Why Buy Gold?

We are in the middle phase of a long-term cycle where financial assets are falling and real assets are rising. To put this into context it is best to look at a previous example. In the late 1970s and early 1980s, inflation soared and interest rates were in their high ‘teens. The price of real assets peaked and financial assets bottomed-out. At the time America appeared to be a write-off and the Dow Jones traded on single digit Price Earnings multiples. Everyone loved gold but hated stocks. This was of course the time when equities and bonds began their greatest ever bull run. By the New Millennium we were indulging in a ‘new paradigm’ where share prices never fell and gold was rejected as a relic of our supposedly ignorant ancestors. It proved to be the turning point for both sets of assets.

These cycles have of course been encountered previously. Jim Rogers, author and co-founder of the Quantum fund with George Soros has identified five cycles where commodities boomed and financial markets slumped and these phases have averaged 17 years over the course of two centuries. In modernity, even if we ignored the unprecedented money printing and assume that this was just a normal cycle, it would mean that we have a further 7 years of commodity price appreciation to come. To be conservative in our time frame we have started the cycle with the post-Russian crisis oil price slump in 1999 as opposed to the final lows seen in the likes of gold two years later.

Having endured two decades in the doldrums it is no surprise that gold is not widely owned, in spite of a substantial rally in recent years. While equities actually fell in the last decade, the gold price rose by some 280%. Some investors have an indirect exposure to precious metals through mining shares or funds the majority do not hold bullion in any form. It is worth remembering that gold mining stocks have a geared effect of roughly 1.7 times compared with the underlying bullion price which can of course work for or against the investor in a magnified manner. Wealthy investors typically buy precious metals through their private bank, which can be artificially transacted through a metal account, structured products, certificates, forwards, futures or option contracts. It is uncommon for them to hold bullion in the bank’s vault and even then the percentage exposure is often small. The most compelling aspect of the gold story is the low degree of public ownership. Its price appreciation has spurred the selling of scrap gold and inhibited the purchase of jewellery which is seen as a luxury item. However, this has been offset by investment demand which was manifested in the scramble to buy coins and bars during the recent financial crash. There has also been a feverish accumulation of paper-based gold investments by investors.

While most funds and certificates mimic precious metal prices through derivatives some have a genuine element of bullion backing. Nevertheless there are concerns as to whether the bullion you own on paper is backed by real metal in a vault assigned to an equivalent value of the fund. Many Exchange Traded Funds (ETFs) are highly reputable and convenient but investors should be aware that some have the facility to lend out gold to earn a hidden fee which adds another layer of counterparty risk. There is a great deal of difference between gold being available when called upon and bars being specifically set aside for an individual or fund. This is why storage costs appear so cheap for some providers as the full complement of bullion is not necessarily in custody at all times. The acid test would be for all investors to demand all their investment in bullion form on the same day which is of course an extremely unlikely event. The unlikelihood of such an event has been similarly exploited in the past by medieval goldsmiths who issued notes in excess of the value of gold in their possession. This was the origin of our modern fractional banking system at the heart of the credit crisis and even the long-term devaluation of the dollar itself.

In the aftermath of the crisis, investors are rightly fearful of the safety of large, indebted institutions and question the validity of every investment they buy. The ability to have real, physical gold stored securely in an insured vault in a neutral, safe and highly regulated jurisdiction is a great comfort for investors. The fact that it is available for collection or inspection adds immeasurably to the credibility of Guernsey Gold in these days of opacity and corporate trickery.