An interesting read for the weekend. SMF069

Gold bugs haven’t lost the Midas touch

Commentary: Get ready for the return of the golden age

OUTSIDE THE BOX

Sept. 13, 2012, 1:18 p.m. EDT

SYDNEY (MarketWatch) — The Federal Reserve is giving the U.S. economy another injection of financial stimulus, and, on cue, gold buyers cheered. The world now remembers financier J.P. Morgan’s words to Congress in 1912: “Gold is money. Everything else is credit.”

Investors have poured money into exchange traded funds that buy gold. Some central banks are now rebuilding their gold reserves. In Germany, gold is available in airports and train stations from “Gold to Go” vending machines. Shoppers can buy a 1-gram wafer of gold or a larger 10g bar. Gold bugs speculate about a new age of gold.

Since the replacement of the gold standard with the U.S. dollar standard, gold’s price has fluctuated widely. In January 1980, gold reached a high of $850 an ounce, reflecting high rates of inflation and economic uncertainty. Subsequently, the recovery of the global economy saw gold prices fall over almost 20 years, reaching a low of $253 an ounce in June 1999.

From 2001, gold began to rise due to a mixture of increased demand, especially from emerging nations such as India and China. In 2007 and 2008, gold received an additional boost from the onset of the global financial crisis. Concern about a banking system collapse drove gold prices to a peak above $1,900 an ounce in August 2011. An ounce of the metal neared $1,760 after the Fed announcement on Thursday.

In reality, the rise was driven by fear. The depth of the financial crisis, concern about the security of other assets including once risk-free government bonds and a fragile banking system prompted a flight to gold as a safe haven.

The monetary policies of governments and central banks, emphasizing low interest rates and printing money to restart the global economy, also underpinned the gold price. A weak U.S. dollar and the questionable prospects of other major currencies, such as the euro and yen, also drove demand for gold, as de facto currency.

Yellow-brick road

For investors, gold is not without problems. Shares of gold mining companies and gold-miner ETFs, such as Market Vectors ETF Trust Market Vectors Gold Miners and Market Vectors Junior Gold Miners ETF, may not provide the sought-after exposure to gold. The value of mining companies behaves more like shares than the gold price.

Most investors prefer to invest directly in the precious yellow metal. Increasingly, investors use gold ETFs, a mutual fund or unit trust which is listed and tradeable on a stock exchange. Some ETFs, such as SPDR Gold Trust and iShares Gold Trust , hold the metal itself. Others synthesize the exposure to gold using instruments linked to the gold price, such as gold futures and derivatives.

Where the ETF uses derivatives and other financial instruments to obtain exposure to the gold, it is exposed to the risk of default by the financial institutions with which it contracts. Even where the funds are invested in physical gold, the metal is held via custodians, often financial institutions, exposing shareholders to the failure of these entities. This is ironic given the fact that the investment in gold is specifically motivated by fear of the failure of the financial system.

Investors also worry about the risk of confiscation of gold holding. In reality, any government can confiscate anything — gold, savings, property — in times of economic emergency.

In 1933 President Franklin Roosevelt issued Executive Order 6102, prohibiting the private holding of gold and requiring U.S. citizens to turn over their gold bullion or face a $10,000 fine (equivalent to around $170,000 today) or 10 years’ imprisonment. In response, opportunistic coin dealers encouraged investors to buy expensive “numismatic” or “collectible” coins, taking advantage of an exemption in the 1933 order which protected these assets from government seizure.

Seeking to reassure investors, some ETFs have installed fiber-optic cable-linked cameras in their gold vaults. Investors can monitor their holdings via the Internet. Of course, this clever marketing gimmick does not protect the investor from the failure of a custodian or financial counterparty as well as confiscation risk.

Moreover, gold is not a great store of value, at least over long periods.

Bad-news bulls

Gold bugs excitedly speculate about gold prices reaching $2,300. But even at that level, gold would merely match its January 1980 peak price after adjusting for inflation; in other words, the holder had earned nothing on the investment for almost 30 years!

Indeed, the gold price adjusted for inflation is the same as the price in the Middle Ages. Dylan Grice of Société Générale summed up the case for gold as a store of value: “A 15th century gold bug who’d stored all his wealth in bullion, bequeathed it to his children and required them to do the same, would be more than a little miffed when gazing down from his celestial place of rest to see the real wealth of his lineage decline by nearly 90% over the next 500 years.”

Gold prices can also be highly volatile. In late 2011, after reaching record levels, the gold price fell nearly 20% very quickly.

Warren Buffett observed that if stock investors are driven by optimism about prospects, then “what motivates most gold purchasers is their belief that the ranks of the fearful will grow.” Harry “Rabbit” Angstrom, the central character in John Updike’s novels about American suburban life, spends $11,000 on the purchase of 30 Kruggerrands (a South African-minted gold coin). Rabbit explains the purchase to his wife: “The beauty of gold is, it loves bad news.”

In chaos, war or collapse, gold reasserts its grip on humanity.