Ignore the "buy gold now" crowd

Pile of Gold Jewelry - coins, chains, necklaces, earrings, rings and other scrap gold. iStockphoto

(MoneyWatch) Last July, Merrill Lynch predicted gold would hit $2,000 an ounce by the end of the year. Money manager Peter Schiff has predicted gold will hit $2,300 by next year and within a few years hit $5,000. These kinds of predictions seem to be driving investor interest in gold.

It's no surprise that so many investors pay attention to such forecasts, despite all the evidence that there are no good forecasters. It's also no surprise that gold seems to defy one of the basic laws of economics as the investment demand for gold has increased along with its price. Prior to 2003, when gold was under $300 an ounce, I don't recall any investors asking if they should include an allocation to gold in their investment plan. Yet today, after a more than five-fold increase, it's one of the most frequent questions I get. In fact, a CNBC survey from last year showed that gold was most often cited by investors as the "best investment," topping even real estate and stocks.

If you're looking for a gold forecast, you won't find one here. I've seen enough of the academic evidence showing that there are no good forecasters, just overconfident ones. However, I will provide you with information so that you can at least make an informed decision about gold. We'll begin by looking at the most commonly cited explanation for investor interest in gold.

Inflation

Probably the most common reason for buying gold is that it's believed to be hedge against inflation. Despite this widely held belief, gold has historically been a poor hedge of rising prices and wages (with the exception of the very long run, such as 100 years or so). For example, on Jan. 21, 1980, the price of gold hit the then-record high of $850. On March 19, 2002, gold was trading at $293, below where it was 20 years earlier. Note that the inflation rate for the period 1980-2001 was 3.9 percent. Thus, the loss in real purchasing power was about 85 percent.

How can gold be an inflation hedge when it loses 85 percent over 22 years in real terms?

The fact is that gold doesn't correlate with inflation. Instead, it tends to correlate with monetary policy. Gold tends to rise when monetary policy is easy, such as during the 1970s and 2003 to present. When monetary policy tightens, as was the case in the 1980s, gold tends to fall.

While we don't know when, it's highly likely that the Federal Reserve will eventually tighten monetary policy, ending and eventually reversing its policy of quantitative easing (bond buying). That would lead to a rise in interest rates and the opportunity cost of owning gold (which is now virtually zero). In other words, it's low real interest rates that support the price of gold.

Supply and demand

In their 2013 outlook, Goldman Sachs (GS) estimated that the marginal cost of production (or the cost of producing one more unit than currently being produced) is around $750 per ounce, or less than half its current price. The laws of economics state that prices tend to move toward the marginal cost of production over the long term. After all, producers will produce more and more if there's profit to be had.

Such a gap between the cost to produce gold and the price is a pretty big incentive to up the production. All else being equal, prices should eventually move toward the marginal cost of production as supply increases. This is especially true for gold, since unlike other commodities, nearly all the gold that has been produced is still in circulation and potentially available for sale.

Currency hedge

Investors often offer two other explanations for their interest in gold. The first is that gold makes for a good hedge against currency fluctuations. Except that a recent study found that the change in the real price of gold seems to be largely independent of the change in currency values. In other words, it's not a good hedge of currency risk.

Bear markets

The same study also looked at whether gold serves as a safe haven during bear markets. The researchers found that gold fell in 17 percent of the months that stocks fell. If gold were a true safe haven, then we would expect very few, if any, such observations.

With these facts in mind, it's hard to see how gold represents the "safe haven" many investors view it as. It's hard to see that an allocation should be made to gold with what we might call "sleep well money." Remember, the price of gold has risen because of concerns over the Fed's loose fiscal and monetary policies and been supported by negative real interest rates. There's certainly the possibility that the inflation many fear won't materialize, the U.S. economy will get back on track, the Fed will end its current policy, and that real interest rates will revert to their mean. And for gold, perhaps that would lead to a repeat of what happened from 1980-2002.

If you're thinking about buying gold because your fears have been stoked by forecasters such as Schiff or because gold has been on a hot "streak," I'd urge you to think again. On the other hand, if gold fits into your long-term plan and you can handle the periods when gold stalls or falls, gold might merit a small allocation. Personally, I prefer that allocation be made to a broader based commodity index such as the DJ-UBS Commodity Index.

  • Larry Swedroe On Twitter»

    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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