Gold investment

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his article is part of our Rising Star Portfolios series. Follow all of Alex’s trades and musings on Twitter.

Gold is a hot topic among investors these days. Some are arguing that the gold run is just getting started. Others argue that we are in a gold bubble that is poised to pop. Still others maintain that gold is a store of value — a way to protect their wealth. I don’t agree with any of these arguments, but I will put forth one of my own: Having a strong conviction about future gold prices is arrogant.

What exactly are you analyzing?
However dazzling, gold comes up short when it comes to:

  1. Cash flow analysis (no cash flows).
  2. Any kind of practical fundamental analysis (there are no bottom-up fundamentals).
  3. Any realistic absolute valuation technique.

What we do have is economic data about gold. The data tell us that total 2010 demand for gold amounted to 3,812 tonnes. On the supply side, mines pumped out 2,543 tonnes of gold in 2010. Adding in “recycled” gold (think Aunt Betty trading in her gold trinkets) coming back into circulation, the total supply entering the market last year was about 3,900 tonnes.

Demand of 3,812 tonnes, supply of 3,900 tonnes … sounds like market equilibrium! Not exactly.

The real numbers
Those supply and demand numbers are annual figures. Unlike most commodities, very little gold is actually consumed each year (a fact that may preclude gold from being called acommodity). In other words, supply is in a sort of perpetual long run while demand, well, isn’t.

World total supply of gold is currently about 162,000 tonnes. Mining output adds just 1%-2% to this supply. To put in context how little that is, consider this: If you were to buy all the gold that traded on the London bullion exchange on an average day, you could purchase an entire year’s worth of new gold supply in just four days.

Pure industrial demand — demand for gold that will actually be consumed in some value-creating activity — accounts for just one-quarter of 1% of supply. That’s essentially a rounding error, and it means three things: (1) gold can’t be analyzed based on demand for it in business operations; (2) demand needs to increase about 1%-2% annually just to maintain gold prices; and, most importantly, (3) gold prices change based on investor sentiment, not the underlying industrial value of gold. This last point is key. If you are going to have an opinion on gold, you had better know who owns and trades it.

Where did all the gold go?
If there are 162,000 tonnes of gold out there, and just 420 tonnes or so are consumed each year, the obvious question is, “Who owns all that gold?” Let’s divide the owners into three groups.

  1. Central banks. Central banks collectively hold about 30,000 tonnes of gold, accounting for 18% of supply. There seems to be a misconception that central banks have been aggressively acquiring more gold — in fact, their sales and purchases just about broke even last year.
  2. Exchange-traded funds. Gold ETFs own surprisingly little actual gold. The largest,SPDR Gold Trust (NYSE: GLD  ) , holds only 1,213 tonnes, or just 0.7% of supply. Other ETFs, such as the iShares Gold Trust (NYSE: IAU  ) , own even less.
  3. Everybody else. After subtracting gold held by central banks and ETFs, we still have 80%, or about 130,000 tonnes, left to account for. The two remaining groups are institutional investors and retail investors. It’s next to impossible to determine the split between these two, but it seems safe to say that a ton (pun somewhat intended) of gold is held by retail investors. This scares me, and it should scare you.

What’s so scary?
All investors can be victims of their emotions, but none suffer worse than the average retail investor. Fund flow data from mutual funds show that investors routinely buy high and sell low, riding alternatively waves of emotion-driven greed and fear at precisely the wrong times.

Why does this make gold scary? Benjamin Graham, Warren Buffett’s mentor, said that the market is a voting machine in the short term, but a weighing machine in the long term. What he means is that, in the short term, stock prices are influenced by emotions and popularity, but in the long term, the market will price stocks based on their fundamental value. Well, what happens when the asset not only has no fundamental value, but is primarily owned by the most emotional of investors?

Fear — of inflation, depreciating currency, political unrest, economic stagnation, or recession – is a primary driver of retail-level investment in gold. Combine that with the notoriously emotional, fear-and-greed-driven investments these investors make, and one thing is clear: If you are going to reach a conclusion about gold, that conclusion had better be based, at least in part, on your perception of the general investing community’s perception of fear-inspiring macroeconomic variables. And if you think you have an edge at reading fuzzy macroeconomic data over millions of worldwide investors, you are undeniably arrogant.

Good luck with that.

Unwitting Angels: When Fund Investors Become Bankers

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The plan sheds light on a little-known occurrence: the use of a fund’s assets to provide life support to borrowers that can barely make interest payments on bonds already owned by the fund. Such loans are rare but could become more common, say fund experts. In a sense, investors are being asked permission to have their good money thrown after bad. On the other hand, these loans can forestall or even prevent losses from a default and can provide extra income. The Nuveen proxy statement says that, if investors approve the proposal, the funds could lend to an issuer of distressed municipal bonds to “facilitate a timely workout of the issuer’s situation” and if such a loan “is the best choice for reducing the likelihood or severity of loss on the fund’s investment.” The resulting loan would be privately negotiated between a fund and the issuer and thus probably wouldn’t trade. Its value on the fund’s books would be estimated by the managers in conjunction with an outside valuation service. John Miller, co-head of global fixed income at Nuveen Asset Management, says the firm’s funds don’t hold any bonds from issuers that it believes are in immediate need of direct loans like these. “We don’t have any specific situations under consideration right now,” he says. “My prediction would be that this [kind of loan] might come up once every few years and is likely to [apply to] a very small portion of any particular fund.” He adds that it is highly likely that the loans would be collateralized, or secured, by income-producing assets. Other Nuveen funds already have investment policies giving them the “flexibility” to make such loans, says Mr. Miller. To the best of his knowledge, he says, “We’ve only done this [kind of private loan] on one occasion in the past, but we want all our funds to be equally prepared if this comes up in the future.” Hugh McGuirk, head of the municipal-bond department at T. Rowe Price, says such private loans are rare. “In my 18 years,” he says, “it’s in single digits, the number of times we’ve done this.” But, Mr. McGuirk emphasizes, his firm has made such loans only to higher-quality borrowers that temporarily need cash, rather than to issuers in distress. Are private loans to a struggling municipal borrower in the best interests of a fund’s shareholders? It can take months for a municipal issuer to hire an investment bank to raise new capital in a formal offering, whereas a quick cash infusion could tide an issuer over. That could keep the fund’s existing bond from defaulting and buys time until the local economy improves or a project is completed and begins to generate revenues. Meanwhile, the borrower should pay an attractively high rate to get quick cash, say portfolio managers. Whether out of opposition or apathy, not enough shareholders voted on Nuveen’s proposal to achieve a quorum, so the close of the voting period has been extended from July 25 to Aug. 31. “My sense is that this may be a new wave in connection with municipal securities,” says Barry Barbash, a partner at Willkie Farr & Gallagher who formerly headed mutual-fund regulation at the Securities and Exchange Commission. Says Jane Kanter, a mutual-fund attorney at the law firm Dechert: “You’d think other fund companies are actively looking at this even as we’re speaking, saying, ‘Wait a minute, this is a good idea. We need to have this.’ ” Your fund’s “fundamental investment policies” should indicate whether it is authorized to make loans. In the schedule of portfolio holdings, watch for those designated with a footnote signifying that they are illiquid securities. By checking to see if the number of those holdings rises sharply from one period to the next, you should be able to detect whether your fund has gotten into the distressed-lending business. In the brave new world of a financial funk that just won’t seem to lift, fund investors may need to get used to the unsettling idea that we could all be bankers now.