A bite from the gold bug is good for your wealth

published 13 November 2009

Gold is hitting new highs. And in the long run, it's going to head higher. So think about buying in now, says Dominic Frisby.

The gold price has broken out to record highs it's over US$1,100 as I write this. Gold stocks are soaring. Comparisons are being made between now and the gold fever of 1979-1980, and India's central bank has just bought $6.7bn-worth at $1,045 an ounce (an investment that's already up 5% in barely a week). At last, the chattering classes are chatting about gold.

Good times for gold bugs. At least you'd think so. But it depends on where in the world you are. Imagine an Australian investor. Not unwisely, he decided to buy some gold at the start of the year. If he didn't get his act together quickly, he might have paid as much as AU$1,400 an ounce in January. If he missed that, by February it would have cost him AU$1,550 per ounce to hop on board. Yet now, that poor Australian who, of course, thinks in Aussie dollars rather than US ones, is sitting on something like a 20% loss gold has slipped back to around AU$1,200 an ounce.

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Of course, it's all down to this year's astonishing rally in the Australian dollar, but it's a surprising statistic nonetheless. Similarly, Canadian, British, Japanese or European investors have all seen some nice appreciation in their gold, but new highs? No. These were largely set last spring, and gold is now 5%-15% off those highs, depending on which currency you measure it in. The high in sterling, for example, was £700 an ounce; it is currently just over £650 an ounce.

Why am I saying this? Because it demonstrates how much of this rally in gold so far has been down to US dollar weakness. There will come a time when gold has reached new highs against all currencies. That's when we'll really be off to the races. But, for all the excitement, that has not happened yet.

The best way to protect your wealth

We have a natural tendency to think of an asset's value in terms of the currency in which it's priced. You measure the price of London-listed companies in pounds. You measure your commodities and US indices in dollars, Germany's DAX in euros, and so on. But it's a good exercise to measure your investments in alternative currencies so that you can see how your wealth is really holding up.

For example, the Aussie dollar might be strong now, but it was one of the hardest-hit currencies during 2008. And the US dollar might have been woeful since March, but it had a great 2008. The pound also had a woeful 2008, and worryingly hasn't yet seen much of a rebound against most rival currencies. The key to preserving your wealth is to hold the majority of your cash in the strongest currencies. But given this sort of volatility, that's easier said than done. How do you choose?

That's why I like gold. It's the best alternative currency available. It may not be an accepted medium of exchange these days, but it does fulfil the other key function of money, which is to act as a store of wealth. And I'm certainly not the only one to think this way. Indeed, a friend of mine who used to be a trader for Merrill Lynch in New York explained how they were trained to view gold not as a commodity, but as another currency.

Like most investors, I have funds for speculating perhaps in junior mining companies (for my favourite current tips in the sector, see below), or to bet on the direction of a particular market. But my physical gold holdings are not speculative. Instead, I see them as part of my long-term savings as money I have put aside to spend at a later stage, perhaps on a house, perhaps to give to my children, or possibly on my retirement.

I've chosen gold as the medium for this savings part of my portfolio because over the past ten years it has consistently been the best performer of the major currencies. Sure, it's down almost 9% this year against the Aussie dollar, but it was up 32.5% against it in 2008. On a year-in, year-out basis it has been the best-performing money, its purchasing power increasing against all other currencies, as the selection in the chart above shows. Even though it pays no interest, it has been the best store of wealth.

Can gold's bull run continue?

Of course, with gold starting to attract more attention, some investors are getting jittery. As GMO's James Montier points out, now "everyone has an opinion on gold". So will its strong run against paper currencies continue?

Yes. To understand why, you have to grasp what's driving gold's increase. In the 1970s, inflation took off, and we also saw a soaring gold price. As a result, it's become the received wisdom that gold is a 'hedge against inflation'. Given that many pundits reckon that deflation is just around the corner, this leads them to believe that gold is heading for a fall.

But this perception is wrong. In fact, gold hasn't been a particularly effective guard against inflation over the years. During the 1980s and 1990s we saw rampant growth in both the supply of money and of credit (which many would regard as the 'true' definition of inflation, rather than rising prices). As a consequence, we saw huge price rises in many asset classes, from houses to stocks to art. Wages increased too. Yet during this period the gold price fell for 20 years, declining by 75% from peak to trough all told. Gold was a rotten hedge against the inflation of the 1980s and 1990s, when the 'real' value of other assets was increasing. But it was the perfect hedge against the inflation of the 1970s, when the 'real' value of other assets was being demolished.

As Adrian Ash of Bullion Vault points out, what stopped gold's bull run in the 1970s was the decision by the then-Federal Reserve chairman Paul Volcker to raise US interest rates to nearly 20%, to get ahead of inflation. With investors once again secure in the knowledge that they would be able to get decent real returns on cash and other assets, they pulled out of gold and put their money to work elsewhere.

Meanwhile, during deflations, cash or money is widely seen as the best asset to hold. But during a deflationary bust, local currencies can collapse altogether just look at Iceland so there's a big risk to owning it. That's when you're glad of your gold. In fact, gold's purchasing power ie, the price of gold relative to everything else increases during deflation. Professor Roy Jastram, in his book The Golden Constant, found that gold's purchasing power has increased relative to other goods and services during every period of deflation as far back as the 17th century. In other words, again, it acts to preserve your wealth while the value of other assets is falling.

So in fact, you can argue that gold, rather than acting as a hedge against inflation, is instead a hedge against stress and uncertainty in the financial system. And there are plenty of reasons to be concerned about that. Regular MoneyWeek columnist James Ferguson of Pali International argues that the banking sector is still, for the most part, insolvent. I agree with him. Governments, too, are sinking in a sea of debt. It is at just such times that you need your gold.

This bull market in gold, now nine years old, should continue for as long as monetary policy remains loose and investors are left uncertain about the future. I don't see any signs of it tightening anytime soon. There is still no discipline up top. Government waste is everywhere, particularly in the West. India has just spent US$6.7bn which they had in foreign reserves buying gold. In the same week we spent £25bn which we don't have on propping up bankrupt banks. Policy-makers are determined to save the banking system at any cost. Banks are not lending and private debt is still shrinking, but quantitative easing (money printing) is still being pushed through in a desperate bid to inflate credit. Someone has to face up to these problems and tackle them, but there are no signs of any Volcker-type central bankers making a return to the world stage. Until that happens, fiscal indiscipline, even insanity, will continue to reign and gold will remain my currency of choice.

So is now a good time to buy gold?

Of course, no bull market moves up in a straight line, and in the short term, gold could go lower. As I pointed out earlier, much of the recent gains have been down to US dollar weakness. And while the American economy is in trouble, and the US has been fiscally irresponsible, in the short-term I don't see much further downside for the dollar from here.

The trade-weighted dollar index is currently at 75. It could go on to re-test last year's low at 72, but it could also reverse. And if it does so, it's likely that everything else from stocks to gold will too. In fact, while I would not hold any of my long-term savings in US dollars, in my shorter-term, speculative portfolio, I have partly gone to cash and I have gone to US dollars.

But if I was sitting on a pile of Aussie dollars, on the other hand, I'd be looking to swap them for any number of things. I'd be looking at foreign currencies, foreign companies, commodities and, of course, gold. The Aussie dollar is trading at highs seen only twice in the last 20 years in autumn 2007 and summer 2008. It could always go higher. But the risk-reward favours some kind of reversal. So it's possible that if we see a correction in stockmarkets, and a rise in the dollar, that gold may fall against the US dollar, but it may rise against say the Aussie dollar.

So the answer to the question "should you buy gold right now?" depends on which currency you're using. But assuming that you're a British investor the pound is somewhere in the middle of the US to Aussie dollar extremes then if I didn't own any gold at all, I'd start accumulating a position at once, and use pullbacks to increase my rate of accumulation.

And regardless of what currency you're buying in, in the long run, gold is heading higher. I expect to see around $1,400 an ounce by spring 2010. For more on how to buy gold, see below.

Where to go for gold

The easiest way to buy gold bullion is to phone up a bullion dealer such as Baird's (Goldline.co.uk; 020-7474 1000) or ATS Bullion (Atsbullion.com; 020-7240 4041). Old-fashioned gold sovereigns seem to get you the most gold content for your money, and you pay very little premium for 100-year-old, Victorian coins. They are also exempt from capital-gains tax (CGT). Sovereigns are not, however, the most attractive coins, in my view. I prefer Britannias (also exempt from CGT) and Pandas (Chinese gold coins), but you pay a premium for these.

You can also buy bullion and have it stored for you, allocated in your name, with Bullion Vault (Bullionvault.com) or Goldmoney (Goldmoney.com). Alternatively, for exposure to the gold price, you can buy exchange-traded funds (ETFs). I prefer to keep my long-term savings in physical bullion, but ETFs are convenient for use as trading vehicles. The US-listed SPDR Gold Shares (NYSE: GLD) is the most liquid. There's also the World Gold Council's initiative, Gold Bullion Securities (LSE: GBS).

As for gold stocks, the simplest way to play the major miners is via the US-listed Market Vectors Gold Miners ETF (NYSE: GDX). This tracks the HUI, the index of US-listed unhedged gold stocks (the fact that these producers are unhedged means they have full exposure to changes in the gold price good when gold is rising, not so good when it's falling). There is also the less liquid London-listed ETFX Russell Global Gold Mining Fund (LSE: AUCP), which tracks the performance of the Russell Global Gold Index. I'm less keen on this fund as the index it tracks is rather over-exposed to gold major Barrick, with a 15% allocation.

For those with stronger stomachs, junior miners are the place to be. The only problem with the juniors right now is that many have had a good run, and I'm reluctant to chase stocks that have doubled or even tripled. So I've unearthed a few laggards for you. But do remember that these are very high-risk, high-beta stocks that could, in theory, go to zero these are for your speculative money only. Before you buy, have a look at a chart of each company, work out a price you're happy to pay, offer it and stick to your guns. Don't chase these things up!

Ascot Mining (PLUS:ASMP/XETRA:AM3.DE) has a market cap of just £10m. It has various projects in Costa Rica, the first of which is already producing small amounts of gold. Ramping up production next year should give the stock a lift, as would a listing on a more liquid exchange, so this is one to buy and lock away. The management team has just bought shares at a premium to the market price, which is a good sign, despite a dispute on one of their joint venture projects. Do be aware that you'll need a broker who can buy PLUS stocks I use TD Waterhouse, who can also deal in Canadian-listed stocks, such as those below.

I like African Queen (CA: AQ) and its sister firm Sacre Couer (CA: SCM). Sacre Coeur operates in Guyana. It has some exciting hard rock assets as well as alluvial gold (gold found in riverbeds). With test production of the alluvial gold progressing, you might see some exciting news on actual production before year end.

African Queen is a grass-roots explorer, so a lot can go wrong, but it is a potential rocket. They've just signed a joint venture with gold mining giant Newmont on a property in Ghana (Africa's second biggest gold producer) that has a 1.1 million ounce historic resource, although it's believed there's even more waiting to be uncovered. And surface sampling on their Mozambique project has yielded excellent results along a 10km stretch. Results on the ground magnetic survey should come in over the next week or two. The geologists think they've hit a very big bullseye.

Finally, consider Ecometals (CA: EC). This group has been through the mill a bit over the last few years, but it's coming through the other side. It's another one to buy and hold as it has exciting developments in the pipeline: some manganese projects that should generate cash flow by next year and one potential home run. This is the Rio Zarza project in Ecuador, which is next to Aurelian's Fruta Del Norte project (now owned by Kinross), which was one of the discoveries of the decade. Ecometals' geologists are very excited and believe there could be extensions of Fruta Del Norte's mineralisation. Final permitting is all but in place and we should see the drill rigs turning before month end.

For full disclosure, I own stock in all of the above firms. And just to repeat my previous warning: don't invest money in these stocks that you can't afford to lose in a worst-case scenario.

This article was originally published in MoneyWeek magazine issue number 461 on 13 November 2009, and was available exclusively to magazine subscribers. To read more articles like this, ensure you don't miss a thing, and get instant access to all our premium content, subscribe to MoneyWeek magazine now and get your first three issues free.