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From The Vault: The Special Case For Gold – Features and Interviews – Hard Assets Investor

Written by Tom Vulcan   
Friday, 24 October 2008 10:18

 

[Editor’s Note: From The Vault is a new HAI feature that periodically highlights some of the best and most timeless content on our site. In light of recent market turmoil, Tom Vulcan’s gold piece seemed appropriate.] 

 

“Water is best, but, shining like fire blazing in the night, gold stands out supreme of lordly wealth.”

                            Pindar – First Olympian Ode

 

Since the Greek poet Pindar described gold in these glowing terms in 476 BCE, its identification with wealth has changed very little over the ages.

Indeed, priced as it is now and viewed against both the increasingly ragged backdrop of the U.S. economy and current credit crunch, its association with wealth, secure (or “lordly”) wealth, is particularly strong.

Why Buy Gold?

Three of the most fundamental reasons for buying gold are the following:

  • For economic security
  • For physical security
  • Against contingencies

 

For Economic Security

Gold is an excellent long-term hedge against inflation.

In the very long term, and despite sometimes quite significant short-term price fluctuations, gold has been shown to maintain its store of value in terms of real purchasing power.1 In other words, as the value, i.e., purchasing power, of the dollar falls (and inflation goes up), so the price of gold rises.

Unlike any of the world’s currencies, each of which represents debt incurred by the relevant issuing government, gold is not a liability. And since it is not a liability, it can neither be repudiated, nor its value undermined by inflation. This stands in stark contrast to the world’s paper currencies that, printed as they are, by “fiat,” always lose value in the long term (this can, and does, also happen in the short term.)

In addition, gold has been shown not only to provide a strong hedge against a declining dollar2 (when gold is traded throughout the world it is always bought and sold in U.S. dollars, i.e., it is nominally priced in U.S. dollars), but also to be a better hedge against the dollar than other commodities.3

For Physical Security

Gold is a secure asset.

In the past, when there was a gold standard, governments banned individuals from holding gold – preventing those individuals, in effect, from holding (and preserving) their wealth beyond the control of government. As the young Alan Greenspan put it in 1966: “In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case of gold.” Now, however, it can be freely held.

Held as an asset, not only is gold liquid, but it is also subject neither to the freezes nor to the imposition of exchange controls that can, at times, threaten other asset classes and currencies. As, once again, Mr. Greenspan put it back in 1966: “It [gold] stands as a protector of property rights.”4 It has a physical security not associated with any number of other assets.

 

Against Contingencies

Gold is an excellent “crisis” hedge.

Undisputed worldwide as a store of value, gold can be a form of “insurance” both in times of crisis and when there are extreme untoward movements in other asset classes. For example, during the period of hyperinflation in Germany from 1918-24, gold maintained its purchasing power while the value of bonds and stocks were catastrophically diminished.

Set apart as it is from other commodities because of its acceptability, portability, homogeneity and indestructibility, the market in gold is both universal and highly liquid. You can buy and sell gold around the globe. Even James Bond in “From Russia with Love,” traveled with some 50 British gold sovereigns hidden in his briefcase – just in case!

What Place Should It Have In My Portfolio?

Holding gold as a strategic asset can help you diversify your portfolio.

A long-term asset portfolio needs to be diversified. Diversification helps reduce both risk and volatility. The key to diversification is a choice of assets with returns as little correlated to each other as possible. Essentially, each of your asset classes needs to march to a different tune: Movement in one should be reflected as little as possible in the movement of any other.

Since there is little correlation (it is, in fact, low to negative) between the returns on gold and on financial assets, such as equities, gold can help provide just such diversification (i.e., when financial markets fall, the price of gold tends to rise, and vice versa).

Recent research5 into the difference between gold and other assets has demonstrated that, in the long term, there is no important correlation between changes in inflation, interest rates and GDP and the returns on gold. In contrast, such macroeconomic variables are strongly correlated with returns on such financial assets as bonds and equities.

The same research has also shown that changes in such macroeconomic variables have a much greater effect on the returns on other commodities (particularly non-ferrous metals and oil) than they do on gold.

A general market decline, therefore, will not be reflected in a general decline in the price of gold. Gold will, in fact, provide protection against such declines.

In addition to reducing risk, improving a portfolio’s diversification will also help to reduce its volatility. Reducing its volatility will, in turn, often result in higher compound rates of return.

While it is more usual to look at different asset classes when building a portfolio, in the case of gold, it is certainly worth considering it as an asset class in and of itself (rather than as an individual security within the commodities asset class) and, consequently, investing in it directly.

How much gold you should add to your portfolio, however, will depend upon the risk profile of your portfolio. If, on the one hand, you have a low-risk portfolio, the inclusion of gold can help enhance its performance. On the other hand, if you have a high-risk, high-return portfolio, gold’s strong lack of correlation to the equity and bond markets could help bring stability in times of either economic turmoil or falling markets.

 

Conclusion

Since timing the market is impossible and your investment in gold is for the long run, the important thing – many people believe – is that you buy it, not when you buy it.

While the recent surge in gold prices has brought speculators into the market, and has increased the short-term correlation between equities and gold, it has done little to rattle the long-term position of the metal as a good portfolio diversifier and a safe store of value.

 

NEXT UP: Base Metals

Precious metals are pretty, but base metals are where the real action happens.  Or see below…

 

ENDNOTES

1. Harmston, S. (1998) Gold as a Store of Value, London, World Gold Council.
2. Capie, F., Mills, T. & Woods, G. (2004) Gold as a Hedge against the US Dollar, London, World Gold Council
3. Kavalis, N., (2006) Commodity Prices and the Influence of the US Dollar, London, GFMS Limited
4. Greenspan, A. (1966) Gold and Economic Freedom, The Objectivist.
5. Lawrence, C. (2003) Why is gold different from other assets? An empirical investigation, London, World Gold Council.

 

LINKS FOR MORE INFORMATION
Doug Casey: The Case For Gold
Resource Investor
Gold Investing 101

Industrial Metals
Written by HardAssetsInvestor.com   
Sunday, 04 November 2007 13:13
Gold and silver may get all the glory, and look pretty, but when you want to build an economy, it’s the industrial (or base) metals that steal the show. As such, base metals have emerged as a key way for investors to tap into the rapid development of emerging economies like China. As China builds new apartment buildings and factories, it needs iron for the trusses, copper for the pipes and aluminum for the appliances.For investors just getting started, here are the most widely used base metals in the world, in order of global consumption.Steel (Iron)

The granddaddy of metals for most of the last millennium has been iron. Iron, by itself and as the major component in steel, is the most widely used metal in the world.

That would make it a great tool for investors interested in tapping into economic growth, except for one thing: There is no direct way to trade it. Unless you want to buy a few freight cars’ worth of I-beams, there’s no direct way to get exposure. This is likely to change, as the London Metal Exchange (LME) is currently working on plans for futures and OTC contracts tied to steel, but there are serious hurdles to overcome.

For starters, there are a huge variety of steel types in the market. What kinds of steel would the contracts cover? Carbon or alloy? Galvanized sheets? Cut plates? Fine grain? Atmospheric resistance? Fundamentally, a futures contract has to be based on a commodity definition that will be useful to suppliers and customers … and steel producers have been dead set against the development of a steel futures contract.

Until the LME and the producers figure it out, the best way for investors to access the steel markets is through steel-producing equities. Key players include Rio Tinto (RTP), Cia Vale do Rio Doce (RIO), Mittal Steel (MT) and Nucor (NUE).

Investors can also access the broad steel equities market through the Market Vectors – Steel (AMEX: SLX) ETF, which tracks the AMEX Steel Index, which includes 36 steel-related stocks.

Aluminum

After steel, aluminum is the most widely used metal on the planet. It is one of the key ingredients in the rapid expansion of infrastructure around the world, and demand for aluminum is growing.

What is aluminum? It’s light, pliable, rust-resistant and has high conductivity. Those features make it an incredibly important metal for industrial use, particularly for the transportation industry. Your car is mostly aluminum (and plastic), from the body to the axles and maybe even the engine. And that airplane you flew on your last business trip? Without aluminum, you wouldn’t have gotten off the ground. Even those cans of soda and beer the flight attendants passed around (if you were lucky) were made from aluminum: almost a full quarter of the aluminum produced today goes into those handy little containers.

Primary aluminum is mined out of the ground as bauxite ore, changed into alumina or aluminum oxide, and then finally smelted into aluminum. Bauxite deposits are mainly found in Australia, Guinea, Brazil and Jamaica. (At least, that was the order of production in 2000, the most recently available data.) The whole process is hugely energy-intensive, which means that the price of aluminum has some tie to the price of energy. Typically, smelters are located in areas with cheap energy.

Primary (new) aluminum trades on the New York Mercantile Exchange (NYMEX) with the ticker “AL,” and on the London Metals Exchange (LME) as “Primary Aluminum.” Recycled aluminum is traded as “Aluminum Alloy.”

Many investors, however, find it easier to access this market through equity plays. Key players include Alcoa (AA), Aluminum Corp. of China Ltd. (ACH), Kaiser Aluminum Corp (KALU).

Copper

Our friend copper has been around for ages. Everyone from the early Egyptians to your neighborhood plumber has relied on copper to make the world work. Today, copper is everywhere, from the coins in your pocket to the plumbing in your house to the power lines and the electrical plant down the way. Even the cell phone in your pocket relies on copper for its intricate circuit board.

The largest market for copper is building construction (pipes and wires), followed by electronics and electrical products, transportation, industrial machinery and consumer products. Because of the huge demand from construction, copper prices tend to fluctuate on economic indicators such as U.S. housing starts, Chinese GDP growth and other macroeconomic reports. In 2006, China accounted for about 20% of the world’s consumption1 of copper, and that percentage is expected to grow. In other words, reports from The Wall St. Journal of even the smallest shifts in Asian economies can push copper prices around substantially.

Where’s it come from? Chile is the big dog, producing four times the volume in copper of the No. 2 group, the United States. Peru, Australia, Indonesia, Russia are also big players, but more than anything, you need to think about Chile.2 In 2006, global mine production was less than expected because of production problems and labor disruptions in Chile, and this kept copper at record highs. Hiccups like this are increasingly being offset by recycling, but even with the U.S. pulling 30% of its copper from recycling plants, copper futures remain hugely volatile.3 Copper spot prices rose from $0.75/lb in March 2002 to over $3/lb in March 2007.

Plastic pipes anyone?

Copper trades under the ticker “HG” on the NYMEX.

Substitutions/Copper: Aluminum can be used for electrical equipment, power cables and automobile radiators. For heat exchangers, titanium and steel are used. In plumbing applications, plastics are the common substitute.4

Key Players:

Freeport McMoran Copper and Gold (FCX), BHP Billiton (BHP)

Zinc

The fourth most popular metal in the world’s industrial beauty pageant is zinc. Like aluminum, zinc comes in two flavors: primary (coming from mines, about two-thirds of what’s used) and secondary (scrap and residues).

Most zinc is used as a galvanizing agent to prevent corrosion in iron and steel – those rough gray nails you used to put down your deck, your galvanized steel fishing boat, etc. The rest of the zinc (about 25 percent) is used as zinc compounds in all sorts of other stuff: paint, agricultural products, plastics, rubber and as a raw chemical in medicines and supplements. That “copper” penny in your pocket is, at least if it was minted after 1982, mostly zinc.

Really, zinc is a condiment in the industrial metals world, like salt in the kitchen. It hardly ever gets used by itself, but it spices up other metals and makes them better. Because of that, it has historically followed the price fluctuations of base metals at large, particularly copper. That may, however, be changing: In 2006, zinc saw rapid price increases due to low stocks at the LME, increased world demand and tight world supply.

China, which exports a great deal of zinc, continues to wield the big stick in the market, followed by Australia, Peru and North America. Zinc can be traded on the NYMEX (LZ), at the LME (Zinc) and (as of March 26, 2007) at the Shanghai Futures Exchange (TA).

Substitutions/Zinc: When looking at substitutions for zinc, you’re looking to replace what zinc helps make. Plastics, steel & aluminum substitute for galvanized sheet. For corrosion protection, paint, plastic coatings and other alloy coatings are used. There are many elements that substitute for zinc in the chemical, electronic and pigment fields.

Key Players:

BHP Billiton (BHP), Teck Cominco Ltd. (TCK).

LeadLead, as anyone who’s picked up a car battery knows, is very heavy and dense. It is also a soft and corrosion-resistant metal. While it’s been abandoned in many applications due to environmental and health concerns, it’s still a major metal in global industry. The greatest use of lead is in Sealed-Lead-Acid batteries, which has seen continued growth, particularly in uses such as uninterruptible power supplies for computer applications and in machinery (like your car). Lead is also used in lots of smaller applications: ammunition, oxides for glass and ceramics, casting metals, sheet lead, solders, coverings and caulkings.

Lead was the best-performing commodity through the first nine months of 2007.

Nickel

Behind lead is nickel. Nickel’s primary use is as an additive to make stainless steel. The aerospace and power generation industries use it in combustion turbines because of its corrosion resistance, and it finds a home in batteries, coins and other applications as well.

Nickel has been much in the news recently due to sharply rising prices and supply constraints at the LME. The LME actually intervened in the nickel markets in 2006 when supplies got too tight to meet demand, a rare occurrence for any well-functioning market. Surging demand for stainless steel in China has caused the Chinese to fire up nickel pig iron processors, which (at a relatively high cost) can create stainless steel without true nickel.

Tin

Lastly, there’s lowly tin. Tin’s been around forever and is mined around the world, but almost half of what’s used now comes from Southeast Asia. Tin is used mostly as an alloy with other metals, but also has uses as a protective coating.

Tin hit an 18-year high on the LME in 2007, as rising demand and slow-growing supply caused a classic short squeeze on the markets. The tin market continues to be tight.

Accessing The MarketsAside from buying the futures or individual company stocks, there are a few approaches investors can take to the base metals market. For steel, there’s the aforementioned Steel ETF (AMEX: SLX) from Van Eck. For aluminum and the rest, European investors can buy individual commodities futures ETFs from ETF Securities, or baskets of base metal securities as well.

Stateside, investors have an increasing number of choices as well. The best-established base metals futures basket is the PowerShares DB Base Metals ETF (AMEX: DBB), which includes exposure to copper, aluminum and zinc. Newer iPath ETNs offer focused exposure to Copper (AMEX: JJC), Nickel (AMEX: JJN) or a basket of industrial metals (AMEX: JJM), including copper, aluminum, zinc and nickel. The ELEMENTS Rogers International Commodity Index ETN (RJZ) offers the most diversified basket of coverage, combining precious and base metals in an ETN and holding aluminum, palladium, tin, nickel, platinum, copper, gold, zinc, silver and lead.

On the equities side, the SPDR Metals & Mining ETF (AMEX: XME) lumps in everything from steel to aluminum, gold, energy, manufacturing and other issues. The top holdings are U.S. Steel, Freeport McMoran Copper and Gold, Titanium Metals and Consol Energy.

Conclusion

Base metals aren’t glamorous. They don’t make headlines outside of the commodities markets, and aside from Jim Rogers, you aren’t going to hear pundits on CNBC talking about what a great investment lead is. But here’s the dirty little secret about base metals: They have been by far the best-performing sector of the commodities markets over the past three, five and 10 years. Best by a mile.

NEXT UP: Agricultural Commodities

Exploring the softer side of the commodities market.

LINKS FOR MORE INFORMATION

The argument for base metals
The argument against base metals
How iron works
Copper Development Network
All About Aluminum
Lead Soldiers On

Agricultural Markets

Timber Markets: Strong As An Oak

Water: The Ultimate Commodity

Alternative Energy: Can It Compete?

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