Thursday, May 5, 2011

Up, up and away in my beautiful balloon, or is it a bubble?

Gold may float like a butterfly, but remember the rest of the line.

The Hedged Economist recently participated in a discussion of gold verses dividend growth stocks entitled simply “Gold vs. Dividend Stocks.” The website,, is actually more like a collection of websites on different financial topics.

Since the discussion mentioned above, a number of people have asked about gold or touted it as an investment. Nothing that has occurred since the previous posting on gold has changed. (Gold: Be sure you know what you’ve hedged,Gold again,
and Worth repeating and, yes, gold again)
The price goes up and down, and gold remains a shiny yellow metal. It still hedges the same risks, has the same risks of ownership, and doesn’t produce a thing.

Some of the exchanges are presented below mainly in order to add perspective to the previous postings on this blog. In general, I find it interesting to talk with people who have actually followed gold and looked at its price over alternative holding periods. It’s a lot easier than talking with someone who only knows that he or she bought gold in at $800 in ‘79 and has a negative return after inflation. The really hopeless ones are people who discovered gold in 2006. Talking to them is like talking to the dot com believers of the late ‘90’s or people who bought stuff they didn’t need because their house had made them rich.

Comment received:

• I've still got the first 1 oz. Kruggerand I ever bought back in the mid-80's. It cost me a bit over $250.
According to the BLS inflation calculator $250 in 1985 would buy $519.14 today. I guess the spot price of $1453 today means I've done reasonably well over 26 years with an equivalent 'yield' of 4% above 'official' inflation compounding annually.
(1453 / 519.14 ) (1/26) = 1.0403 -> 4.03%
Not great, but it beats a poke in the eye. ;-)

The Hedged Economist’s response:

I have a similar story. However, using inflation as the risk and differences in return after inflation as the measure of performance, it appears 7.64% is the real compound average annual growth rate on the S&P when dividends were reinvested if the investment were made January 1, 1985, and 6.96% if made December 31. Those figures are as of end of year 2010. I can't claim I did the calculation. The data are from a website entitled Money Chimp (

The chimp says it uses the Shiller stock performance data and CPI as the inflation factor. I apologize for not knowing which CPI. If I explored the website a little more, I might be able to find it, but the reference was fine for the posting on timing investments that I was writing back in January. (Actually, I was checking my performance against that legendary chimp that often beats the professional investors. Don’t know if this is that particular chimp, but periodically the market makes a monkey out of most of us, so I thought I consult one).

The 4% return is why I refer to gold as a hedge similar to insurance. (See: Gold: Be sure you know what you’ve hedged) A 4% real return on an insurance policy would be nice to have. So, your K-rand makes sense from that perspective. (I didn’t check your math).

The only thing I accomplish by moving between mining stocks, gold miners, gold, etc. is to smooth the ride a bit (gold bounced around a lot). Also, occasionally looking for hedges that serve as alternatives to gold also keeps the amount invested lower than it would be if a gold exposure were the only thing one used. For example, for a while in the late ‘90s TIPS with over 3.5% real rates were available. Holding them gives one both an inflation hedge and interest rate exposure (two things one gets from gold). For me that allows me to keep more in stocks with growing dividends (d-g stocks). I also figure some d-g stocks, like energy producers, provide an inflation hedge.

There are things physical commodities hedge that no financial instrument hedges, namely a financial market freeze. But, then one still has to trade the gold. For many other risks, the choice between a 4% real return on gold or, for example, a +3.5% on a TIPS (when the TIPS offers a cash flow) is not a layup shot. For me, a stock’s return is more appealing for almost all my capital. I take the risk of a financial market freeze to get the greater return, but forgoing the higher return on the K-rand in storage isn’t going to bust most investors.

Another exchange on gold:

Comment received:

I have quadrupled my investments in gold coins and gold stocks in the past 10 years. Also, you can write covered calls on gold mining stocks, such as Goldcorp, to generate a 10 to 20 percent profit annually. So, do not tell me that gold does not produce an income. It certainly does. You just have to be knowledgeable and not prejudiced against gold like most people on this board.

The Hedged Economist’s comment:

Congratulations on Goldcorp (GG): it has been an excellent mining investment. But, also look at Barrick Gold (ABX) or Newmont Mining (NEM). It wasn't gold as much as a very successful miner. Now, in the precious metal space look at Silver Wheaton (SLW). Successful new ventures / stock issues in this space can do phenomenally well. Great pick.

I'm not real good at analyzing new issues of mining companies, so for new ventures and new issues I stick to other industries. In that space (i.e., new ventures) GG's performance would be a success -- but, the type of success one targets because not every new venture works out.

"The gold doesn't produce income" refers to physical gold. That will change if the regulatory proposal to allow gold as collateral on repo's is adopted. Right now I'm not aware of any way to write covered calls on physical gold. I would think it would be allowed on the ETFs. If you’re aware of something else, we're always interested in learning.

Nobody here is prejudiced against making money. We just each share our limited experience.

Another comment received:

With all of the talk above about gold being a hedge against various things (generally apocalyptic stuff), what's the hedge against gold losing its value? It's always been considered valuable, but its price has gone down from time to time (as noted above). What's the defense against that?

Full disclosure: I am by nature not prone to insure against risks other than the most obvious ones. I have car insurance and homeowner's insurance. I have enough life insurance to tide my wife over should I die. I have health insurance. That's it. None of my investments are hedged, unless you count sell-stops under my capital-gains investments as "hedging." I guess I don't find life nearly as much fun to live if I sit around all day thinking of all the things that could go wrong and then figuring out how to insure against every one of those risks. As lots of fear-mongers proclaim (and make a good living at proclaiming), the risks are endless. It seems like such a negative way to live.

I understand that therefore, I am unprotected against certain rare events that others are protected against. I'll take that trade.

The Hedged Economist’s comment:

For me, a hedge usually ends up being a long in something else. I'm always looking for something that zigs when other things zag. For me, the hedge to falling gold prices has been mainly stocks.

You mention "gold being a hedge against various things." I'd word it differently. I'd say "gold is USED as a hedge against various things." But, it isn't the only, or best, hedge for many of them.

If you’ll indulge me, let me give some examples. I’ve used other mineral miners to address some of the risks that gold is often used to hedge (long BHP, FCX). The stock of a senior gold producer whose cost per is below the price of gold will behave differently from a junior miner engaged in exploration or developing a new mine (long NEM). In a comment on another article I mentioned using TIPS (bought when they had attractive real interest rates) as a hedge against inflation. Many people use gold for that purpose.

Like you say, one should allocate resources based on probabilities. That's why I said I don't like the 5% in gold as a hard and fast rule. I can’t see any risk with a stable 5% probability that only gold addresses.

I have a slightly different philosophy. If I see a risk that I can eliminate at a low cost or with a positive return, I get rid of it. Then…“relax and enjoy life.”

EPOGOLG: This posting and the exchanges it reports were written between March 30 and May 1. Given developments this week, one additional comment: as the saying goes, “don’t try to catch a falling knife.”

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