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November 2010

Market Commentary

By: Wabash Capital Investment Committee

This year, our clients have asked us more about gold than any other asset class.  It’s easy to see why.  Over the past decade, gold has risen nearly five times.  Since collapsing in price during the credit crisis in 2008, gold recently has risen to new highs above $1,300 an ounce.  Gold investors hammer the table that buying gold is the only reasonable action to take in the current environment where the Federal Reserve is actively printing money.  Their well thought out argument suggests all of these new dollars flooding our economy will eventually lead to hyperinflation, driving gold and other commodity prices sky high.

Because gold does not pay a dividend or produce a cash flow, its only return is a higher future price.  A gold investor’s future return is completely reliant on future investors paying more than they paid.  Gold’s primary drawback today, in our opinion, is that prices have risen so consistently for such a long time that quite a bit of inflation expectation has already been priced into gold.  Never mind what might happen against the backdrop of potential deflation, something that cannot be discounted given recent data suggesting consumer prices are actually moderating.

Most investors see gold as the perfect hedge to rampant inflation ahead.  In reality, though, if real inflation ever arrives, it could be quite bearish for gold prices. Here’s why.  If inflation takes hold, the financial markets will begin to price in the Federal Reserve’s reaction to inflation (re:  raising interest rates).  The Federal Reserve has maintained that fighting inflation is their core mandate, and if it takes hold in our economy the Federal Reserve will undoubtedly raise rates to kill it.  If there really is too much stimulus going into the system today, the Fed will have to raise rates a lot in the future.  This will have a cooling effect on the economy and gold prices will decline in response.

As a frame of reference, the last time gold had a decent run was during the inflationary 1970s.  Gold climbed from $35 an ounce in 1970 to over $800 an ounce in 1980.  Once Ronald Reagan appointed Paul Volker to be Chairman of the Federal Reserve, he established the Feds credentials as an inflation-killer by raising rates dramatically.  How did gold investors fare?  From a high of $850 in 1980, gold declined to a low of $303 in 1982.  Gold investors did not see those 1980 highs for 26 more years, meaning their 28 year total return was 0%.  Now it is true that had you invested in gold in 1970, even the lows reached in 1982 produced a very nice return.  But the lesson is clear --- gold’s ability to hedge inflation is weakened as its price rises, and gold prices can be stagnant for a long time if inflation remains low.

While we think the Federal Reserve will be vigilant in stopping future inflation, we do think it is prudent to consider the potential for future inflation when investing.  Fortunately, the tools to hedge inflation have expanded over time.  We favor the use of U.S. Treasury Inflation Protected Securities (TIPS) to hedge inflation risk.  They have been an excellent investment this year, outperforming other U.S. Treasuries.  Because the principal rises at a rate equal to the rate of inflation as measured by the Consumer Price Index, any uptick in inflation will register in these securities, and they have the added benefit of protecting your initial capital investment from serious loss if inflation never materializes. 

For equity investors, keeping a portion of your investments in international stocks provides a hedge to domestic inflation driven by a weakening dollar.  Just recently, we modestly increased our international exposure by adding an allocation to emerging markets, the fastest growing sector in global equities.  This investment has the added benefit of having an outsized exposure to commodities, many of which have intrinsic value due to their use in the manufacturing process for electronics and for many agricultural uses.

To summarize, while we do think gold can be a good long term hedge to inflation, its current price makes it a less effective hedge than it was ten years ago, and one should think carefully before making a big commitment to it today, especially given the many other option available to investors.

Members of the Wabash Capital Investment Committee:

Donald Edwards, CFA  Committee Chairman

Chris Doll

Jim Exline