A Golden Bubble?

Warren Buffett has stated: "Gold gets dug out of the ground in Africa, or someplace.  Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it.  It has no utility.  Anyone watching from Mars would be scratching their head."

Taking a cynical view of gold is challenging in a climate where gold -- now at over $1,000 per ounce -- has appreciated more than 300% since 1999 and 41% since just this past fall. 

The classic case for gold as an investment, according to an article in Barron's, is that "it is considered a hedge against inflation, and a safe haven in times of turmoil."  Is this accurate?

The price of gold reached $850 per ounce in 1980 only to fall to under $300 in 2001.  This 65% decline occurred although inflation persisted during that time period.  According to John Bridges, an analyst at JP Morgan, gold has not kept pace with inflation even at its current $1,000 per ounce level.  If gold had appreciated at the rate of inflation since 1980, then it should be worth between $1,500 and $2,500 at present. Thus, the price today looks high on a nominal basis, but not in inflation-adjusted dollars.

Academics differ on the value of investing in gold.  Some argue that in the long run, gold may not act as much of an inflation hedge or, given its extreme volatility, provide excess return.  Others, like Geoff Considine, argue that a long-term strategic allocation to gold has a positive benefit to a portfolio since its returns have a low correlation to other asset classes. 

Considine admits, however, that "there must be some rational way to value gold -- it cannot be a great investment at any price."  He then concludes that gold is selling at a premium. "The disproportionate run-up in gold may ... reflect some behavioral bias towards gold as a 'safe' store of value, but it mostly owes to simple performance-chasing."

The value of gold seems not so much dependent on actual inflation as the fear of inflation or other global turmoil.  Its price has exhibited extended periods of highs and lows as this fear ebbs and flows.  Significant money can be made in gold if you time it right, but large losses can occur if you get it wrong.

All of this is not to say that the price of gold will not continue to rise.  Nor does it mean that intelligent money managers who invest in gold are mistaken.  In the end, however, one can sympathize with the sentiments of the investor Vitaliy Katsenelson: It is very difficult for investors -- as compared to speculators -- to own gold because it is hard to put a logical value on it.  Gold is only worth what people perceive it to be worth at any particular moment.

Words of Wisdom

Never invest in anything that eats or needs repairing.

-- Billy Rose