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Second Quarter 2013 Newsletter

posted on

All That glitters...

July 16, 2013

Everyone likes gold. It is so pretty and shiny. Rappers, (old) dentists, prospectors, historic James Bond villains, Scrooge McDuck (Huey, Dewey and Louie’s great uncle), King Tut’s mortician and the Rothschild family were/are all gold lovers. There are many more, too numerous to list. But most people don’t know an awful lot about this precious metal. For instance, a large majority of gold on the planet is located near the Earth’s core, having gravitated there during the earth’s formation. All “discovered” gold is the result of meteorites, which carried it and crashed into the Earth’s crust. Really.

Gold is a frequent topic in the investment world, too. Just like other assets, its popularity is often inversely related to its potential future value. It is often more desired when it is trading at a high price than when it is priced at lower levels. Less than two years ago, gold hit its all-time high price (in US dollars) of $1,920 an ounce. If you tuned in to either CNBC or Fox News Channel, you saw an extraordinary number of “buy gold now” commercials, which trumpeted the importance of everyone owning their share of a can’t miss investment. $4,000 - $5,000 per ounce targets were discussed as a question of not if but when.

Some well-known Wall Street types have also sung gold’s praises:

“We are living in a world of money printing. … That is why I have to recommend gold again. ... Once gold surpasses $1,800 an ounce, it will run to the low-to-mid $2,000s.” Felix Zuelauf, Zuelauf Asset Management. “Here’s What’s Cooking for 2013,” Barron’s, January 21, 2013.

“Investors can choose between artificially priced financial assets or real assets like oil and gold, or to be really safe, cash. … My first recommendation is GLD—the SPDR Gold Trust.” Bill Gross, PIMCO. “Stirring Things Up,” Barron’s, February 2, 2013

“I am recommending gold, as I have done for many years. I will continue to do so until the gold price hits the blow-off stage, which is nowhere in sight. … The environment for gold couldn’t be better. … Gold could go to $5,000 or even $10,000.” Fred Hickey, The High-Tech Strategist. “Stirring Things Up,” Barron’s, February 2, 2013.

A few weeks ago gold fell below $1,200 an ounce, nearly a 40% drop from its highs. The amount of gold commercials on TV also seems to have diminished.

Back when gold was making its highs, our firm received some calls from clients inquiring whether we had any plans to add gold to their portfolios. Most likely, more than a few were disappointed to hear that we were not going to incorporate this precious metal into their long term planning.

Our reason for not owning gold is because, even though it is very shiny, gold simply doesn’t do much. Yes, its price reacts to supply and demand, but that has nothing to do with its ability to produce anything. Warren Buffet makes a succinct argument against the need for gold in a portfolio in his Berkshire Hathaway 2011 Annual Report, written when gold was $1,750/oz.:

“Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion. Call this cube pile A.

Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?

Beyond the staggering valuation given the existing stock of gold, current prices make today’s annual production of gold command about $160 billion. Buyers – whether jewelry and industrial users, frightened individuals, or speculators – must continually absorb this additional supply to merely maintain an equilibrium at present prices.

A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.

Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold. I’m confident, however, that the $9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.”


But don’t take our, or Buffett’s, opinion. Look at these cold, hard numbers:

Gold vs. indexes 1973-2013*

The above chart shows the annualized returns of various asset class indexes. Please note that gold has decreased in price about 15% since March 31, 2013, having broken below $1,200 per ounce in June. This decrease would give gold an even lower long term return than shown above. Unfortunately, its volatility is higher than that of the S&P 500 Index. Consequently, although gold clearly has periods of dramatic price movement (in both directions), it fails to be a satisfactory long term portfolio vehicle due to its low long term return and high volatility.

In conclusion, feel free to buy as much of that pretty, shiny stuff as you want. Just understand that as a long term investment, gold may glitter but it doesn’t do a great job of making or keeping you wealthy.

Second Quarter 2013 Asset Class Returns

In early May 2013, the 10 year US Treasury bond yield was 1.65%. Less than two months later, that yield stood at 2.65%. Coincidentally, in the last quarterly report sent to you in April, we outlined what would happen to Treasury bonds of various maturities if rates moved up. Well, in the last two months of the second quarter, we watched this very event unfold in real time. It wasn’t pretty. Prices of all types of bonds and bond funds got whacked - Treasuries and high grade corporates, high yield (junk) and municipal tax frees. Even some debt instruments that were supposedly sympathetic to rising rates – Treasury Inflation-Protected Securities (TIPS) and floating rate bank loans, also lost value.

It is fairly clear why all this happened. Although the US is not enjoying dynamic growth, it is becoming increasingly evident that we are not in danger of falling back into a recession. In addition, the single family housing market is showing a surprisingly strong rebound after years of zero, or in some cases, negative growth. This optimism makes the continued suppressing of interest rates by the Federal Reserve unlikely as Fed Chairman Ben Bernanke’s most recent words seemed to indicate. With artificially induced lower rates coming to an end, bond investors of all sizes and shapes decided to sell first and ask questions later.

The broad stock market reacted with a meaningful selloff in June, only to bounce back the last few days of the month, thus producing positive returns in most domestic equity asset classes for the quarter. In a continuing trend, Value and Small Cap asset classes beat Large and Growth by a small margin. After leading in 2012, Real Estate was the only negative number among US equity asset classes for the quarter. Domestically, the first half of 2013 has been great. Other than Real Estate, all equity classes had low to high teen returns. Overseas, equity markets have not performed as well. All International asset classes had losses, but these were dwarfed by Emerging Markets, some of which had double digit losses year-to-date.

Over the last few years, certain market commentators have discussed the positive correlation of various global markets, intimating that asset class investing was losing its ability to properly diversify portfolios. In 2013, nothing could be further from the truth. In fact, the first six months have shown 10% to 15% greater returns in the US vs. International counterparts, and nearly a 30% difference between the best US asset classes and the worst Emerging Markets. Clearly, the benefits of Modern Portfolio Theory, and the proper weighting and diversification of asset class investing, is performing as well as it ever has. The apparent change in direction of interest rates is now a major factor in all global markets. It will be interesting to see how the push-pull of higher rates and growing earnings affect domestic and international stock and bond markets for the remainder of this year, and this decade.

Both the weather and the markets are heated, which points to a need to stay cool in both areas. We’ll take care of your portfolio. You monitor your sunscreen and liquid intake. Together, we’ll hopefully make it to autumn without too much discomfort.


Sincerely,


Frederick F. Kramer IV, JD
Chief Investment Officer
Dixon Hughes Goodman Wealth Advisors LLC