Carr's Call: Gold retains its hold status

No doubt you’re up to your eyeballs in articles on gold. However, given the unprecedented price action and given that I was long – and wrong it seems – it’s not an issue I could leave.

In particular, I want to address a great misnomer in the market – and that is that gold is no longer safe. Many now argue that the yellow metal has lost it’s safe-haven status, and so should be excluded from an investor’s portfolio. No return, so what’s the point?

Theories abound as to why gold fell, but I’m not going to address them in detail. That’s simply for the reason that I don’t know myself. I’d only note that most seem to agree that there was really no rhyme or reason for the fall – or at the very least the magnitude and speed of the fall. I mean gold fell 14% in two trading sessions, or $US212, which was the biggest two-day fall since the 1970s.  That by itself points to something odd, as does chart 1.

Click to enlarge

I’ve used this chart before and I’ll no doubt use it again, as it often contains very good information content. From the chart, you can see that investors who play the futures/options market (exchange-traded funds and the like) had been reducing long positions since about October last year. You can also see that the gold price tracked down alongside this in tandem.  So far so good, and there is nothing unusual in this (price action isn’t one way).

Note that when gold fell off a cliff though, it wasn’t led by traders/investors. Net long positions were still quite elevated and around the same, or even higher sometimes, as mid last year. The fall took them by surprise, by and large, and so this fact does point to something other than a change in investor sentiment per se.

But regardless of the reason gold fell, its price fall does highlight the reason why investors should include gold as a part of their portfolio. I realise this sounds bizarre, as most analysts and much of the commentary was all about gold’s death knell. People said, quite intuitively, that gold was no longer a safe haven. This sounds very logical, but it’s very wrong in my opinion.

Think of what the gold price rout reflects (what it’s a part of); sudden and abrupt changes in any given investment asset for no apparent reason. If the price fall was confined to gold, I could see see some merit in the argument against gold. But it wasn’t. All commodities are being hit – silver, copper, crude, softs – and almost without exception, the price action cannot be justified by fundamentals. That is, in most cases there is no supply glut – demand hasn’t shrunk etc. Remember, last year it was iron ore.  At other times equities are hit – price routs, fat finger errors, corrections or what have you. Crude had its slump after the G7 threatened to unleash oil from their reserves if prices didn’t come down.

The simple fact is, we are living in a very volatile world. Quantitative easing (QE) is distorting so many prices, including bonds and currencies. These then have real effects elsewhere – on commodities, equities and other areas – and the impact of QE is exacerbated by the growth of high-frequency trading, algorithms and the derivatives market.

It is this volatility which makes gold even more attractive, notwithstanding the recent rout. Gold only comes into its own during times of crisis or uncertainty. It yields no return for holding it etc, as many people are happy to highlight, and its intrinsic value is the subject of much debate. But, the truth is, gold isn’t in a portfolio to provide investors with an annual return, to be dumped if it doesn’t deliver. That’s for traders. It’s certainly an additional advantage to note annual price gains have been over 30%, on average, for 14 years now. But that isn’t the point of gold, and the primary reason why it is so valuable.

One of the primary reasons people hold gold is as a store of value. A better way to think of gold is as insurance, or an insurance premium. Use it to protect you and your wealth in any adverse scenario, to make sure you have something left in other words. The price could fall another $US300, and that reasoning wouldn’t change.

Unfortunately, we don’t need to make up fanciful fairy tales to envisage some fairly disruptive or even dire scenarios. A terrorist attack in the US, natural disasters, war – to say nothing of the very real threat posed by inflation.  Noting these, one of the unfortunate downsides of economic policy at the moment is that we have nothing left to deal with any further adverse events.  Nothing to calm markets.

More than ever then, and as I discussed in my April 10 note Krone capitalism is a safe bet, investors must diversify abroad and across assets. They must pay special attention to store of wealth considerations, which is especially the case given that government bonds have no value now and are one of the most unsafe investments around. (A price collapse at some point is a 100% certainty, and in most funds you get a unit price – so you are exposed to capital price moves not yield).

To show you how serious this issue is becoming, Swiss citizens have the required 100,000 signatures to call a referendum to ban its central bank from selling gold and force it to hold 20% of its assets in gold (currently 10%).

People want to protect their wealth. Now, I’m not suggesting retail investors hold 20% of their wealth in gold. The usual advice is 5-10%, and that is a good estimate I would think – especially as I’m actually bullish risk assets! On that basis, and if you want to mark-to market, the current gold price rout has only taken about 1% off your portfolio since its peak in 2011. In Australian dollar terms, that’s actually a hit of only 0.1%. This underscores another advantage for Australian investors – in times of trouble the $A tends to get belted, highlighting further the value of holding gold.