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Daniel Nestlerode: Why Gold Works as an Investment

by on June 17, 2012 6:45 AM

Toward the end of the second Bush Administration, I began to notice that gold had been performing quite well for nearly seven years.

In those days, before the crash of the housing and banking, gold was an afterthought in many investment circles. The aftermath of the tech crash at the turn of the century was followed by easy money and a rapid expansion of the financial and the housing industries.

Like most rapid advances in specific industries, this one had the seeds of its own demise built in, and indeed that is exactly what happened. It was in this heady time that I began to add gold to the portfolios that I manage.

Since then I have added more exposure to the precious metal to the point where it is now 11.5 percent of the money that has been entrusted to me to manage for others. It is also my third-largest holding. Given this commitment to the yellow metal, I continuously review the grounding for my holding as I am charged with making money for my clients.

The gold market is very small compared to the stock market or bond market. It is, as we say in the industry, a thin market. Thin markets are often volatile, rising and falling in price faster than well traded equities or bonds. Gold is not a productive investment.

That is to say, investing in gold doesn’t create growth in our economy and doesn’t lead to more employment. Money parked in gold is money removed from the economy. Gold pays no dividends, and what’s more, if you own either the metal or the gold bullion-based exchange traded funds (ETFs), they carry annual costs to maintain.

The only way to make money in gold is if it rises in price, or as some say, the currency falls in value against gold. I prefer to hold the exchange traded funds because the prices are published daily and are easily traded. With all this in mind, why on earth would anyone buy and hold a commitment to the bullion price of gold?

The investment business is all about performance. Performance is measured and cuts through all the rhetoric and lands at the results. Over the past five years, gold ETFs have provided my clients a 57.76 percent profit, one of my better performing investments. Still, past performance doesn’t guarantee future returns, so the issue looms: Should I sell now or continue to hold on to my gold hoard?

The Federal Reserve was legislated into existence back around 1913 or so with the expressed purpose of maintaining the value of the dollar.

In 1913 gold was pegged by law around $20 per ounce. Fast forward to 2012, and the value of the dollar has declined 96 percent, while gold has risen from about $20 to around $1,600 per ounce. As some say, currency falls in value against gold, and it would seem that the Fed has some other agenda than defending the value of the dollar.

To be sure the rise in the price of gold has come in fits and spurts, so blindly buying and holding gold over the past ninety-four years has not been a nice smooth ride, but more like a scary rollercoaster.

The Fed now seems focused on stimulating the economy and protecting the banking system from any failures and promoting full employment (whatever that is?). That puts protecting the value of the dollar in fourth place in their hierarchy of important issues. So if the Fed keeps doing what it has done for the past three-plus years, this seems to augur well for the future price of gold. There are, of course, no guarantees here.

On the supply side, gold is devilishly expensive to find, mine and refine. Gold has value just because it is difficult to obtain. Politicians cannot legislate more gold into existence, like they can with paper money.

Furthermore, it seems unlikely that the world will sharply increase its supply of gold as it did when the Spaniards pillaged Mexico and Peru and hauled their plundered gold back to Europe. Even so, a rather large and unexpected find of gold could put the brakes on the rise in gold prices, so one must be vigilant.

Eventually, I will sell my gold holdings. Many years ago, during the early years of the Reagan Administration gold peaked at over $800 per ounce and declined in price over the following eighteen years. The policies that Reagan and his administration and then Federal Reserve Chairman Paul Volker put into place chilled the price of gold and other precious metals and spurred the return of money to the wider economy and the investment markets in general.

Stock prices bottomed in 1982 and went on a two-decade rise. If we elect a new administration this fall or if the current administration changes its economic policies, then I will rethink my gold holdings. Fortunately, my investment experience includes the past love/hate relationship investors have had with gold.

I don’t know if we are at the top price or close to it or have already seen the peak in gold prices (last September at $1,853 per ounce) or are just on the way to higher prices. You can bet, however, that I am paying close attention to the government’s actions and the electorate’s choices as they influence the price of gold.

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Dan Nestlerode is the Director of Research and Portfolio Management at Nestlerode & Loy Investment Advisors in State College. A graduate of Penn State University, Nestlerode has been an investment advisor since 1965. He can be reached at danielj@nestlerode.com.
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