Why own gold
Gold is first and foremost a form of financial insurance – protection against the periodic setbacks suffered by traditional paper assets, including stocks, bonds and paper currencies, particularly the US dollar.
In the last several years, we have seen gold fulfill its role as financial insurance in the face of a series of crises involving everything from terrorist attacks to massive bank failures. But as recently as the 1990s, gold’s key role as financial insurance was not so apparent to investors. The 1990’s were characterized by rising stock markets, a strong dollar, low inflation, stable interest rates, peace and prosperity. Most investors saw little need for gold in their financial plans.
At ITM Trading we believe that gold must be a permanent fixture in every portfolio.
Historically, there have been eight principal
factors that have led to rising gold prices:
High inflation, or the fear of high inflation
Gold is renowned as a hedge against high inflation. The last time America saw double digit inflation, the price of gold set new records, soaring to an all-time high that was not surpassed again for a quarter of a century.
A decline in the U.S. dollar or other key world currencies
Gold is bought and sold in U.S. dollars, so most declines in the value of the dollar causes the price of gold to rise. In addition, the depreciation (or deliberate devaluation) of any currency causes the price of gold to rise in terms of that currency.
Turmoil in stock markets
The most effective way to diversify your portfolio and protect the wealth created in the stock and financial markets is to invest in assets that are negatively correlated with those markets. However, there have been times in recent history when gold has performed well while the Dow was rising (2002-2007). Gold is the ideal diversifier for an equity portfolio, simply because gold has traditionally risen as other asset classes fall.
The economic and financial forces that determine the price of gold are vastly different from those that determine the price of stocks. The value of a stock depends on a company’s earnings and growth projections. The value of a company’s debt instruments depends on their safety and yield. The value of gold, on the other hand, depends on factors such as political and economic unrest, currency fluctuations and inflationary expectations. Almost universally, those factors that boost the gold price serve to depress the price of equities.
While there are exceptions to every rule, there are significant historical examples which serve to illustrate this axiom vividly:
Spiking interest rates
The price of gold tends to increase as interest rates rise. Although many investors seem to think that hikes in short-term interest rates halt inflation in its tracks, the historical evidence does nothing to support that notion. Higher interest rates are inflationary in themselves since they raise the cost of borrowing by making loan payments higher and increasing the cost of living.
Banks are a key component of the the world economy and when major world banks fail, the entire world economy shudders. Included in the category of “banking crises” should be the failure of big investment banks like Bear Stearns and Lehman Brothers in 2008.
Because people tend to view banks as among the safest places to keep their money, when the entire banking system is weakened, people tend to lose faith and seek the safety and security of gold.
Oil and other commodity price shocks
The relationship between gold prices and petroleum prices has been discussed, analyzed, and examined extensively over the past three decades. Although the prices of gold and oil don’t exactly mirror one another, there is a general correlation. If oil prices rise or fall sharply, investors can usually expect a corresponding reaction in gold prices.
The fundamental reason for the correlation is that higher oil prices lead to higher rates of inflation at the same time that they reduce the real rates of growth in industrialized countries.
International loan defaults and other debt crises
As governments or public companies default on loans or other debt obligations, the public becomes distrustful and begins to lose confidence in government, financial institutions, and paper assets. Uncertainty in the financial markets drives people to the security and value of gold.
Throughout history, tensions and crises around the world have disrupted international commerce, distorted economic conditions, and threatened the vital interests of economically developed nations. During these periods of international crisis, gold is the best form of financial insurance to protect your portfolio. Through periods of truly serious international tensions involving military conflict, gold has proven to be vital to investment portfolios. Because the world is a dangerous place today, you should take these lessons from history and include gold in your portfolio.