What’s the point of gold?

One of the problems with putting a price on gold as gold perma-bears regularly point out is that it doesn't pay an income.

Generally, the starting point with valuing an investment is to work out how much income it will pay you in the future, then work out how much you are willing to pay for that.

With gold paying neither dividends nor rent, you can't do that. So how do you value it?

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I've just read an interesting report from Julian Jessop at Capital Economics that has a crack at it

Three scenarios for gold: from $1,000 an ounce to $5,000

Capital Economics has outlined three scenarios for gold over the coming few years. The basic assumption underlying the scenarios is that gold ultimately benefits from financial shocks. In this case, their biggest concern is the eurozone.

Jessop notes that gold has "moved fairly closely in line with the cost of insuring against sovereign defaults in Europe." In other words, as anxiety grows about the condition of Europe, the gold price tends to rise.

Their central scenario is that Europe experiences a "relatively orderly" break-up, with one or more small countries leaving the eurozone. As a result, the Federal Reserve would keep monetary policy ultra-loose (even if it avoids more quantitative easing), and gold would rise to $2,200. Even at this price, it would still be lower than the inflation-adjusted all-time high of 1980 (which was $2,400 in real terms). It would also be reasonably priced compared to oil.

But what about other outcomes? There's the disaster scenario, of course. If there's "a chaotic break-up of the euro", then this could well result in a Lehman-style financial crisis. Throw in a military conflict between the West and Iran, and you could see the gold price spike to "as high as $5,000". It's a pretty extreme, though not unthinkable outcome, and Capital Economics only assigns a 10% chance to this scenario.

The other possibility, is the more optimistic view. The global economy continues to recover. The eurozone manages to hold it together. As a result, the Fed starts to tighten monetary policy earlier than expected. In this case, Jessop reckons that "the downside for gold should still be limited by strong and rising demand from emerging economies, and we woud not expect to see a return to the November 2008 lows [of $710 an ounce]." But $1,000 an ounce would be a possibility.

I'd say that's a pretty sensible range of views. But it leaves us with a very wide range of predictions - $1,000 to $5,000 an ounce. And realistically, these could be well off the mark. If the global economy went into meltdown, who knows just how high gold would go? Alternatively, if the economy recovers, and the Fed starts raising interest rates, would $1,000 really mark the bottom?

And none of this takes into account the danger of a hard landing in China. Hedge fund manager Hugh Hendry of Eclectica sees this as being an even bigger threat to the financial world than Europe. Everyone is focusing on Europe, as he notes. Very few people are really paying attention to the risks from China.

So as an investor, what does this mean for you in practical terms?

Gold's role in your portfolio

We like gold. But as we've also noted a number of times, both here and in MoneyWeek magazine, you shouldn't have all of your money in gold and certainly not in gold mining stocks. We all have our own views on asset allocation, and what's right for you will depend on your own circumstances. But I'd see 10% as a reasonable sort of holding.

Gold is insurance. It's there to diversify your wealth. But it's also there to ensure that even in a worst-case scenario, you'd still have something of value in your portfolio.

Gold is not like cash in the bank. Its nominal value can go up or down. If you'd piled all your money into gold at the 1980 peak, you'd still be sitting on a loss in real terms (ie after inflation). Just as if you'd piled into stocks at the height of the tech bubble. That should be obvious to anyone who can look at a price chart, but with descriptions like safe haven' often bandied about, it bears mentioning.

The point of gold is that it offers you some protection when most other assets are going down. Gold's ultimate advantage over any other asset is that its value cannot fall to zero. It can't go bankrupt. You can't say that for any other asset.

So when people are fretting about the state of the global financial system, and the integrity of all other assets, that's good for gold. Once confidence returns, and other assets start looking more attractive, that'll be bad for gold.

The point is as with any asset - to make sure that you aren't over-exposed to gold, so that even when the bull market in gold ends, the rest of your portfolio is benefiting from the return of the good times.

However, with Europe on the edge, and China wobbling too, I suspect we're at least one big panic away from genuine confidence being able to return to the market. So I can easily see gold hitting new highs before this bull market is over. We have more on this and the outlook for global currency markets in particular - in the latest issue of MoneyWeek. If you're not already a subscriber, subscribe to MoneyWeek magazine.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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