Saft on wealth: What is gold for?

March 16, 2012

By James Saft

(Reuters) – An apparent economic recovery and a recent tumble in the price of gold has investors wondering if the precious metal has lost its place in a portfolio. Gold, having soared higher since the onset of the financial crisis, is down about 17 percent from its September peak, and has fallen 7.5 percent in less than a month. In large part, gold’s comeuppance is attributable to improving economic data and a sense that – terrible as things may be in Europe – the banking system will not implode. So, then, if the world’s not ending why own gold? Arguing the case against gold ownership is none other than Warren Buffett, who argues for equities and calls gold a non-productive asset. Why hold gold, which never innovates, never increases profit margins and never opens up new markets? “If you own one ounce of gold for an eternity, you will still own one ounce at its end,” Buffett wrote in his most recent annual letter to shareholders. here “This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the future,” Buffett said. Gold, Buffett correctly points out, has benefited first from a fear trade, bought up by investors who worry that central banks and governments will engineer a raging inflation in order to erode away the debts they struggle under.

Secondly, as with all assets that rise sharply in price, gold has gotten a push higher by momentum buyers, those who add their money to the rush in hopes of getting out when the trend wanes. Remove those supports and gold should fall, sharply and rapidly.

THE BACKSIDE OF QE Buffett is surely right about gold’s inability to procreate or grow, but I think he presents the fear trade as too much of an all-or-nothing bargain. Gold is a kind of anti-investment, an insurance policy against the bad actions of other people.

Sure, it won’t invent a new widget and make you rich, but neither will it, like some company executives, overpay itself and re-price its share options. It is reasonable, given the recent run of data, to think that another round of quantitative easing is less likely in the U.S. That surely must reduce the current value of gold, which unlike dollar bills can’t be made to come into existence by a central banker.

But it is important to remember that the impact of QE isn’t over simply if the Fed no longer prints money. There is still the issue of how to retract the huge amount of liquidity from a recovering economy. It is important to note that longer-term U.S. debt has been selling off very strongly recently. That could be entirely benign, as it could simply reflect a more optimistic outlook for growth and hence a more normal outlook for inflation.

I’d worry, though, about what happens to inflation expectations if and when that move to higher rates is sustained. If the Fed has coaxed growth out of its cave it may then find it hard to get inflation back in its box. Gold is insurance against that, though like most insurance it most likely will never pay off, but has value anyway. “As an owner of gold (and of Berkshire Hathaway stock) I can categorically say I don’t own gold because I think the future will be dominated by monetary malfeasance. I own it because I think it might be,” Societe Generale strategist Dylan Grice wrote in a note to clients. An economic recovery, which is only a supposition at this point, does not solve the long-term indebtedness problem of U.S. and European economies, much less the demographic problem of Japan. It is a bit early to put those worries away entirely. Grice, cleverly, also points out that the correct comparison is not between stocks and gold but between cash and gold. Clearly Buffett understands the option value of cash. He is, after all, often ready to step in with a chunky cash investment when a company he admires is in need and gives him a good price. Like cash, gold offers a kind of option value, and is really simply another form of cash, though one with different risk characteristics than dollars, euros or yen. Like cash, or equities for that matter, gold is not an all-or-nothing proposition but a useful part of a portfolio.

(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)

(Editing by Jennifer Merritt and James Dalgleish)

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