Seven Reasons To Hate Gold As An Investment

Over the past few years, pretty much every investor has become familiar with gold. The shiny precious metal has surged in price and has managed to hold strong while broad indexes have slipped, highlighting its appeal as a diversification agent and safe haven investment. This has prompted many investors to ramp up their allocations to the space in order to take advantage of these favorable trends and lead their portfolios to broad gains. After all, gold-backed ETFs such as IAU have seen tremendous gains over the past few years including double digit returns in the year-to-date period and more than a 165% surge in the past five year period, figures that far outpace similar investments in the S&P 500 over the same time frame [see also Three Reasons Why Gold Is Overvalued].

Despite the many positives for gold, the metal has run into some significant headwinds as of late. The price of gold has slumped by about $300 from its recent highs and was trending around the $1,600/oz. level thanks to broad concerns over the global economy and a push back into dollars (though a rally in recent sessions has pushed the metal above $1,700). Since gold around the world is priced in U.S. dollars, an uptick in the value of the greenback tends to limit the demand for precious metals, making them less attractive in comparison, especially by those who view gold as an alternative currency [see Eight Legendary Gold Investors]. Thanks to this slumping price and the apparent topping out of gold in the short term, many are starting to reconsider the wisdom of investing in this precious metal. Fears over a bubble bursting in gold are starting to grow and a lack of demand from emerging markets, coupled with a stronger dollar, could force gold prices sharply lower to close out the year.

Yet, beyond these price concerns, there are a number of other issues that investors need to be aware of when considering allocating capital to the space, as there are several reasons to avoid the precious metal from an investment perspective. Below, we highlight seven reasons for why investors may want to temper their expectations for the metal and consider a more diversified approach that doesn’t include such a large allocation to the ‘barbaric relic’:

The biggest knock against the yellow metal is its relative lack of uses in the industrial world. Close to two thirds of the current supply is used up in jewelry while investment accounts for another 20%. The remaining uses of gold go to dentistry, electronics, and a smattering of other applications that make up less than 5% of total demand. This is in sharp contrast to pretty much every other product in the commodity world. While copper and soft commodities are almost exclusively used for industrial purposes, the rest of the precious metal group sees a great deal of their production scooped up by industrial uses as well. Silver, platinum, and palladium, all find their way into several key applications including catalytic converters and electronics, not to mention more ‘new age’ technologies such as alternative energy. Although this may not necessarily be a bad thing given that it ensures that gold is entirely tied to ‘fear’ and dollar confidence, it does suggest that when industrial demand is surging, gold could be left out in favor of its more ‘useful’ cousins [read Gold ETFs Shine, Silver ETFs Shine Brighter].

While bid/ask spreads are generally pretty tight for gold futures, stocks, and ETFs, investors are likely to encounter a different trend in the physical gold space. Premiums on one ounce gold coins can be as much as $90 over spot price, a level that, at current prices, represents a nearly five percent cost to investors. While premiums go down when investors buy larger quantities, they are still a significant cost, with 10 oz. bars currently possessing a roughly 2.7% premium per ounce. One has to expect a similar, if not greater, situation to arise when selling a bar of gold suggesting that one has to obtain a nearly 10% gain just to break-even on a gold investment. Add in extra costs to ship the products, develop secure storage locations or to get a safe deposit box at a bank, and investors who seek to purchase gold and sell it within a short period of time seem almost destined to lose money.

Inflation, as represented by CPI, has been extraordinarily low for quite some time now in this country. In fact, inflation has only topped 5% once in the past 25 years while double digit inflation has not been in the marketplace since 1980. Furthermore, rates on bonds are also plumbing fresh lows on a seemingly monthly basis, suggesting to many that inflationary risks are still pretty slim, at least for the time being. This trend is further confirmed by a number of aspects in the American economy which appear to be deflating rather than inflating. For example, home prices are still flat and are no longer in ‘bubble territory’; instead it is quite the opposite as many analysts are calling for further losses in the housing sector.

A similar situation is happening in the consumer credit arena as well, as many citizens look to deleverage their balance sheets and clamp down on spending. As a result, many economists are worried about deflation and not inflation, much like Japan after its credit bubble popped in the late 80′s. Granted, this low inflation rate might change in the near future given the rapid increases in money supply and the possible loss of faith in the dollar, but at least for the time being, a slow steady rate of price increases looks to be here to stay, limiting gold’s appeal in this environment [see Detailing Gold's Wild Q3].

One of the top reasons for gold bugs’ love of the metal is that the product isn’t subject to the whims of central banks around the world. Gold cannot be printed while dollars can be in an apparently unlimited supply driving down the value of dollars relative to gold. This is a great point for the most part as the Federal Reserve has done a terrible job of managing the money supply and the value of the dollar over its history, leading further credence to this idea. However, the main problem is that gold often ends up being tied to fiat decisions no matter what. For much of American history, the price of gold has enjoyed a fixed relationship to dollars. This rate was set by the government and has been adjusted several times in order to respond to market forces and crises such as the Civil War in which the dollar could not– at least for a short time– be converted into gold. Fast forward to the Depression and a similar situation arose when FDR confiscated all of the gold in the country and immediately devalued it by close to 60%.

The point is, even at times when gold was the money of the land, governments had a substantial influence over its price either revaluing it outright or decreasing the metalic content of coins by fiat. Furthermore, gold only really has value because people believe it does. How this is any different than fiat currencies seems questionable at best and remains a very real problem for those who are advocating its return as a monetary instrument. While gold would arguably be a better monetary base given the current situation and the never-ending dollar printing, to think that it will not be influenced by fiat decisions seems pretty unlikely to say the least [see Three Ways To Play $2,000 Gold].

Over the past few years, gold has been an all-star of the investing world, putting up gains that few investments could match. For example, over the past decade, gold has risen from about $250/oz. to its current level above $1,600/oz. an impressive gain at a time when broad markets were flat. While this is a pretty good track record, over longer time periods the metal hasn’t done so well, failing to produce similar returns for investors. In fact, during the decade from 1991-2001, gold prices were pretty much flat while the S&P 500 nearly quadrupled. Furthermore, for any investors unfortunate enough to buy into gold at the end of 1979, right before the metal’s all time peak, another flat performance was pretty much guaranteed over the 80′s, if not significant losses. Meanwhile, the S&P 500 nearly tripled in the same time frame, once again crushing gold’s performance. While some might argue that these are ‘cherry picked’ results– and to an extent they are– it is difficult to find a decade that gold outperformed the S&P 500 besides the most recent one, suggesting that unless recent trends continue, investors with huge positions in gold may be very disappointed [read Three Reasons Why Gold Is Overvalued].

Gold, like many commodities, is notoriously difficult to value. The product has no cash flows, dividends, or earnings, so values must be calculated based off of market sentiment and supply/demand imbalances and nothing more. While this may be fine in markets such as cocoa or wheat, gold, thanks to its historic role as money and its lack of industrial uses, can have sort of an odd relationship with markets due to this reality. Gold will often trade off of fear levels which is obviously hard to judge and can swing wildly in a short matter of time. Thanks to this, gold’s price is pretty much determined by investor sentiment, making valuation models useless for this asset class. “Gold is going up because people are buying it, and people are buying it because it’s going up,” said Leonard Kaplan, president of Prospector Asset Management in Evanston, Ill., and a longtime gold trader, highlighting just how tough it can be to figure out why gold goes up or down in a given trading period [read Are Gold Miners A Buy?].

One geopolitical situation that looks to be impacting gold over the next few months is certainly the crisis in Europe. The continent has failed to get its debt situation under control and an expanded European Financial Stability Facility seems to be a necessity in order to boost confidence in the struggling bloc. Even then, an expanded program could sink the French economy and push investors to consider the trillion dollar market as only slightly better than the PIIGS nations. If this happens, it could still make investors reconsider a huge allocation to euros and bring up a fresh crop of issues in its stead. After all, what is bad for Europe has proven to be great news for the dollar over the past few months as the greenback has gained against its main currency counterpart in the past few weeks.

Given this, many should not be surprised to note that gold has had a very rough stretch as the metal tends to move inversely compared to the U.S. dollar’s value on the world stage. Assuming that these trends continue into the near future, and thanks to continued uncertainty in nations such as Spain and Italy, not to mention growing worries over France, they probably could. This would force many investors to buy up dollars as protection, pushing gold investments sharply lower in the process once again [see The Complete Guide To Investing In Gold].

Gold bugs are likely to be experiencing a mild heart attack by this point in the article but the above reasoning is hard to deny for most investors. With that being said, it doesn’t necessarily make gold a bad investment overall– especially in the short-term– just that investors need to consider these issues before plunking down a huge chunk of their portfolio’s dollars into the precious metal. While gold seems poised to keep its current price thanks to continued expansion of the monetary base around the world, it is always important to keep things in perspective.

Gold is not the be all end all of precious metals investing and many should likely consider diversifying across the space in order to protect against any market movements. After all, the rest of the precious metal group still has the same currency appeal as gold but can offer different risk/return profiles that could make them excellent choices for investors seeking more diversification in the space. Personally, I am long gold in both ETF and physical form, however, this represents a small portion of my portfolio that is used to hedge against a total collapse in the broad economy. In other words, a small allocation to the metal seems warranted given the broad concerns in the global marketplace and as an insurance policy against a collapse. With that being said, an allocation to gold exceeding even 10% of a portfolio seems like a terrible idea given the reasons outlined above, especially over the long-term, as history certainly isn’t on the shiny metal’s side [read The Ultimate Guide To Gold Investing].

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Disclosure: Long IAU, gold bullion.