The Allure of Gold Beckons

October 2, 2008

Whenever financial market talk turns to depression, the prophets of gold are heard as well.  An article published today in Money and Markets by Larry Edelson makes a pitch for investing in gold, predicts a substantial coming depreciation in the dollar, and advises people to keep wealth highly liquid in these turbulent times.  In other words, repeat the strategy that worked best in the 1930’s.  After the collapse of Lehman, gold ran up about 22%  in less than three weeks by September 29th, seemingly proving the merit of the buy-gold strategy, and one does not have to be a gold bug to conclude that recapitalizing financial institutions will likely involve some dose of inflation to whittle away the real burden of debt.

Three things ought to be kept in mind when contemplating a portfolio shift into gold.  Number one, gold is a commodity and subject to extremely volatile swings like many other commodities.  From its fixed price of $20.67 per ounce prior to 1935 to a peak of $850 in January 1980, gold advanced 8.4% per annum, but it fell 6.0% per annum over the ensuing 19-1/2 years to $253 per ounce in September 1999, only to then increase some 24% per annum to an all-time high of $1032.70/ounce on March 17, 2008.  Gold volatility is not limited to long expanses of time.  After the peak last March, gold fell at a roughly 28% annualized rate to $746.47 on September 11th, rebounded to $909.50 this past Monday and fell 8% in the next three days to $838.60 at present.  Gold is cherished as a more enduring store of value than any paper monies, yet one irony is that its value bounces around wildly along the way. An investment last March 17th in gold is still 19% under water.

Number two, gold does not have the best long-term return in normal times.  In examinations of the Great Depression, the contrast is often made between the strength of gold after 1934 and the preceding plunge in share prices.  Since 1934, gold has advanced 5.2% per annum from $20.67 to $838.60, but the Dow Jones Industrial average has increased 6.6% per annum, notwithstanding its 25% drop from last year’s all-time high.  And those comparisons only encompass capital appreciation.  When investing in gold, one foregoes the opportunity costs of interest or dividend income.

Finally, gold correctly can be marketed as the best medium of exchange and store of value when the world as we know disintegrates.  For situations short of such extremes as nuclear war, a plague, a severely compromised aspect of the earth’s environment, or a cataclysmic economic accident like the 1930’s depression or 1970’s inflation, gold may not be optimal. 


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