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Economic View: Budging (Just a Little) on Investing in Gold

July 27, 2013 by Leave a Comment

A friend posed that question to me a few weeks ago, after watching gold’s wild ride over the last few years. The price of gold was less than $500 an ounce in 2005, but soared to more than $1,800 in 2011, before falling back to about $1,300 recently. He wasn’t sure what to make of it all.

My instinct was to say no. Like most economists I know, I am a pretty boring investor. I hold 60 percent stocks, 40 percent bonds, mostly in low-cost index funds. Whenever I see those TV commercials with some actor hawking gold coins, I roll my eyes. Hoarding gold seems akin to stocking up on canned beans and ammo as you wait for the apocalypse in your fallout shelter.

But I was also wary of imposing my gut instinct on my friend, who was looking for a more reasoned judgment. I knew that some investors saw gold as a key part of a portfolio. The author Harry Browne, the onetime Libertarian presidential candidate, recommended a permanent 25 percent allocation to gold. In 2012, the Federal Reserve reported that Richard Fisher, president of the Federal Reserve Bank of Dallas, had more than $1 million of gold in his personal portfolio.

So, before answering my friend’s question, I dived into the small academic literature on gold as a portfolio investment. Here is what I learned:

THERE ISN’T A LOT OF IT The World Gold Council estimates that all the gold ever mined amounts to 174,100 metric tons. If this supply were divided equally among the world’s population, it would work out to less than one ounce a person.

Warren E. Buffett has a good way to illustrate how little gold there is. He has calculated that if all the gold in the world were made into a cube, its edge would be only 69 feet long. So the cube would fit comfortably within a baseball infield.

Despite its small size, that cube would have substantial value. In a recent paper released by the National Bureau of Economic Research, Claude B. Erb and Campbell R. Harvey estimated that the value of gold makes up about 9 percent of the world’s market capitalization of stocks, bonds and gold. Much of the world’s gold, however, is out of the hands of private investors. About half of it is in the form of jewelry, and an additional 20 percent is held by central banks. This means that if you were to hold the available market portfolio, your asset allocation to gold would be about 2 percent.

ITS REAL RETURN IS SMALL Over the long run, gold’s price has outpaced overall prices as measured by the Consumer Price Index — but not by much. In another recent N.B.E.R. paper, the economists Robert J. Barro and Sanjay P. Misra reported that from 1836 to 2011, gold earned an average annual inflation-adjusted return of 1.1 percent. By contrast, they estimated long-term returns to be 1.0 percent for Treasury bills, 2.9 percent for long-term bonds and 7.4 percent for stocks.

Mr. Erb and Mr. Harvey presented a novel way of gauging gold’s return in the very long run: they compared what the Roman emperor Augustus paid his soldiers, measured in units of gold, to what we pay the military today.

They report remarkably little change over 2,000 years. The annual cost of one Roman legionary plus one Roman centurion was 40.9 ounces of gold. The annual cost of one United States Army private plus one Army captain has recently been 38.9 ounces of gold.

To be sure, military pay is a narrow measure, but this comparison offers some support for the view that, on average, gold should keep pace with wage inflation, which, thanks to productivity growth, runs slightly ahead of price inflation.

ITS PRICE IS HIGHLY VOLATILE Gold may offer an average return near that of Treasury bills, but its volatility is closer to that of the stock market.

That has been especially true since President Richard M. Nixon removed the last vestiges of the gold standard. Mr. Barro and Mr. Misra report that since 1975, the volatility of gold’s return, as measured by standard deviation, has been about 50 percent greater than the volatility of stocks.

Because gold is a small asset class with meager returns and high volatility, an investor may be tempted to avoid it altogether. But not so fast. One last fact may turn the tables.

IT MARCHES TO A DIFFERENT BEAT An important element of an investment portfolio is diversification, and here is where gold really shines — pun intended — because its price is largely uncorrelated with stocks and bonds. Despite gold’s volatility, adding a little to a standard portfolio can reduce its overall risk.

How far should an investor go? It’s hard to say, because optimal portfolios are so sensitive to expected returns on alternative assets, and expected returns are hard to measure precisely, even with a century or two of data. It is therefore not surprising that financial analysts reach widely varying conclusions.

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In the end, I abandoned my initial aversion to holding gold. A small sliver, such as the 2 percent weight in the world market portfolio, now makes sense to me as part of a long-term investment strategy. And with several gold bullion exchange-traded funds now available, investing in gold is easy and can be done at low cost.

I will continue, however, to pass on the canned beans and ammo.

N. Gregory Mankiw is a professor of economics at Harvard.

Article source: http://www.nytimes.com/2013/07/28/business/budging-just-a-little-on-investing-in-gold.html?partner=rss&emc=rss

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Today’s Economist: Bruce Bartlett: Gold’s Declining Price Is a Reversion to the Mean

April 23, 2013 by Leave a Comment

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Bruce Bartlett held senior policy roles in the Reagan and George H.W. Bush administrations and served on the staffs of Representatives Jack Kemp and Ron Paul. He is the author of “The Benefit and the Burden: Tax Reform – Why We Need It and What It Will Take.”

Since the beginning of the economic crisis in 2008, conservatives have been predicting that inflation is right around the corner. They base this prediction on the vast increase in the money supply that the Federal Reserve brought about in order to keep the financial system from imploding. Because a too-rapid rise in the money supply did indeed bring about inflation in the 1970s, conservatives believe that a repetition of that experience is inevitable.

Today’s Economist

Perspectives from expert contributors.

Many conservatives jumped heavily into the gold market in 2009 based on their expectation of inflation or even hyperinflation. They believe that gold is the best possible hedge against inflation because it is something real, whereas “fiat money” is essentially worthless.

Initially, gold investors were rewarded. The price of gold roughly doubled between 2009 and 2011, from about $900 an ounce to about $1,800 an ounce. Since then, however, the gold price has fallen fairly steadily, reaching about $1,600 an ounce before a sharp break in the last two weeks that brought the price down to about $1,400 an ounce. (Kitco, a precious metals dealer, is a good source of recent gold price data.)

The rise in gold also led some conservatives to renew their advocacy of the gold standard. They believe that all our economic problems are fundamentally caused by the unstable value of money, which results from Federal Reserve manipulation. The Lehrman Institute, a well-financed conservative organization, has been actively promoting a return to the gold standard.

The core argument for the gold standard is that the real price of gold doesn’t vary over time. All nominal price changes result solely from changes in inflationary expectations, gold standard advocates believe. They point to research by the economists Roy W. Jastram and Stephen Harmston to the effect that over very long time periods the real, inflation-adjusted gold price is roughly constant.

What gold standard advocates tend to forget, however, is that the “very long time periods” part of the analysis means over centuries. The short-run price of gold basically indicates nothing insofar as monetary policy is concerned. As a thinly traded market, gold is often subject to manipulation and prone to bubbles and crashes.

Warren Buffett warned about a gold bubble in a 2011 letter to investors in his company, Berkshire Hathaway, in which he said:

Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.

What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As “bandwagon” investors join any party, they create their own truth – for a while.

Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices. In these bubbles, an army of originally skeptical investors succumbed to the “proof” delivered by the market, and the pool of buyers – for a time – expanded sufficiently to keep the bandwagon rolling. But bubbles blown large enough inevitably pop. And then the old proverb is confirmed once again: “What the wise man does in the beginning, the fool does in the end.”

In the long run, the price of all assets revert to their fundamentals. For the last four years, gold speculators have implicitly believed that the rise in gold represented an adjustment to the fundamental fact of underlying inflation resulting from expansion of the money supply. But in that time, the actual rate of inflation has not confirmed gold’s signal. According to the Bureau of Labor Statistics, the Consumer Price Index rose 2.7 percent in 2009, 1.5 percent in 2010, 3 percent in 2011 and 1.7 percent in 2012.

Inflation so far in 2013 has been so modest that some analysts are anticipating deflation – a falling price level, the opposite of inflation. The Wall Street Journal reports that prices for gourmet cupcakes are crashing. Even a longtime “inflation hawk,” James Bullard, president of the Federal Reserve Bank of St. Louis, is now warning that downward price pressure is becoming a problem that may require the Fed to further ease monetary policy.

In an recent paper, the economists Claude B. Erb and Campbell R. Harvey present strong evidence that the gold market was severely overbought. The increase in gold prices did not represent a change in the trend of inflation. As the chart indicates, even with the sell-off, the price of gold is still high and has a long ways to fall to get back to the “golden constant” that gold-standard advocates cite as proof that the dollar should be pegged to gold.

Claude B. Erb and Campbell R. Harvey

Most gold bugs consider themselves to be libertarians and support the gold standard and gold as an investment because of their deep distrust of government. But the greatest libertarian of the 20th century, the economist Milton Friedman, always thought that the gold standard was nuts. His argument was put forward most thoroughly in a 1961 academic journal article, “Real and Pseudo Gold Standards.”

I was going to close this post by making fun of a just-published book, “$10,000 Gold: Why Gold’s Inevitable Rise Is the Investor’s Safe Haven” and suggest putting it on the same shelf with “Dow 36,000,” published in 1999, or “Are You Missing the Real Estate Boom? The Boom Will Not Bust and Why Property Values Will Continue to Climb Through the End of the Decade — And How to Profit From Them,” published in 2005. But then I noticed that the publisher of the gold $10,000 book also published “Gold Bubble: Profiting from Gold’s Impending Collapse” in April 2012, so I will let it pass.

Article source: http://economix.blogs.nytimes.com/2013/04/23/golds-declining-price-is-a-reversion-to-the-mean/?partner=rss&emc=rss

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Strategies: In a Gold Lovefest, Shades of 1980

July 23, 2011 by Leave a Comment

Worried about Greece, the future of the euro, the debt ceiling in the United States, or maybe even about the entire global economy? Buy gold bullion.

Plenty of investors, at least, have been thinking that way, driving the price of gold to nominal, if not inflation-adjusted, highs.

Last week, as separate teams of high-level negotiators sought solutions to the Greek debt crisis and to the debt-ceiling morass in Washington, gold crossed $1,600 an ounce for the first time ever.

While the price fell on signs of progress on these nettlesome issues, gold ended the week at $1,602.60. (That’s well below its 1980 inflation-adjusted peak of $2,516, said Edward Yardeni, an independent economist.) Gold hasn’t been flying this high since the halcyon days of supply-side economics early in the Reagan administration.

Ben S. Bernanke, the chairman of the Federal Reserve, is hardly a gold bug, but he has taken notice. In response to brisk questioning by Representative Ron Paul — the Texas Republican who is running for president for the third time, and has advocated a return to the gold standard — Mr. Bernanke acknowledged that he is paying attention to gold prices.

“I think the reason people hold gold is as protection against what we call ‘tail risk’ — really, really bad outcomes,” Mr. Bernanke said at a Congressional hearing this month. “To the extent that the last few years have made people more worried about the potential of a major crisis, then they have gold as a protection.”

In a recent column, I noted that some experts don’t consider gold an appropriate asset in a typical diversified investment portfolio, partly because it generates no earnings, yet holding it entails cost. Gold is, however, certainly a financial asset, held by many central banks and prized by many private investors around the world.

Jeffrey Sica, for example, president of SICA Wealth Management in Morristown, N.J., is bullish about gold and other commodities — and bearish about nearly every other asset class.

“Right now, I think gold looks better than ever,” he said. His reasoning mirrors Mr. Bernanke’s, at least in this way: Mr. Sica say that he sees a painfully high probability of unfortunate events occurring in the months ahead, and that he believes gold will provide some shelter.

He departs sharply from the central banker’s views, though, in saying that the Fed’s expansionary policy known as quantitative easing “just hasn’t worked.” Furthermore, he expects the economy to weaken further, and the European sovereign debt crisis “to be with us for some time, regardless of whatever is arranged short term, and it will end up hurting many banks.”

While there may be what he calls a “relief rally” if the immediate crises seem to be resolved, he says that there has been a “general loss of confidence in the ability of central banks and governments to manage the economy.”

“That will continue to give gold and other precious metals a boost,” he adds.

Even at central banks, gold’s standing has risen in some respects lately. In June, UBS held a gathering of managers of central bank reserves, multilateral institutions and sovereign wealth funds, and found that a plurality believed gold would be the best-performing asset class through the end of 2011.

WHAT’S more, said Larry Hatheway, chief economist for UBS Investment Bank, a majority said they expected that the dollar would no longer be the most important reserve currency in the world in 25 years. Instead, they expected that “a portfolio of currencies” would replace it. Less than 10 percent envisioned gold ascending to that role.

Still, the World Gold Council, which tracks gold stocks, says the world’s central banks already hold roughly 29,000 tons of gold. Only about 166,000 tons have been mined throughout world history, the council says, so the central banks hold a significant portion of it.

Why? Most of it is a legacy of the time when major currencies were pegged to gold — in the days before Aug. 15, 1971, when President Richard M. Nixon took the United States off the gold standard. With more than 8,000 tons, the United States has more official gold stocks than any other country, the council says.

The United States ought to use that hoard to return the dollar to a gold standard, says Jeffrey Bell, who is trying to make this an issue in the 2012 presidential campaign. Mr. Bell has advocated the gold standard for years — and did so as the Republican senatorial candidate in New Jersey in 1978.

He was defeated by Bill Bradley, sometimes known as Dollar Bill because of his solid performance as a basketball player for the New York Knicks.

Mr. Bell recalls ruefully: “I used to hold up a dollar bill at campaign rallies and say, there’s nothing behind this now, we have to put something solid behind it. History shows that I lost.”

Lewis E. Lehrman, a friend and ally of Mr. Bell’s, says a gold standard would require the government to balance its budget and its current account. He says that, among other things, it would have made it impossible to accumulate the enormous private-sector debt load that led to the financial crisis of 2007.

Mr. Lehrman, once the president of the Rite Aid Corporation and now a philanthropist and historian, ran for governor of New York in 1982 but was defeated in the general election by Mario Cuomo. In a telephone interview last week, Mr. Lehrman said, “The debts in the American banking system that were amassed simply would not have been feasible if you had direct convertibility of currency into gold.”

He acknowledges that returning to a gold standard won’t happen overnight. But, he says, it will happen, “because the failure of all of the other approaches will become evident to the American people.”

The last apex of the back-to-gold movement was perhaps in 1980. It may have been a signal that the price of gold was about to peak. Could we be approaching a turning point now? “You could make that argument,” Mr. Bell says. “The big question is whether the government and the Federal Reserve will be able to get the economy under control without a return to gold.”

Article source: http://feeds.nytimes.com/click.phdo?i=0e51133e4469d7cb584be8488ce091e6

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