Commentary: What About Gold?

Gold is now trading at a record high, and interest in the commodity continues to grow. This is a typical pattern seen during difficult economic times when investors seek a hedge against financial uncertainty, which can be found in abundance as 2009 draws to a close.

Global stock markets remain well off of their peaks. Real estate prices are depressed in many nations. Unemployment remains stubbornly high. Concerns about the declining strength of the U.S. dollar have rocked exporting nations, as their goods have become more expensive for American consumers. Vietnam devalued its currency in an effort to remain competitive in the export market with China, where the currency is pegged to the greenback.

Fears about the potential for inflation have also hit the radar. Central banks continue to push money into the system in an effort to revive flagging economies and reverse rising unemployment, even as Japan has announced the return of deflation. Nuclear threats from North Korea and Iran, as well as ongoing wars in Afghanistan and Iraq, provide further reasons for caution.

Who’s Buying?

With all the uncertainty, central banks around the globe have great incentive to buy gold, as it enables them to diversify away from the U.S. dollar and provides a hedge against inflation. Central banks in China, India and Russia have been recent buyers, and oil-producing nations are likely to follow suit, as they have similar incentive to buy. Hedge funds and exchange-traded funds are buying, too. All of this activity has inflated the price of gold and captured the attention of retail and institutional investors alike.

A Closer Look

The days of miners striking it rich with picks and shovels are long gone. Nowadays, gold mining is largely a commercial operation, whereby tons of earth are processed in order to retrieve mere ounces of gold. The output is primarily used for creating jewelry, manufacturing electronic components and investment purposes.

From an investment perspective, gold doesn’t pay a dividend or provide cash flow. Profits are made based purely on price appreciation driven by supply and demand. At present, demand is high, and some analysts believe that production has already peaked.

While some investors believe gold is an adequate inflation hedge, research conducted by SEI has shown that this investment may not be the best choice for this purpose (see “Are Your Returns Real? TIPS for Investors,” published October 2009). While correlation analysis shows that gold has a leading relationship with inflation and would therefore increase in value before and during inflation increases, this relationship is subject to change depending on macroeconomic and geopolitical factors, as well as overall supply and demand. In addition, gold has experienced real yields lower than 20% during the time period from 1972 to mid-2009, and the price volatility it has shown during this same time period is too high for consistent inflation protection.

In the current market, gold is sitting at a record high. It costs roughly $400 an ounce to produce and sells at nearly triple that number. So if you aren’t holding gold today, buying at a record high may not be a prudent move.

Prudence aside, the key question is, “Could gold go higher?” The short answer is “yes.” From an economic perspective, triggers for a massive run-up that would see gold prices rise by hundreds of dollars per ounce could include anything from another Dubai-style default to a double-dip recession, escalating deficits or purchases by the Chinese government.

That noted, holding bullion is an expensive proposition, requiring insurance and storage space while generating no income. And while gold serves as a currency hedge for nations, most domestic investors are buying and selling goods in their home currencies, so the decline of the U.S. dollar or the devaluation of the Vietnamese dong has little meaning.

SEI’s View

For these reasons—lack of cash flow, inadequate protection against increases in inflation, price volatility and the current cost to buy and hold— SEI does not dedicate a portion of its asset allocation to gold or to commodities in general. We do not believe that commodities have provided significant, long-term value, but rather that they represent short-term trading opportunities.

In summary, while speculators may pick up a few dollars over the next six to nine months before the price of gold reverts to the mean, long-term investors seeking prudent risk management and limited volatility will stick to strategic asset allocation decisions and participate in the gold rally only indirectly, such as through existing holdings in mining stocks. SEI sits firmly in the latter camp.

This material is provided by SEI Investments Management Corp. for educational purposes only and is not meant to be investment advice. The reader should consult with his/her financial advisor for more information. This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. There are risks involved with investing, including possible loss of principal.