In my last post on the investment consultant Harry Schultz, I noted that Schultz had advised investors to place half their funds in blue chip gold mining stocks and gold bullion.
The reasons for this were the massive spending programs instituted by governments around the world which Schultz (and many others) expect to eventually result in significant inflation. Significant inflation generally means currency devaluation and corresponding gold price appreciation.
But what are the risks of following Schultz’s advice? There are a few risks that investors should be aware of.
Gold is an inherently volatile commodity. Commodities tend to do things that people don’t expect them to do. Just think of the oil price falling all the way from $147 a barrel to the $30-$40 range. Who would have thought that would happen and who would have thought it would happen so quickly? If you’re going to dabble in commodity markets you have to expect (and have a tolerance) for significant volatility.
But more importantly, we are currently in a gold price appreciation cycle that has already been underway for approximately seven years. How much longer that cycle will run is anyone’s guess. The important thing to be aware of though is that the cycle is already mature and the really astute investors have already made large profits in gold because they were buying 5-7 years ago.
Lots of people who don’t understand the dynamics of the gold market are currently buying gold for the sole reason that it has gone up significantly in recent times. Than in itself is not a reason to buy anything.
In my opinion, gold prices are just beginning to show some of the hallmarks of a bubble, and I readily acknowledge that the bubble may get a lot bigger yet before it deflates.
It should be remembered that practically all bubbles form initially for sound fundamental reasons. But as the bubble takes shape and grows, the fundamental reasons are gradually swept away as market participants attempt to profit from rises that are not based on real demand. In so doing, market participants interfere in an otherwise “natural” process and cause much more severe peaks and troughs to occur than would otherwise be observed. When the bubble pops, it usually happens very quickly and dramatically.
This of course is one of the foundations of George Soros’s theory of reflexivity and the recent fluctuations in the oil price are a textbook example of what Soros refers to. Reflexivity of course should be obvious to any reasonably intelligent investor and I don’t think that Soros needed to write books on the subject.
However, reflexivity as applied to commodities is especially important because commodity prices are determined by global supply and demand fundamentals with significant interference from speculative trading activity in order to attempt to manipulate outcomes (i.e. make outsized profits).
Speculative traders have no use for the underlying commodities that they trade - their demand is artificial. Therefore, speculative traders can artificially increase (and decrease) prices to levels that they would never reach if these traders were absent from the market (once again, oil is a good recent example).
You can always assess an industrial company’s balance sheet and look at the type of industry it operates in and assess the reliability of its cash flows, but how do you determine what a fair price for a commodity is? It’s much more difficult.
An average investor has far more chance of predicting the cash flows for a stable business (a difficult task in itself) than they have of determining what the demand and supply fundamentals for the gold market are (or any other commodity market for that matter).
Investing in gold mining stocks has its own unique set of risks.
Firstly, there is geopolitical risk associated with gold mines in many parts of the world. Countries like the United States, Australia and Canada are very safe and stable; many parts of Africa (for example) are not. Of course, you can limit your investments to companies that only operate mines in politically stable parts of the world. This seems sensible to me.
Secondly, gold mining companies usually use derivatives to decrease the risk of their operations. However, it’s quite possible for gold miners to make serious mistakes with their hedging and derivative strategies and this can lead to adverse results for companies that get it wrong. In extreme cases, a company can end up collapsing as a result (it has happened).
Thirdly, many gold mining stocks do not pay dividends. You are therefore totally dependent on capital appreciation for your return – it’s a risk. (Investing in gold bullion not only provides no income, it actually incurs storage costs.)
Fourthly, production costs at mines can vary widely from one year to the next due to factors that the mining companies can’t control. For example, when the price of oil skyrocketed, most miners also watched their production costs skyrocket because many use diesel generators for their power source (they have to in remote areas where most mines are located). The recent falls in the oil price are of course of great benefit to gold miners.
I think the arguments put forward by Harry Schultz and others for an increased gold price are logical. However, I also realize that macro-economic forecasts are difficult to make with accuracy. Many economists get things wrong (often dramatically so) and anyone who places their faith in such forecasts (or forecasters) does so at their own risk.
While I said in my last post that I would be prepared to allocate a small percentage of my portfolio to gold, this still has to be assessed against what is available to me in the equities markets (non-gold sectors). I believe that there are still more attractive opportunities in the non-gold sectors of the equity markets.
While Schultz has a lot of credibility, I wouldn’t want to go betting half my portfolio on a rising gold price (as Schultz suggests his readers do). It’s just too much of a risk to take. A little in gold is fine, but gambling half my funds is not something I would ever do.
Note: None of the above constitutes financial advice. You need to do your own research and consult appropriately qualified people for advice (where necessary).
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