If Loving Gold is Right I'd Rather Be Wrong

I just finished a unit on finance in a math-for-non-math people course I'm teaching this summer. In the finance unit we cover some models and equations that determine the future value of investments, and after class, over several days, three different students asked me what I thought about gold as an investment. One student told me that her uncle was converting all his savings into gold. I blinked hard, twice. Recently, almost every other commercial on Sirius-XM's CNBC channel urges you to buy gold directly from a company that will ship it to your door or help you convert your savings to gold stored in one of their vaults. More than once during the past three months I have talked to someone who is converting a meaningful part of his 401(k) to gold. Gold, gold, gold. With the governments around the world printing so much money, shouldn't we just buy gold, gold, gold? Everyone is doing it! 

We should not do it precisely because everyone is doing it.

I had a boss in 1997 whose only investments were shares of Apple (AAPL) and gold ingots in his safety deposit box, two assets that, at the time, had been left for dead by the investment community. Well, if he still has those assets, he has done quite well on both. If he bought gold for about $300 per ounce, he is up about 400% versus about a 20% gain in the stock market, if that. My former boss knew precisely when to buy gold (or any investment): buy it when no one else likes it, when everyone scoffs at it. Ha, ha, investors said in the mid-nineties, I won't dirty my hands with gold. Yet, gold runs in long bull-market cycles, decades long; however, my claim is that even if gold doubles from $1500 to $3000 per ounce over the next three years, you are still better in stocks, many of which will do better than that. The steepest part of gold's run we've already seen.

What does gold really do? Gold is primarily used as a hedge when investors fear currency will loose its value because of inflation, but inflation is not always bad. A little inflation is actually good for investors. After all, it's ugly cousin, deflation, destroys wealth by reducing the value of all assets. A little inflation lifts the value of most asset classes. It's hyperinflation that we don't want. My claim is that we won't see hyperinflation (think Weimar Republic in the 1920s), which would force us to use scientific notation to order a coffee.  Still, the truth is that even in moderate inflation, stocks do well, especially stocks that can pass on their input costs to consumers. If you hold cash or bonds during inflation, you loose money at a very fast rate. 

Most people think that the U.S. Federal Reserve's current monetary policies are too loose and are introducing too much money into the system; that flood of currency, most claim, has forced commodities like oil and gold to shoot up in price. I disagree. If there were truly too many U.S. dollars in the system, gold and oil would not be going up in value in terms of other currencies as well. The Federal Reserve is introducing money into the system in order to replace all the dollars that went to money heaven during the economic disaster of the last few years and hasn't come close to replacing all that lost money; finally, oil is high because fear of future unrest in the Middle East (or whatever other fear you want to insert; oil traders are a panicky lot) and because of too much oil speculation by investors, not inflation. So inflationary fears have caused the appearance of inflation, not real inflation. Gasoline costs so much, in part, because people like us can trade oil futures, and that is scary. Gold costs so much because investors and citizens alike are afraid of inflation; hence all the commercials urging us to buy gold.

This gold bar is worth about $600,000 at today's gold price.  

Now I'd like you to imagine that you did what my student's uncle is doing, namely, convert your savings to gold. How big a nugget would you have? The picture above shows a gold bar that is worth roughly $600,000 using today's market price. Do you have $600,000 to invest in this gold bar? Would you be satisfied putting this in your safety deposit box? It won't pay you dividends; it may increase in value but probably not at the same rate it has over the past several years. It is pretty, though, I guess.

Here's what I'm buying instead of gold: the not-so-shiny metal aluminum---or, actually, Alcoa (AA), a producer of aluminum. If the Federal Reserve is creating inflation, then AA shares will increase in value. If the inflation we think we're seeing is just the expectation of inflation, brought about by speculators, then AA will also increase in value. The stock trades at around $16.00 and has run up a bit too much in recent days because of an oversold bounce in the stock market in general. But you'd be safe initiating one quarter of a position in AA at these levels and waiting for pullbacks this summer to add to that position and, therefore, lower your average purchase price of the stock. The stock with a 14-handle or below is a clear buy.

A one-year chart of Alcoa. I will be adding to my position on any pullbacks.

You see, Alcoa, historically has been a cyclical stock that trades in the lower teens in a recession and then trades in the mid-thirties when the economy is roaring. I plan to collect many shares of AA in the low teens and then sell them at thirty or beyond in a few years. I may not even get the chance to wait that long. If the global economy takes off again in a few years, which I believe is the case, a large international miner or industrial company may buy Alcoa, paying us shareholders a nice premium on our shares before the cyclical top of the economy. Furthermore, the company typically increases its dividend as the economy starts to grow. Right now the dividend is a paltry 3 cents per share. When the stock traded around $40, Alcoa paid a quarterly dividend of $0.17. As the economy and earnings improve, Alcoa will want to return more cash to shareholders, which will boost its share price.

Gold doesn't pay a dividend. It's just shiny, and the only reason gold stores any value is that we've all agreed to let gold store value. My bet is that by next summer aluminum will outshine gold.