Gold's Renaissance

It’s funny, but the late-night commercials that used to push food dehydrators and Ginsu knife sets are now touting gold as an investment vehicle. And while some may pass it off as a short-lived investing fad that will end badly, there’s no doubting the growing importance of gold as an asset class.

Since 2001, the price of gold has quadrupled.

Contributing factors to gold’s strength include a weak U.S. dollar, falling consumer confidence and sputtering global stock markets. In other words, the conditions for more gains in gold seem ripe.

No wonder this has brought renewed interest from investors and advisors about investing in gold.

The World Gold Council was formed in 1987 by the world’s leading gold mining companies with the aim of stimulating the demand for gold.

George Milling-Stanley is based in the council’s New York office. In 2002 he became a member of the team that developed Street Tracks Gold Shares (GLD), the gold exchange-traded fund (ETF) that was launched on the New York Stock Exchange in November 2004.

Before joining the council in 1996, Mr. Milling-Stanley worked for six years on the precious-metals trading desk of Lehman Brothers, the New York-based investment bank. His responsibilities included the development of customer business and the firm’s research and analysis of the metals markets.

He visited with Research to discuss the reemergence of investing in gold.

Research: Why is gold an important asset class?There are five main reasons why gold is an important asset class:

First, returns on gold are not correlated with returns on other investment assets, so gold provides very effective diversification as a component of a balanced portfolio. This is particularly true at times when equities are seriously under-performing — and that is important because it is during such periods that many markets tend to go into freefall at the same time. In general, markets under stress tend to behave more like each other, to become increasingly synchronous. Gold does not follow that pattern.

Second, another important characteristic of gold is its relatively low volatility. This is an aspect of gold that surprises a lot of people, who think of gold as a risky asset. In fact, over the long run the gold price is actually less volatile than the S&P 500, for example. Now, a blue chip stock market index is generally less volatile than the equity shares that comprise it, so that really is saying something significant about gold. There is another feature, and this is something that gold has in common with other commodities. The gold price tends to become more volatile when it is rising, whereas with equities the reverse is more often true. Price volatility for gold and commodities in general contains a different message from high volatility in the equity markets, where it typically signals a decline.

Third, gold is an effective hedge against a decline in the dollar. When the dollar falls in value, typically the gold price rises. The response is not always immediate, but history teaches us that this is what happens every time, even if on occasion we have to wait a little. In fact, this “inverse correlation,” as economists call it, predates the existence of the U.S. dollar. Over history, the gold price has always been inversely correlated with whatever the leading currency of the world happened to be. For several hundred years, that currency was the pound sterling. In more recent times, the U.S. dollar has been the world’s top currency. In future, it might be something different — perhaps the Chinese renminbi, the Indian rupee or something no one has even thought of yet. But whatever the next leading currency in the world is, I know one thing for sure — the gold price will be inversely correlated with it.

Fourth, gold has also proved itself to be an effective hedge against inflation over the long run. The world finally gave up on using gold as the benchmark against which all national currencies were measured in 1968, and the price of gold was allowed to float freely and find its own level in the world markets. Since that time, gold has maintained its purchasing power. In fact, gold has an even longer track record in this respect. A recent study that is available on the World Gold Council website at www.gold.org looked at the relationship between gold and inflation right back to the 18th century. The study found that over that period, a 1 percent increase in the general U.S. price level led to a 1 percent increase in the price of gold.

Lastly, gold also has a very long track record as an effective safe haven in times of geopolitical or economic disruption. Last year’s rise in the gold price was strongly influenced by the behavior of investors. They bought gold as a means of protecting their portfolios from the sharp fall in equity markets that occurred as the credit crisis unfolded.

During the first big downturn in equity markets between mid-July and mid-August, gold did not do especially well in absolute terms; it was more or less flat. However, it did well in relative terms if you consider that equities fell by 9 percent over the same period. During the next downward leg in October and November, gold outperformed in both relative and absolute terms, rising by 12 percent as equities fell by 10 percent.

Gold recently broke all-time highs, the $1,000 per ounce mark. Is it overvalued?My five key price drivers over the past six years are as follows:(1) Healthy internal market dynamics, with stable supply and rising demand. (2) A long-term secular decline in the value of the American dollar. (3) Growing fears over a possible future rise in inflation. (4) The equity markets have spent the past six or seven years recovering to where they were in 2000. They achieved those levels last year, and then the subprime lending crisis knocked the steam out of the recovery. (5) And finally, I don’t think anyone could argue with the fact that geopolitical tensions are worse now than they were in the early months of 2001.

The internal dynamics of the gold market look increasingly promising, with little chance of any increase in gold mine production, and continued rising demand even in the face of higher prices.