Gold is a misunderstood asset. It's often portrayed as a safety play but how can it be? Only recently it fell more than 15% within a few days. As the market got twitchy over Europe, this so-called safety-play even underperformed stocks.
Gold is also often wrongly considered a great diversifier for your portfolio. While it's closer to the mark to say that gold's a hedge against inflation that's not necessarily the case either. I mean, inflation hardly went away during the '80s and '90s, yet gold's price drifted all the while.
It's important to understand exactly what you can expect from gold, or what you could be missing if you don't hold.
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Today I want to get to the real reason to buy gold right now. Because, when you boil it down the case for investing in gold is stronger now than ever. I hope that by the end of today's issue of The Right Side, you'll understand why I've been buying gold again.
You're not buying financial protection
The thing about gold is that it is suffers from sudden corrections in price as we saw recently when it fell from over $1,900 to the mid $1,500s. Commonly gold goes up as the dollar goes down as do most commodities. And that makes sense. If the dollar is worth less, then you'd expect the sellers of gold to ask for more dollars for every ounce.
Conversely when the dollar goes up, gold goes down. Recent market jitters sent investors running for the safety of the dollar, thus sending commodities down. That left many gold buyers bemused Wasn't that why they held gold for safety?
Well, actually no. You see, you can't get financial protection with gold. Gold can move down alongside the rest of the market. As we've discussed here before, the futures markets (which is where the gold price is really set) trade contracts that are highly leveraged. And when the markets turn down, this leverage can cause brutal price corrections.
There's no financial protection with gold. What you get with gold is political protection. As hedge fund manager Harris Kupperman says "You don't own gold because you expect it to do remarkable things you own it because you are scared of your government doing remarkable things."
Gold buys political protection
When you look back, what you notice about gold's performance is that it does well when the political situation is bad
Largely speaking, the '70s wasn't a great time for the politicians. This was a decade that was defined by scandal (Watergate), war and economic crisis. Oil price shocks, inflation and unemployment caused faith in the political machinery to crumble. Gold did well.
But then all of a sudden, credibility was restored. Paul Volker was installed as chairman of the Fed and Ronnie Reagan as president. In the UK too, regime change ushered in a new era of growth as credibility re-emerged in the political arena. Needless to say, gold did very badly during the '80s and '90s.
Faith in democracy and specifically the Western political system was riding so high that it surely helped bring down the iron curtain over Eastern Europe.
And while the system was riding a high, the politicians pushed through one of the most audacious political plans ever attempted. European monetary union. Now that really was something.
Who needs gold when there's unerring faith in politicians and the paper money they peddle?
The need for political insurance is rising
Over the last ten years or so, things have started to unravel. The belief that the politicians can fix the economy is on the wane. Can you fix a debt problem by throwing more debt at it? Well President Obama certainly seems to think so. He's planning to railroad through his $447bn jobs plan' irrespective of opposition. As for the debt ceiling "aargghh put in a higher one"
Europe's no better. Just about every country in the Union has now flouted the Stability & Growth Pact. You remember those rules that said nations weren't to run deficits of more than 3%, or run up a debt of more than 60% of GDP? Well those rules were ignored and now countries are on the verge of insolvency. As for the political machinery it looks wholly incapable of dealing with the mess.
No wonder then that gold has been on the rise. There is widespread fear that we will see a catalogue of a politically remarkable events in the year ahead. I'm talking about bank nationalisations, capital controls, currency devaluations, tax changes and general wealth confiscation. Anything goes when the nation is in trouble and wealth holders are the ones most vulnerable.
This is where holding physical gold comes in. What you've got here is not financial security, but physical security that's the security that politicians can't touch it.
Yes the US government did seize individual investors' physical gold during the Great Depression under a special 'executive order' by President Franklin D. Roosevelt. But it's unlikely that Obama or Cameron would get the backing to exercise such power today.
Ultimately the fear over politicians will drive people to gold. And believe me, fear is a great motivator. If investors continue to lose faith in the political machinery and fear grows then expect demand for gold to continue upwards.
Remember, gold is always exposed to the financial markets its price can be hammered down as traders scramble to cover leveraged positions. But over the long-term, gold has the ability to recover even where (or should I say especially when) the economy does not.
How to buy gold today
There are several ways to buy gold. In terms of security, you can't beat physical possession gold coins like British sovereigns, or South African krugerrands. But then again, you'll have to store and insure them.
I like a diversified approach to gold investing. I've got physical gold in a safety deposit box and I've got exchange-traded funds(ETFs) in my SIPP and ISAs. Right now, I increasingly like the look of gold shares. That is gold mining stocks. They look cheap and if the price of gold can get to $2,000 (and stay there) then I think there's a good chance the gold stocks will fly.
Undoubtedly the mining shares are more speculative than gold bullion. But there are ways of picking up a geographically (and therefore politically) diversified bunch of gold mining stocks.
We'll leave that for another issue of The Right Side. If you're yet to get some exposure to gold, then start with some physical gold coins that's should be your bed-rock. For an introduction on gold investing click here.
This article is taken from the free investment email The Right side. Sign up to The Right Side here.
Important Information
The FSA does not regulate certain activities, this includes the buying and selling of some commodities such as gold.
Your capital is at risk when you invest in shares - you can lose some or all of your money, so never risk more than you can afford to lose. Always seek personal advice if you are unsure about the suitability of any investment. Past performance and forecasts are not reliable indicators of future results. Commissions, fees and other charges can reduce returns from investments. Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Please note that there will be no follow up to recommendations in The Right Side.
Managing Editor: Frank Hemsley. The Right Side is issued by MoneyWeek Ltd.
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