Gold is a sterile asset that yields neither interest, dividends nor rentals and costs money to hold, but its price has surged to record levels, doubling since 2001.  Why? Who is buying it and what are their reasons?  How is its performance linked to the condition of the world economy and, especially the health of the US dollar?  And, most pressingly, how can you decide whether it represents a useful way of diversifying your portfolio, an asset you should include in your pension provisions – a good investment or an overvalued bandwagon?

Goldwatcher explains the pros and cons of gold as a twenty first century investment – when investing makes sense, when prices make sense and when they don’t.  The book addresses everything the independent investor needs to know about investing in gold.  It  addresses gold’s history as a repository of value; what drives supply and demand, why and how the US dollar and global macroeconomic factors affect gold price, how experts in the filed of money management see its prospects and when prices are reasonable.  Situations are explained in which gold will be invaluable to investors as stateless money that keeps its value even in the worst of times; a niche investment with value underpinned by scarcity; an investment to include in a portfolio to spread risks; and a suitable investment to include in pension provisions.

As unbiased analysts the authors are neither bulls or bears, rather they examine different scenarios that could play out in currency and financial markets, the effects they would have on investors, and what investors can do to protect themselves from adverse developments.

The Goldwatcher

Demystifying Gold Investing

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By John Katz Frank Holmes

John Wiley & Sons

Copyright © 2008 John Katz
All right reserved.
ISBN: 978-0-470-72426-2

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Chapter One

Introduction: Why Gold?

'The recognition of risk management as a practical art rests on a simple cliché with the most profound consequences: when our world was created, nobody remembered to include certainty. We are never certain; we are always ignorant to some degree.'

Peter L. Bernstein: Against the Gods - The Remarkable Story of Risk

'We have entered the third millennium through a gate of fire.' Nobel Laureate Kofi Annan, United Nations Secretary General 2001

Unbiased Research

How do you decide if and when you should buy gold when opinions on its future value can be poles apart? Pundits at one extreme forecast an inevitable dollar crash that ends with a 'bonfire' of all paper currencies and global financial meltdown. Gold, they say, will be the most sought after asset on the planet and it is going to be priceless. Sceptics at the other extreme say it belongs 'on the neck, in teeth and on the pinkie'. But it is obsolete in the information age and past its sell by date as a monetary asset. They say it won't be worth much to anyone except a jewellery manufacturer or a dentist. Most commentators call it a safe haven investment. But many brokers with experience of gold rush frenzies that ended in tears remind us that the system of outright gambling in financial markets, politely called spread betting, was invented to give punters a chance to play the volatile gold price. In their opinion gold is a speculative punt and is not an investment.

Opinions at the extremes tend to be flawed. As an unbiased analyst I am neither gold bull nor bear, pundit nor sceptic. Working from the grey area between the extremes I have analysed when owning gold makes sense and when it doesn't and when gold prices do or don't make sense. Answers to key questions raised are not always clear cut. But there is no doubt about why the mythical treasure at the end of the rainbow is always a pot of gold and never a few truckloads of copper, zinc, coffee or anything else. Gold is the great universal consolidator of value. A million dollars of gold priced at $600 an ounce weighs only 104 pounds and will fit in a safe deposit box. A single 400 ounce gold bar is worth $240000. A kilogram about the size of a golf ball $21000. A one ounce gold coin $600. Even a five gram slither, marketed with a certificate of authenticity, is over $100. This book has origins in research on investments insulated against financial market risks. The research started in September 2001 shortly after the 9/11 terrorist attacks in the US. Gold was on the agenda as a legendary safe haven in troubled times and, subject to price, it still is. In Part One of this book 'Demystifying the Gold Price' I review what motivates people and organisations to own gold, who buys it and the factors that influence how much they are prepared to pay. Gold used to be officially 'the measure of all exchangeable value' and 'the scale to which all money prices are referred'. Over the twentieth century, as the US became the global superpower, the dollar assumed more and more of gold's traditional role in the international monetary system. After US President Richard Nixon severed all links between the dollar and gold in 1971 the dollar also usurped gold's role as the universal measure of value. Gold is now another alternative investment with a different risk reward profile to financial assets. Owning it in good times can be as rewarding as watching paint dry. But, because it comes into its own whenever there is uncertainty, owning some gold is something to keep in mind when we make risk management plans.

Nowadays, of course, we can introduce hedge funds and other modern investments into our portfolios. Indeed the world's top financial brains have been producing a seemingly endless stream of derivatives and other financially engineered structures that not only reduce risk exposure but are expected to make us money at the same time. Among the brilliant academic economists now also engaged in hedge fund management is Andrew W. Lo, Finance Professor at the prestigious Massachusetts Institute of Technology's Sloan School of Management. Working at the cutting edge of information technology he is devising a programme that will simplify risk management. All you will have to do is punch a range of information personal to you into a computer with data on the risks you can and can't tolerate. An algorithm will then tailor a portfolio for you suitably hedged against unwanted risks. The Professor acknowledges his plans still sound like science fiction and it will be ten years before his programmes are up and running. To be sure technology has already revolutionised the way we invest and will continue to. But, when it comes to making the strategic decisions, we will remain in the driver's seat. Just as we are when we drive a car with automatic cruise control. The cruise controller doesn't decide whether to travel on an A or B road or whether to drive at fifty or seventy miles an hour. We do.

While the Professor empowers his computers we can and must empower ourselves to manage risk more effectively. By understanding the challenges we are facing in the twenty-first century we can position ourselves to deal with any adverse consequences. This book is a compilation of analysis and information on twenty-first century financial risks and on gold as an alternative investment that can limit risk exposure. Commentary and analysis that follows is supported by links to reliable sources of current information. But there is no link to any information source on when an unexpected crisis is going to happen. Even the Professor's algorithms will never have that link. The legendary billionaire investor Warren Buffett has repeatedly warned that derivatives are weapons of financial mass destruction. But nobody can tell if or when the multi trillion dollar derivatives market will be further disrupted by another unexpected crisis. Or when anything else unexpected will happen. Warren Buffett, Andrew Lo, you and I, along with everyone else on the planet, will find out about an unexpected crisis at the same time after it has happened. But some of us will have made better plans than others to deal with the consequences. Remember it was only ten years ago when the hedge fund Long-Term Capital Management run by Nobel Prize winning economists collapsed. Roger Lowenstein's book When Genius Failed, details how a group of élite investors engaged with financial derivatives created a trillion dollar hole in the international banking system that brought world financial markets to the brink of imploding.

If ever a derivatives crisis or other mishap roils financial markets again hedge fund protection could prove to be as useless as holding all your eggs in a basket in your right hand when you trip over your left shoe lace.

The Stateless Money Franchise

I first heard gold spoken about as a 'franchise' from an advertising professional who told me I would understand it better if I looked less at economics textbooks and tried more to understand why people everywhere in the world trusted it. She urged me to focus on the remarkable franchise that comes with the word gold through its umbilical links with money and wealth. I could agree with her about these links. But I asked if she wasn't over egging the symbolism of a single word. No, she replied, the word gold in marketing and advertising is magic. Only economists think of the gold standard as a monetary arrangement that no longer applies. In the real world the gold standard has always been shorthand for the finest qualities for anything and everything from personal ethics to butter on a supermarket shelf or Rolls Royce jetliner engines. Then, to dispel my doubts about the commercial power of a single word, she reminded me of the time when, with a word, the jewellery tycoon Gerald Ratner torpedoed the share price of his company and ended his career as chief executive. While telling his success story to an audience of marketing professionals he quipped that some of the cheap wares sold in his shops were crap. Wallmart, she assured me, sell similar cheap jewellery ranges to those Mr Ratner mentioned. But they are enormously successful because they don't sell crap. She urged me to look at their web site and see for myself how they engage the magic of gold to embellish their cheap jewellery. And, yes, they do associate their wares with the mystique of gold. The jewellery they sell is made from 'the oldest precious metal known to humankind, with lustre and remarkable properties that have allowed it to be crafted into the world's most coveted and exquisite jewellery'. Nevertheless for about $20 they offer two pairs of '10 karat shiny yellow gold ear ring hoops'. That's how the masters engage the gold franchise to market trinkets made from thin metal tubes with a little gold content. Their marketing is so successful that they were at one time the biggest distributors of gold in the United States, the second biggest user of gold in the world. India is the biggest.

Gold has unique properties that underpin demand for jewellery, gold as an investment and its stateless money franchise. France's President General Charles de Gaulle spoke flamboyantly about these qualities in a campaign he launched in 1965 against dollar hegemony. Gold backing for the dollar was eroding. It no longer looked like the 'better than gold' global currency it was at the end of World War II when the US owned 80% of the world's monetary gold. Instead it was starting to resemble Mr Ratner's jewellery. President Richard Nixon's Treasury Secretary John Connally said as much when he told European bankers: 'The dollar is our currency but your problem.' Campaigning for a return to the classic gold standard De Gaulle declared: 'There cannot be any other criterion, any other standard than gold. Oh yes! Gold which never changes its nature, which can be shaped into bars, ingots or coins, which has no nationality and which is eternally and universally accepted as the unalterable fiduciary value par excellence.' The General's campaign failed soon after it was launched. Whatever weaknesses there were with the dollar he had no viable alternative to offer to dollar hegemony. But he had one lethal weapon in his armoury. He was entitled under the post World War II Bretton Woods arrangements to demand that settlements of balances with the United States must be made with gold. In 1971, when demands from France and other European countries were draining America's gold reserves, Nixon summarily severed all links between the dollar and gold. In the jargon of the day he 'closed the gold window' and consigned the last remnants of the monetary gold standard to history. Currencies started to trade in open markets independently of each other. Gold, no longer money or a currency, started to trade as a commodity. But it is often still labelled a quasi currency or stateless money. I prefer the stateless money label because it associates gold with its role as a universally recognised store of value over thousands of years.

The heyday of dollar hegemony came at the end of the 20th century with the Pax Americana after the Cold War ended. Peter Bernstein's classic book The Power of Gold - the History of an Obsession was published in 2001. Cynical on gold's traditional monetary role surviving into the twenty-first century Bernstein concluded:

the most striking feature of this long history is that gold led most of the protagonists of the drama into the ditch.... Midas ... Croesus ... Charles de Gaulle, and the gold bugs of the 1980s all were fools for gold, chasing an illusion.... Gold and its surrogates make sense only as a means to an end, to beautify, to adorn, to exchange for what we need and really want.

After the millennial stock market collapse and 9/11 Bernstein changed tack. Acknowledging in a 2002 interview that he never thought he would again recommend investors to hold positions in gold he went on to say:

Gold has this magic quality in the worst of times as a store of value because it is stateless money ... Gold strikes me as an extraordinary asset as a hedge to-day. You can't hedge using the US dollar because if anything is going wrong that's the thing that is going to be going the most wrong. That is what you would want to have gold for.

In 2005 Bernstein again publicly advised investors to hedge against hyperinflation with gold and in February 2008, in a video interview with the Financial Times when gold was already trading above $900 he again endorsed its utility as a hedge against extreme outcomes. The most ringing recent endorsement of gold's stateless money franchise came from Alan Greenspan in 1997 when, as Chairman of the US Federal Reserve, he was the world's most powerful central banker. In testimony to a Congressional Committee he advised against selling any of America's gold in Fort Knox because 'gold still represents the ultimate form of payment in the world. Fiat money in extremis is accepted by nobody. Gold is always accepted.'

Crisis and Financial Market Risk Insurance

It is highly improbable, but not impossible, that in our lifetimes we will experience the unthinkable. A terrorist, military, economic, nuclear, environmental or financial market disaster that disrupts banking and civic systems and leaves us dependant for survival on owning something that can readily be exchanged for things we need to survive. In that situation nothing will be as useful as gold. We know that over the centuries owning some in times of crisis saved many families from starvation and despair. Calamities in the twentieth century included two World Wars, the Cold War with the threat of nuclear confrontation, serial regional wars and several episodes of hyperinflation. The best remembered hyperinflation was in the German Weimar Republic in 1923 when the value of the currency was totally obliterated. Economic and social chaos followed. In its wake came the Nazis and World War II. Currently post Saddam Iraq is experiencing inflation of over 70% with its new currency - and that is after decimation in the value of its old currency only a few years ago. Zimbabwe is experiencing hyperinflation of over hundreds of thousands percent. Granted, comparing Iraq or Zimbabwe with a major international power like Germany is not comparing apples with apples. But Iraq has amongst the world's largest oil reserves and should be prospering. Zimbabwe is richly endowed with resources and was prospering until a few decades ago.

Most of us find it unthinkable that anything catastrophic will happen to us. We don't warm to the idea of hoarding gold as protection against our paper money becoming worthless. Yet, as risks to our personal safety and financial security have magnified since 9/11, we would probably consider some crisis insurance if it was on offer from a conventional insurer. To give effective protection the insurer will have to be in a position to settle claims instantly after a crisis and, if necessary, to settle in gold or another precious metal. Preferably gold. No insurer could guarantee that. And if promises on those lines were made in the sales puff the policy small print would certainly provide otherwise. For insurance against the unthinkable we have to own and possess gold. Stateless money that will keep its value even in the worst of times. Keeping even a small amount in your personal control will afford instant protection whenever you need it. Larger holdings in secure warehouses in any of the world's major financial capitals can be arranged with organisations that simplify all aspects of buying, storing and selling at low costs.

(Continues...)

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Excerpted from The Goldwatcher by John Katz Frank Holmes Copyright © 2008 by John Katz. Excerpted by permission.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

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John Katz is an analyst, strategist and financial writer based in London. To gain experience and qualifications in the Financial Services Industry he completed the necessary exams to qualify as an approved Securities Dealer and Trader and, while working for a hedge fund in London, was accredited by the United Kingdom Regulatory Authorities. He has contributed articles to the financial press,commentated for business television and is the author of Portfolio 2001 – How to Invest in the World’s Best Companies published by Random House Business Books in 1999.

Frank Holmes is CEO and Chief Investment Officer at U.S. Global Investors,Inc., which manages more than $1 billion in precious metals funds and provides advisory services to international clients.He was Mining Journal’s fund manager of the year in 2006, and is a prominent speaker at investment conferences and a regular commentator on financial broadcast networks. Mr Holmes has more than 30 years’ in the investment field.