- Gold has delivered positive returns for 11 consecutive years, can it continue that trend?
- Fundamentals spell gloom for the shiny metal
- Purported safe haven characteristics pale in comparison to global bonds
- Inability to value the metal leaves one guessings its fair value
- Gold miners have underperformed the commodity itself, focus on undervalued equities, not the metal
Gold, the shiny commodity that has delivered 11 years of positive returns faces a relatively tricky 2012. In 2011, the shiny metal has returned 10.1% (in USD terms), outperforming global equities in the process. In this article, we present 3 important reasons why we remain disbelievers of Gold.
1. fundamentals do not provide a compelling case
The fundamentals of demand and supply for gold have not given us much reason to recommend the inclusion of the metal in one’s portfolios. Traditionally, jewellery has been one of the key drivers of the demand for gold, representing 68% of demand based on a 5 year average. However, jewellery demand has been sapped over the past few years, with the latest drop showing a -10% decrease on a year-on-year basis between 3Q 2011 and 3Q 2010. With the consumer discretionary sector starting to encounter major headwinds as suggested by Tiffany & Co’s earnings warning, do not expect the jewellery industry to continue buying much gold as softening external demand combine with high gold prices to deter further large scale purchases.
Chart 1: Traditional Demand For Gold Slipping
Investment demand, another purported key driver of demand has not had much reason to cheer either. Gold demand stemming predominantly from ETFs and similar products has seen negative growth, with a -0.77% growth rate over the 4 preceding quarters on a year-on-year basis.
With the fundamentals of demand not painting an encouraging picture for those bullish on gold, the stable supply of fresh gold and recycled gold provides further reason to remain cautious. Gold mine supply has risen by 15% on a year-on-year basis, with recycled gold rising by 13% on a year-on-year basis in 3Q 2011. Given the lack of official sector sales, should central banks have chosen to release some of their gold reserves, the supply of gold would have surely increased and thus bring down prices according to the laws of demand and supply.
2. Gold is no safe haven asset
Contrary to popular belief and the mainstream media, we do not believe that Gold is a safe haven. Safe haven assets are those which are supposed to provide investors with shelter when markets as a whole get rough and volatility spikes through the roof. Over the years, we have noticed an increasingly disturbing trend between gold and global equities. Taking a look at Chart 2, it is clear that even though gold started off the new millennium with a negative correlation to global equities; it has spent the better part of the decade moving in increasing tandem with global equities, negating its “quality” as a purported safe haven asset.
Chart 2: Increasingly following equities
Gold is volatile. Surprised? Perhaps some investors would be by this “shocking statement”. However, the numbers don’t lie. Taking a look at Table 1 below, it is clear for all to see that gold has been a volatile asset over the past few years. Despite the often publicised volatility in equities by the media, gold’s volatility levels are on par with equities over the recent 3 years period, while outpacing volatility levels in the 1 and 2 year periods, suggesting the shiny metal doesn't do too good a job at stabilising one's portfolio.
|Table 1: Volatility Levels
|Source: Bloomberg, iFAST Compilations
Data as of 12 January 2012
With price drops of as much as -4.8% in a single day over the past 1 year, investors looking to hedge, stabilise or “insure” their portfolios with the commodity should do themselves justice and seriously think twice before buying gold when global bonds dropped a maximum of only -1.05% in a single day in 2011. Investors should take a look at our Top Funds Review 2011 for ideas on which bond funds did well within the asset class that had the lowest levels of volatility.
3. Don't buy what you cannot value!
The curious case of gold has been the lack of valuation measures available to analyse the metal. While stocks and bonds produce a series of cash flows which can be discounted to present value to gauge attractiveness, gold produces no cash flows for investors to value or discount. As a matter of fact, gold actually costs investors cash flow – it makes you pay to hold it. Be it holding physical gold in a vault of some bank, or, holding gold on paper via an ETF, gold does cost investors cash to hold. There are few other asset classes in the world which do not provide a stream of cash flows and charge investors a fee for holding on to it.
The lack of a proper valuation method to analyse gold leaves us with guesses as to what could possibly be the fair value price of the metal. With such an inherent problem, we choose not to haphazard a guess and to advise investors to remain cautious on the metal despite its sterling gains over the past few years. After all, the prices of all assets rise and fall, remember the period between 2002-2007 for US equities? And of course, the subsequent 2 years?
only if you insist
If you insist on purchasing gold, perhaps it would be wiser to consider the equities of gold miners rather than focus on the commodity itself. Generally speaking, the gold miners have failed to keep up with gold’s astronomical rise in price, returning -13% as compared to the commodities returns of 10.1%, a significant underperformance of -23 percentage points. With a product that has continually commanded higher prices for the past few years, the underperformance of the gold miners might not have much longer to run as they begin to reap the benefits via higher earnings.
Taking a look at the NYSE Arca Gold Bugs index, which consists of 15 of the largest and most held public gold production companies, we are struck by the under-valuation of the index. As of 12 January 2012, the index was trading at an estimated PE ratio of 10.68X, with earnings growth of 63.1% in 2012 and 12.2% in 2013. While the 5 year average PE of the NYSE Arca Gold Bugs index is 22.7X we apply a conservative 20% discount as a safeguard to bring the 5 year average down to 18.2X. At current valuations, and assuming the ratio is mean reverting which is usually the norm for such valuation ratios, the index has potential upside approaching 70% by 2013, something we are unable to say about the commodity itself.
Although we have highlighted before the riskiness of playing a game of “buy high, sell higher”, we can empathise with green-eyed investors who have seen gold notch up unbelievable returns over recent years. Nonetheless, we believe that investors should avoid the commodity itself and focus on other assets which can be valued and appear undervalued, such as the equities of gold miners. Should investors insist on owning a part of that shiny metal, SCHRODER AS GOLD&PREC METALS A ACC SGD would be our best choice, as the fund invests in both the commodity Gold, as well as gold mining stocks, making it the most palatable option to us.
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