0%? Really? Zero?

I recently got into a disagreement with a colleague of mine. He believes that the proper allocation to gold (or other precious metals) is zero, and as you might know, I feel gold and or silver are an essential part of every portfolio. I'm sure this conversation is not unique and I wanted to address the articles and information found on the web that attempts to support the claim that you should not own any precious metals. I will address this piece by David Marotta specifically since it encompassed several points I found in other sources.

The primary focus of this article is that gold does not show nearly the returns that stocks do. You will get no argument from me on that point, I believe diversified high quality equities should be the majority, and the core, of every portfolio, but I am not contending that gold should be the lion’s share of a portfolio. Only that an allocation of zero is way off base, especially when you consider the environment we currently live.

As is often the case when one is making an illogical claim, the gold bashers cherry pick data. There are two amazing example of this in the linked piece. The first is a sited work showing that since 1802 gold has barely outpaced inflation while stocks have provided over a 700,000 multiple return above inflation. The first century of this time frame we experienced deflation, the industrial revolution, low total credit market debt, and gold was money, albeit not the only form. These factors make that century so different to the times we currently live that using that data is questionable at best. Though the pendulum had begun to swing, the major turning point toward our current debt based monetary system was in 1913 with the creation of the Federal Reserve. If we take points since the creation of the Federal Reserve, 100, 60, 40 or even 15 years ago the returns offered by stocks over gold are not nearly as impressive or disappear altogether.

The second, and even more egregious, example of cherry picking is when he chose the peak gold price in 1981 of over 800 dollars as a base line. This also happened to pretty much be the nadir in stocks. This high, and low, were the result of uncertain monetary times brought about by Richard Nixon removing any tie to the gold standard in August 1971. Remember that this trend of falling stock prices and rising gold was only halted by Paul Volker raising rates well into the teens. If not for this shift in interest rate policy the accent of gold may not have stopped. Ask yourself if policies similar to those pursued by Volker would be possible today?

Cherry picked data from any point solely because it supports your argument is disingenuous, and there are other factors besides where the S&P500, Dow, or spot gold price is, such as dividends, and managerial costs that should be considered. We can go on and on about the returns of gold vs stocks, but this misses the point. If we were arguing what the correct portfolio would be if you had to be invested 100% for a long period of time, I would generally prefer stocks to gold, but again, that is not the point gold naysayers are trying to make. They feel that you should not own any gold, silver, platinum or palladium...zero, nada. This is why they conveniently leave out the other two liquid assets, currency and bonds, when making their argument. It should go without saying, but historical growth is not the only consideration when investors decide what to own. Different assets have different strengths. If there is a debate over portfolio allocation and one side conveniently leaves out over two thirds of the investment pie (60%+ for bonds and 5-10% for currency) you should automatically know something is wrong. I will focus on one of these asset classes that was left out of the articles discussion, currency or more specifically the US dollar.

Obviously where gold has kept up and slightly beaten inflation the dollar has lost most of its value. Since it has not kept up with gold, it has offered nowhere near the return offered by stocks. Now consider that there is no financial adviser, economist, or author of an article warning you off gold, that would say you should not hold ANY dollars. Dollars are held for liquidity, not growth. You can’t buy anything, be it stocks, bonds, gold, food, or toilet paper in our economy without dollars. So any adviser, be they a stock bull, silver bug, doomer, or prudent financial fiduciary, would tell their client not to hold ANY dollars. Dollars serve a very specific purpose and an allocation to cash, in some amount, is almost always prudent. In times when an adviser thinks other assets are overpriced, or in a bubble that is about to pop, they may recommend increasing your dollar holdings to take advantage of future prices no matter what the dollars long term prospects are. As with dollars, gold plays a very specific role in a portfolio.

Now to explore the author’s data from another vantage point; we do not live in an economy that always moves based on historical averages, nor do we live in a time that looks exactly like any other. That said we can look toward history to try and find similar conditions and what happened following those times. While we're at it, why don't we compare the cherry picked data of our author to determine if it looks like the conditions we are currently experiencing.

I used three data points, the Case Shiller PE Ratio to indicate the value of stocks, the US 10 year bond price, and the Dow to gold ratio. I thought they were the most relevant but if you have any doubts please check other data sets.

Now the only thing that sticks out to me about the point the author chose is the conditions were about as far as current conditions as you could find…ever. I highlighted the points that appeared to be most similar to our current condition in green, 1929, 1966, and 2000.

Here is how stock and gold returns compared for 5 and 10 year periods following those points.

I don't want to be accused of cherry-picking data like Mr. Marotta so please take a look at the above chart, determine what time in history you feel most resembles where we are now and compare returns of gold vs stocks in the links below.

Because of all of the above points Mr. Marotta probably knew his argument held no weight based on returns alone. Considering the dollars negative growth potential as well as various bonds at historically low and even negative yields, both of which he would not advise against owning, he had to put an additional condition to convince his readers that gold should not be held. He picked gold’s volatility.

In his words:

“The optimum allocation to gold is always zero because its return is too low to be a real investment and its volatility is too high to justify its low return.”

He did not use any data or charts to support this claim because, well, it can’t be supported. Have you noticed bond markets lately, how about currency, stock markets? Are they not volatile?

Compare how much oil, corn, real estate, or clothing an ounce of gold can purchase over time. Now do the same with the dollar and other assets. Is gold the volatile one? Sure there are fluctuations but when it comes to purchasing power I would say gold is one of the least volatile assets. Frankly, he pulled the criteria out of you know where, and touted them as the only criteria that matters for a portfolio. I could do the same with criteria like, never invest in an insolvent entity (sovereign bonds are out), limit counter-party risk in periods of high debt, don’t invest in IPO’s that show no profits, reduce exposure to stocks with the PE ratio over X, or if you don’t hold it you don’t own it, and come to a very different conclusion than a 0% gold allocation.

He also uses the phrase optimum allocation when referring to not owning gold, which once again I would agree with, because in an optimum world we would not have to worry about the lunacy of central banks and governments. Unfortunately we do not live in that world. Those who believe that you should not own ANY precious metals seem to misunderstand the world in which we live. In an optimum world gold would only have to protect bathroom fixtures and watches.

The author does cover his butt a little in case a homicidal maniac decides not to purchase gold based on this piece and ends up viewing it as a horrible decision. They close with “If you choose to purchase gold, limiting it to less than 3% of your portfolio will protect you from compromising financial goals that depend on appreciation above inflation.” While in many time frames this may be sufficient it probably isn’t now, but it is also clear they are not suggesting that if you don't own any you should boost your allocation to 3%. This little CYA (cover your ass) that they pull at the end doesn’t change what they are really suggesting, that you should not own precious metals period.

The piece also falls back on the old Warren Buffett comment on gold that gold bashers ate up, “gold is not an investment”. Like other points they make there is some truthiness to this statement, gold should be viewed more as insurance or a store of value, but this still doesn't support their claim. Currency could also be considered a non-investment. Separating gold, silver and currency from your investment portfolio does not warrant not owning any. If there were ever an example of the superfluous nature of semantics, whether to classify gold as an investment is it.

Now for some speculation on the real reason Mr. Marotta and others write such nonsense that doesn’t hold up to even a little bit of scrutiny. Their goal is not to objectively offer the facts to let the reader, who may or may not hold precious metals, determine what a logical portfolio may be. It is to convince those who don’t own precious metals, themselves included, that their choice not to own any is the right one. These articles are not objective educational pieces, or even editorials, they are coping propaganda to provide comfort to those who WANT to believe the authors conclusion.

No comments:

Post a Comment