Is It Time to Sell Gold?

In 30 years of investing, June of 2009 was the first time I've purchased gold. Investors are asking if it's time to give in to the contrarian impulse to sell gold now. But with gold in rally mode and now within a whisper of $1,400 per ounce, you can see why I'm glad we own it. I agree that gold is not something you buy and stick in the portfolio forever. But selling now might be a bit too soon, based on valuations, momentum, and the advent of QE2 (the second round of Federal Reserve "quantitative easing," which is also known as printing money like there's no tomorrow...or at least like tomorrow's consequences don't matter).

Investors don't own gold for its earnings power. You can use earnings to try to sort among the gold alternatives, but a better measure is the value of the gold in the ground. If you do use an earnings-based methodology, you have to use an inflated P/E on the earnings power, with target prices set at about 30X earnings. And that’s not just in this frothy environment, but that’s looking back 15 years. Gold companies simply don’t qualify as a low P/E “value” investment.

However, there is a time for “growth” and a time for “value.” Each style has its day in the sun. To really excel, you need to be more flexible and let the portfolio characteristics drift according to the current market environment. Legg Mason’s Bill Miller lost a lot of money by investing in “value” in 2008, because the best “value” stocks were in the financial sector – and cratered. We are not completely style agnostic. I do have a value bias. However, we are flexible so that if the market isn’t rewarding that style, we can go elsewhere. For example, we can go to gold.

It is also true that gold hardly qualifies as a contrarian investment at the moment. However, the time that you make the most money is as the market is changing its opinion on an asset from “out of favor” to “in favor.” For a period of time, it makes sense to ride the investment up with the herd.

If you look at the gold-vs-stocks valuation, gold is just slightly above its normal price. I would guess that gold would have to reach $2,000 per oz., or the stock market would have to drop 50% or more from current levels, before the value of gold, in comparison to the stock market, looks as rich as it got in 1979/1980, the last major peak. Though it’s making “new highs,” it’s not necessarily incredibly overvalued. Nonetheless, when the major upward trend in gold ends, it’s not an asset class that I want to own forever.

I agree with pundits who say that it’s best to prepare to get rid of gold on a moments notice. We won’t be right to the split second. We won’t catch the exact top. However, it’s one of the best trends in the market right now, and as the tech bubble showed us – tops are almost as difficult to predict the timing (exactly right) as bottoms. I don’t want to walk away from the most profitable area of the market, while it’s still working better than anything else.

Finally, there is the current monetary trend toward currency debasement. In a grand experiment to avoid the consequences of too much leverage, the Federal Reserve has announced $600 billion in QE2 spending. In the boldest off-balance sheet maneuver seen since Enron took the practice to new heights a decade ago, the U.S. Government is extending its current practice of expanding the size of the Federal Reserve balance sheet, which is not counted in the normal government accounting conventions, as if this explosion of currency doesn't matter because it's not on the official balance sheet.

Our concerns about whether investors will continue to buy U.S. bonds have not yet come to pass. As a result, the economy continues to expand based on lower borrowing rates for U.S. companies, which are issuing 30-, 50- and even 100-year bonds at rates so low it would make Bernie Madoff blush. Until the market starts pricing debt rationally, the current rally may be safe. It certainly doesn't pay to hide in money market funds while others make money. Of the things we own, however, gold seems like the safest bet to continue rallying, long after the bloom is off the rose in other types of investments because too many dollars chasing the same amount of goods is the textbook definition of inflation, and eventually that will be the result of today's easy money policies.

The increase in the price of gold and other commodities, in the face of relatively anemic economic growth, especially in the U.S., is probably an early indication of what is to come. The price off "stuff" will keep going up, and the ability of U.S. consumers to be able to pay for it - in dollars - will lag behind. Rising oil and natural resource prices will eventually trickle down to the U.S. consumer, and leave less income in the bank account each month for eating out, or travel. We are seeing hints of what is to come, but before it is over it will be a 2-by-4 across the forehead of Americans everywhere. Even Federal Reserve economists will understand it, by the time this ends.

Protecting against the downtrending dollar means, naturally, not owning things demonated in U.S. currency - especially U.S. government bonds. Additionally, owning natural resource investments, which are priced in dollars and will inflate to compensate for the declining value of the U.S. dollar, makes sense. Energy and commodity investments are starting to make a comeback, and we will invest in them as soon as they can sustain enough momentum to become buy-able in our discipline.
 
 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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