervasive throughout the media. A few of these are represented by serious investors or market analysts, while most others are from speculators and opportunists. Those who proclaim the virtue of holding gold as an asset are often referred to as Gold Bugs, and rightly so. Like many other types of insects, they can be prolific, tend to present themselves at the height of opportunism, and scramble for safety when bright light is focused on their activities.

All of this begs the question: Is gold an important investment to hold, and is this the right time to buy it? To clearly consider the answers, we need to discuss the formation of bubbles in a market, how gold is valued, and what drives people to own the commodity.


The Next Bubble … Gold?

First, we need to discuss the concept of a bubble in our economy. Most recognize that a bubble forms in a particular asset class as interest in the asset heats up beyond reasonable levels, and then may often times explode with humbling consequences. In the late 1990’s the bubble was in tech stocks; in 2006 it was real estate; and in 2008 it was oil. Many consumers may argue that it’s difficult to tell when a bubble is forming in asset values as opposed to rational price appreciation. However, there are a few basic observations that can be used to differentiate:

- When consumers are getting into a market typically dominated by professionals because everyone in that market is making money – that likely represents the formation of a bubble in that market.

- When marketers and promoters expand their advertizing campaigns for seminars, workshops and newsletter subscriptions – that probably represents a bubble in its advancing stages.

- When large numbers of people begin to employ an unreasonable amount of leverage (debt) in order to take advantage of an opportunity – that’s almost always a bubble preparing to burst and take out many of those who recently bought their way into the market.

- When your brother-in-law who hasn’t been able to earn his way out a paper bag comes to you with a sure thing… well, that may not be a bubble, but the outcome is likely to be the same.

Unless you happen to be a professional in a market exhibiting the characteristics of a bubble, or have a trusted advisor with whom you or a close associate may have worked for many years to help guide you through that market, stay away from bubbles. It is the rare individual who has the expertise to keep from being harmed when bubbles burst, and believe me… all bubbles burst!


What Drives the Price of Gold

Gold is priced in the open markets based on the value of the US Dollar and the influence of basic supply and demand principles. The recent run up in gold pricing has been driven largely by the depreciation of the dollar, rather than increasing demand. The Fall 2009 announcement that several large hedge funds had entered into the gold market was seen as a bullish (positive) sign by some; others understood it to be an affirmation that speculative forces had already been at work. Demand decreased in 2008 and 2009 with the weakened economy, but gold’s price continued its climb. Low interest rates extended over a long period of time reduced the dollar’s buying power in domestic and foreign markets. Consequently, the nominal value of commodities such as gold and oil have increased. But just as the value of oil spiked in the summer of 2008 due to speculative forces well beyond the relative strength of the dollar, gold has experienced unsustainable price increases; and interest in the commodity has only increased. Likewise, the price of an ounce of gold, while possibly headed higher in the near-term, will more than likely tumble as a result of shifting market forces.

The dollar is likely to gain value as the economy continues to improve, GDP increases, and interest rates are adjusted upwards. Gold will almost certainly move downwards in near lockstep fashion. An argument can be made that an improved economy means a greater demand for the precious metal, and while this is certainly the case, the production of gold through mining activities remains sufficiently strong to keep increased demand pressures from supporting unreasonably high prices. Certain manufacturing and industrial concerns use gold in their products, but the search for alternatives has yielded some cost-effective choices. Even the consumer demand for gold being experienced in Asia isn’t enough to sustain current pricing given the world’s supply of the precious metal.


Why Gold?

There are few reasons individuals purchase gold. Most people who own it do so because of its value as a sentimental product. Many of us wear wedding rings or other jewelry fashioned from gold without really considering its intrinsic value. Others want to hold the commodity as a tradable currency in the event our economy and society are reduced to ruin by some form of calamity. Finally, there are those who hold gold as an investment, and look for it to provide an increasing value or hedge as part of an asset allocation methodology.

A Currency for Exchange

Owning gold as a tradable commodity or currency is tricky. In order to affect an efficient exchange, the holder needs to have a way to assert the purity of the metal being offered as currency and have flexible units of measure. In the mid-1800’s, assay offices offered measuring services for this very purpose. Today, sophisticated laboratories analyze the metal and determine its characteristics in minute detail. As it turns out, gold isn’t necessarily gold. It may look like gold, feel like gold and even be bitten into like we’ve seen in the movies, but gold comes in a variety of purities most often measured in carats and its value can vary widely.

When purchasing gold coins, jewelry or even ingots and small bars, consumers need to understand that there can be a wide disparity between what a dealer may charge for the item compared to what they would be willing to pay for it. This spread in pricing, or transaction cost, is necessary to offer the business a margin from which to profit, but too many people mistake the value of an item to be what they paid for it. In truth, the value is what you can get for it if you’re selling the item. What you may have paid has little relevance - just ask anyone who purchased Red Hat (NYSE RHT) at the opening in 1999 or a condo in Florida in 2005. It’s not uncommon to find a 20-30% margin between the purchase and sale price for gold coins and small bars, and the mark-up on jewelry is higher still.

Though the need to store gold for the purpose of trade is unlikely, the recent events in Haiti bring this more clearly into focus than at any time in recent memory. Gold may seem to be a broadly acceptable commodity for this purpose; but if we’re in a state of calamity, give me food, water and fuel with which to barter rather than gold. Sometimes we forget that currency is only as useful as what it can buy; and while cash may be king, in the midst of disaster it’s water that keeps us alive.

An Asset Allocation Resource

Many investors expect gold to be a long-term part of their portfolio and may choose to alter the portion of their holdings in gold as market forces shift. These are investors, not simply consumers, and they rarely hold the commodity itself. Gold can be purchased through ETF’s (exchange traded funds), ownership in traditional mutual fund shares, holdings of stock in a corporation involved in the mining or processing of the metal, or through commodities contracts. Each of these offer much greater liquidity and lower transaction costs than holding the commodity itself and as such, present entirely different levels of risk. Gold held in these forms as an investment is still subject to the market forces presented previously, but the ease of transaction and the available data regarding the asset is far superior to what most can experience with the physical commodity itself.

Sometimes, speculators can impact the value of a commodity through these mechanisms, but the regulatory environment in which we now live makes that increasingly less likely. Interestingly enough, it’s rare to see an elaborate marketing campaign for these forms of ownership in gold.

Today’s Gold Market

The price of gold rose to over $1,140 in late trading Tuesday (1/19/2010) as the US dollar continued to sink amid fears over inflation. Many now recognize a market bubble in precious metals with gold leading the way, just as oil did last year, real estate before that, and tech stocks before that. In recent months, we’ve seen and heard more from Gold

Bugs than at any time since the late 1970’s and early 1980’s. You may recall that this was when gold topped $1,000 an ounce before falling by more than 65%. A quick look at gold’s value shifts from the early 1970’s to today shows clear indications of a bubble in gold pricing. Is this a good time to buy gold? In this case, the picture speaks for itself.

We’re all too familiar with the enticing charts showing increases in stock and real estate prices in the 1990’s and 2000’s respectively. We also know what followed as markets plummeted. It only takes a glance at a similar chart of gold valuation to see what could possibly be in store.

Advocates for gold ownership may suggest that the recent increase in US spending, the attending trillion dollar deficits, and eventual inflation pressures will all but mandate an ongoing increase in gold’s value. Possibly, but what is missed is the deflationary impact the recent recession has already had on the price of goods and services. Many economists project that inflationary forces are already included in today’s price levels; some fear future deflation far more than possible inflation.

Will gold climb to $2,000 an ounce? Perhaps, but it’s far more likely to tumble from current levels than it is to continue its rise. In the meantime, most would be wise to remember the adage: bulls make money and bears make money, but hogs get slaughtered. Oh… and bugs can get crushed.




(This is not a solicitation to buy or sell any investment of any kind. Consult with your financial advisor before buying or selling any investment or financial instrument. The purchase of commodities in any form may involve a high degree of risk. Past performance is no indication of future gains.)



Signature Update is offered by Richard Haskell, Managing Director of Signature Wealth Management and CEO of Signature Management, LLC