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What Is Gold's Role?

Gold's role as disaster insurance in a time of easy money.

Michael Rawson, CFA, 12/05/2012

At a joint meeting of the International Monetary Fund and World Bank held in Tokyo in October, Federal Reserve chairman Ben Bernanke said that central bankers in emerging economies should "refrain from intervening in foreign-exchange markets, thereby allowing the currency to rise." Of course, for one currency to rise, another must fall. It can be argued that the Fed chairman was suggesting that the U.S. dollar is overvalued and could be due for a decline. 

Elsewhere Bernanke has emphasized on several occasions that monetary policy, controlled by the central bank, is doing all it can to spur the economy and that fiscal policy, the purview of the government, needs to be more aggressive. In recent decades, monetary policy has been run independently of fiscal policy. That said, many claim that the Fed has become increasingly politicized, and some politicians have gone so far as to suggest that Ben Bernanke be fired or that the government should strip control of monetary policy from the Fed and return to the gold standard. 

Meanwhile, though the Fed’s policies of quantitative easing are potentially inflationary, inflation has been benign to date. But many investors, fearful of equities since the financial crisis and spooked by the specter of inflation in an era of "QEternity," have increasingly considered gold for their portfolios. Gold has historically proved to be an effective inflation hedge, and a declining dollar is positive for bullion prices. But just what role should gold play in a traditional stock and bond portfolio? In this article, we will examine where gold might fit in your portfolio and highlight our favorite exchange-traded funds that offer exposure to the yellow metal. 

Hard to Value, Hard to Ignore
Unlike productive assets such as farmland or dividend-paying stocks, gold seems to lack the fundamental characteristics necessary for valuation. With gold there will be no stream of widgets to sell or cash flows to discount. Warren Buffett famously mused on gold: “[Gold] gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.” While Martians may be scratching their heads, it seems that many rational investors covet gold. Ben Bernanke has argued that gold is not money and that it is held by central banks largely out of tradition. He has also offered some insight into the way many investors value gold. The Fed chairman has said that people hold gold as a protection against tail risk--low probability events with big implications. These so-called “black swans” might include a massive sell-off in the stock market or hyperinflation. 

Reliable data for gold prices from the London Bullion Market Association extends back to 1973. If we regress the price of gold on movements in the stock market and next year’s inflation back to 1973, we find that the price of gold responds positively to both increases in inflation and declines in the stock market.

Two time periods play a big role in explaining this relationship. The stock market fell 15% in 1973 and a further 26% in 1974. Meanwhile, inflation jumped from 3% in 1972 to 9% in 1973 and ramped up to 12% in 1974. During this span, gold proved a fantastic inflation hedge, climbing 73% in 1973 and 66% in 1974. Gold proved its worth as a tail-risk hedge again during the most recent financial crisis, rising 4% in 2008 when the S&P 500 Index plummeted 37%. For the 10 years through year-end 2011, gold was up 450%, trouncing the 30% return of the S&P 500 Index.

The charts below show the annual performance of gold based on sorting and bucketing stocks or inflation into five buckets.

  - source: Morningstar Analysts

Michael Rawson, CFA is an ETF Analyst with Morningstar.

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