Saturday, July 24, 2010

A Contrarian's View of Gold

By ALAN ABELSON | MORE ARTICLES BY AUTHOR

A savvy analyst holds that long-term, the yellow metal could be " fraught with risk." A look at what's causing quality stocks to lag behind the market.

WE'RE ALL GOLD BUGS NOW! And were he still among the quick, that consummate speculator, John Maynard Keynes, would be stocking up on the barbarous relic along with the rest of us.

How could he resist? Thanks in no small measure to the mischievous trashing of so much of the world's paper money, conspicuously including the once-almighty dollar, gold has been on a tear, shooting up some fivefold in value since 2002. In the process, it has exerted a powerful lure for the most unlikely investors, from leverage-loving hedge funds and the casino crowd, who long regarded the yellow metal with nothing but disdain, to staid, adventure-shy institutions and just plain folks, drawn to its ever-brighter glister.

Besides its attraction as the currency du jour, one of the few mediums of exchange that have bucked the tide of debasement, gold, in keeping with its hoary tradition, revels in the world's misery. It has been touted by its growing army of fluttering fans as an all-purpose investment, a hedge against inflation and deflation, whichever at the moment seems more imminent.

Unlike unicorn horns or Confederate dollars, gold is incredibly durable—not only physically, but in terms of the regard it earned down through the eons, despite war, famine, pestilence and all the other bad stuff to which man is prey.

It hasn't hurt its appeal, either, that the alternatives—equities, mundane commodities and less-than-stellar-quality bonds—have within recent memory blown away their devotees like a haystack in a tornado. All of which explains why we were dumbfounded when a report on this most precious metal crossed our desk warning that the long-term outlook for gold was—are you sitting down?—"fraught with risk."

Please, put down those pitchforks, pull up those stakes, douse the fires. The author of the report is not some wild maniac bent on discombobulating decent, gold-loving citizens, but a quite sensible fellow named Peter Berezin, who toils for the prestigious Bank Credit Analyst. If it helps slow your pulse a bit, be assured that in rendering his caution, he takes due note of gold's lustrous virtues.

He points out that in real dollars—that is, adjusted for inflation—it's still 47% below its 1980 peak. Put another way, if it climbs back to that high, scarcely unimaginable, in nominal dollars, gold would weigh in at $2,360 an ounce, or nearly double the current price.

Indeed, Peter does expect gold to get a lift for the next year or so from, among other things, stepped-up central-bank purchases, incredibly low real interest rates and what he dubs a "brewing speculative mania"—investment in gold, including exchange-traded funds, over the past three years has tripled.

But obviously in sympathy with that endangered species—the long-term investor—Peter worries that "while global mining output is likely to trend sideways at best over the coming years, the amount of gold held in vaults and ETFs will remain sizable." And, daring to think the unthinkable, he posits: "Should gold investors become less enamored with bullion, this inventory will hit the market" with decidedly unpleasant consequences for the metal's price.

On that score, he gets some support from Barclays Capital's latest commodity forecasts, which sees gold averaging $1,195 an ounce this year, $1,180 next year, $1,010 in 2012 and $850 for "the long-term." (Let us interject here that while we've found Barclays top-flight in its commodity reporting and analysis and spotting trends for the long pull, we suffer from an abiding skepticism about any precise projections about anything out further than the tip of the forecaster's nose.)

To Peter's credit, he concludes his analysis with specific advice to investors on what to keep an eye on as hints that, after its glorious run, gold might be starting to lose it magnetic allure. He cites a half-dozen early-warning signals:

1) An increase in real interest rates, which he feels are bound to rise as the global economy continues to recover.


2) A decline in inflation expectations. Disinflation, he notes, is "gold's archenemy" and, he believes, over the next few years, deflation is the biggest risk.


3) Evidence the European sovereign-debt crisis is fading. If and when that happens, the appeal of gold as a "currency of last resort" will diminish and prompt the market to price in more central-bank tightening.


4) A further increase in the trade-weighted U.S. Dollar Index. He views the greenback as "among the best houses in a bad neighborhood" that, over time, will strengthen against the euro and the yen, sparking a reassertion of the negative trend between bullion and the trade-weighted dollar index.

5) A spike in speculative interest in gold, perhaps aping the wave of retail buying that marked the peak of the early 1980s bull market in the metal.

6) A further increase in the cost of put and call options on gold compared with those on the Standard & Poor's 500. Currently, Peter observes, it costs $2.70 per $100 to insure against a 10% or greater drop in the SPDR Gold Trust (ticker: GLD), versus $4.20 per $100 to insure against a comparable decline in the S&P 500. "The higher upside that investors are assigning to gold," he avers, "is at odds with the fact that historically, equities have trounced gold as an investment."


And Peter suggests that while "the nimble investor" may still profit handsomely by riding the upward momentum in the gold market, long-term investors might be well advised to lighten up on their gold holdings.


EARNINGS, SOME INVESTMENT wizard once discovered, are the final market determinant. While his name has been lost in the impenetrable mists of anonymity, his splendid insight lives on. And it was most apparent in last week's sharp swing upward after a stumbling beginning.

We happily subscribe to that precept. Our only reservation is that it's a bit incomplete. For, in fact, earnings are the final market determinant—until they're not. Most commonly, they cease to be when something a good deal less tangible but not infrequently more powerful—emotion—takes over. When, that is, investor buoyancy morphs into euphoria.

The best recent example was at the end of the last century, when the dot-com boom, which began as a gradual appreciation of the vast potential of a new technology, wound up in one of the most spectacular speculative sprees ever. As in all such hyper episodes in which reason takes a back seat to mania, it ended in tears.

Forgive our tendency to sermonize, but we do detect disturbing hints that solid earnings gains are not the only force at play in the current equity surge. Even allowing for investors' natural bullish bias—hey, why else would they be willing to put their dough in a dangerously erratic market rather than stick it under the mattress?—there's a noticeable tendency to shrug off abounding bad economic news, like the rise in new claims for unemployment insurance and the decline in the leading indicators, and seize on the most improbable excuse to take a fling.

And not the least of the silly things investors, juiced by higher stock prices, do is credit what Ben Bernanke says. Last Wednesday, for example, they got jittery when the chairman in effect told a Senate committee that he was going to stand pat on further stimulus. Mindful that the market expressed disquiet, he changed his tune overnight, on Thursday assuring a House committee that the Fed was ready to take action, if necessary, to buck up the economy. And the market, without even a moment's thought as to whether the same old, same old would work, breathed a sigh of relief.

And how could anyone over the age of five really believe the European banks wouldn't pass those highly publicized stress tests? (Of the 91 institutions that took the test, a mere seven flunked.) The only real stress was on credulous investors.

Yet on Friday, when the preordained results were made public, the market went up triple digits.

Investors may not yet be euphoric, but they sure are giddy.


IN GMO'S QUARTERLY LETTER, the estimable Jeremy Grantham wonders why quality stocks have lagged in both last year's mighty rally and again this year. And in seeking an answer, he comes up with some interesting possibilities. One is what Jeremy calls the "population profile." There are, he explains, more retirees per new worker than there used to be, and they're selling stocks to pay the bills and buy more conservative fixed-income securities.

By the time they're retired, more than likely, he suggests, they own blue chips, having dumped most of their speculative holdings in the decade before they stopped working. "This is just a guess," he concedes, but it seems eminently reasonable.

He offers another reason for the dilatory movement in quality shares, one he thinks is "accompanied by stronger circumstantial evidence." And that's something he dubs the "let's all look like Yale syndrome."

In the past decade or so, Jeremy points out, institutions and ultrarich individuals (aka, really fat cats) have been upping their stakes in private-equity and hedge funds, commodities and real estate, even venturing into foreign stocks, including emerging markets and small caps. Hedge funds tend to take the position that they don't get paid to buy the likes of Coca-Cola, while private-equity funds, particularly these days, don't go after the great franchise companies.

So what, he asks, is being liquidated to buy all that new stuff? Among other things, old-fashioned blue chips. Jeremy reckons quality stocks might spend much of the next several years underpriced, but "from time to time, will bounce back to fair value." Which, he declares, is "all patient investors need."

.Email: alan.abelson@barrons.com