“You have to be in Gold”

• “We are living in a world of money printing. … That is why I have to recommend gold again. …  Once gold surpasses $1,800 an ounce, it will run to the low-to-mid $2,000s.”

Quotation attributed to Felix Zuelauf, Zuelauf Asset Management. “Here’s What’s Cooking for 2013,” Barron’s, January 21, 2013.

• “Investors can choose between artificially priced financial assets or real assets like oil and gold, or to be really safe, cash. … My first recommendation is GLD—the SPDR Gold Trust.”

Quotation attributed to Bill Gross, PIMCO. “Stirring Things Up,” Barron’s, February 2, 2013.

• “I am recommending gold, as I have done for many years. I will continue to do so until the gold price hits the blow-off stage, which is nowhere in sight. … The environment for gold couldn’t be better. … Gold could go to $5,000 or even $10,000.”

Quotation attributed to Fred Hickey, The High-Tech Strategist. “Stirring Things Up,” Barron’s, February 2, 2013.

Each January, a group of prominent investment professionals gather in New York as members of the Barron’s Roundtable to trade quips, stock ideas, and the outlook for markets and economic trends worldwide. Barron’s—a weekly financial newspaper with a small but devoted following of professional and do-it-yourself investors—publishes a transcript of their remarks over three successive issues. The quotations above are excerpts from this year’s panel discussion, and to the best of our knowledge they represent the only occasion that three of the nine participants have highlighted gold-related investments among their choices for capital appreciation during the year ahead.

Although the year is far from over, it’s off to a rough start for gold enthusiasts. A sharp selloff in mid-April sent bullion prices to $1,395 on April 15, down 15.7% for the year to date and 26.4% below the peak of $1,895 reached in early September 2011. (Prices are based on the London afternoon fix.) For the 10-year period ending March 31, 2013, gold enthusiasts have a more positive story to tell: The annualized return for gold spot prices was 16.83%, compared to annualized total returns of 8.53% for the S&P 500 Index, 10.19% for the MSCI EAFE Index, 17.41% for the MSCI Emerging Markets Index, and 2.34% for the S&P Goldman Sachs Commodity Index.

Taking a somewhat longer view, for the 40-year period ending March 31, 2013, gold performed in line with many widely followed fixed income benchmarks, while lagging behind most equity indices. We find it ironic that the return on gold over the past four decades is essentially indistinguishable from five-year US Treasury notes, often scorned by gold advocates as “certificates of confiscation.”

Gold vs. Benchmarks, 1973–2013*

*40-year period ending March 31, 2013.

Considering the volatility of gold prices, even a 40-year period is too short to provide conclusive evidence regarding gold’s expected return. And the issue is further clouded by shifts through time in the legality of gold ownership and its changing role in various monetary systems worldwide. In his book The Golden Constant, published in 1977, University of California, Berkeley Professor Roy Jastram examined the behaviour of gold in England and America over a 400-year-plus period—and suggested that the long-run real return of gold was close to zero. Even with centuries of data to study, however, he couched his conclusions in cautious language.

When we last commented on gold in March 2012 (“Who has the Midas Touch?), the mysterious metal was changing hands at $1,770 per ounce. We directed readers’ attention to the Berkshire Hathaway 2011 annual report, which presented an engaging discussion by Chairman Warren Buffett on the long-term appeal of gold—or, in his view, the lack of it. Since that time, the role of gold in a portfolio has provoked vigorous debate in the investment community, with thoughtful, articulate, and successful investors lining up on both sides of the issue, including at least three billionaire hedge fund managers making the case for gold.

Some might argue that gold’s price behaviour will never succumb to rational analysis. For those seeking to try, a recently updated paper by Claude Erb and Campbell Harvey offers a useful framework for discussion without necessarily resolving the debate. Along the way, it provides the reader with a few nuggets of historical interest, including a comparison of military pay between US Army captains of today and Roman centurions under Emperor Augustus. (Apparently, little has changed over 2,000 years.)

The authors cite a number of reasons advanced in support of gold ownership, including a hedge against inflation, a safe haven in times of stress, an alternative to assets with low real returns, and its “under-owned” status across investor portfolios. Although the inflation hedge argument is likely the most frequently cited attraction for gold investors, the authors find little evidence that gold has been an effective hedge against unexpected inflation. They go on to poke holes in the assertion that gold qualifies as a genuinely safe haven or presents an appealing alternative in a world characterized by low real yields.

The most interesting argument, they believe, is the claim that gold is under-owned in investor portfolios and that a small shift in investors’ allocation strategy could lead to a significant rise in the real price of gold. Putting aside for a moment the ambiguity of the “under-owned” statement (all the world’s gold is already owned by somebody), the authors suggest it is plausible that individuals or central banks could choose to have greater exposure to gold. If they are insensitive to prices, this choice could cause the real price of gold to rise, particularly if gold producers are unwilling or unable to increase production. (On that note, it’s also conceivable that a significant real price increase would encourage development of electrochemical extraction of the estimated 8 million tons of gold contained in the world’s oceans, dwarfing the existing gold supply.)

The “gold is under-owned” argument has been advanced by a number of thoughtful investors, and only time will tell if such a shift in allocation strategy takes place with the consequences they expect. While acknowledging the bullish implications for gold prices under this scenario, the authors point out that gold prices relative to the current inflation rate are roughly double their long-run average since the inception of gold futures trading in 1975. They suggest $800 per ounce is a suitable target when applying this metric. Which is more plausible—that prices will gravitate closer to their historical average or that a new world order is emerging that calls for a sharply different valuation approach? No one can be sure; hence, the title of their paper, “The Golden Dilemma.”

What should investors make of all this? In our view, long-run investment results for any individual reflect the combination of available capital market returns and the investor’s behavior and temperament. As Warren Buffett has observed, excitement and expenses are the enemy of every investor, and all of us could benefit by examining our inclination to invest with our hearts rather than our heads. The decision to own gold often is motivated by an emotional response to current events, leading to abrupt shifts in asset allocation strategy and a failure to achieve capital market rates of return there for the taking. If adopting a permanent 5% allocation to gold encourages investors to maintain a buy-and-hold strategy for the remaining 95% of their portfolio, perhaps that is the most sensible solution for some. Many other investors undoubtedly will be just as content to stock their portfolios with securities offering interest and dividends—and let gold fulfil their innate human desire for rare and beautiful objects of adornment.

You’ve heard the line about stock picking being better left to blind-folded, dart-throwing orangutans. Now there’s new competition – from cats.

UK newspaper The Observer staged an experiment, pitting a panel of market professionals and a group of students against a ginger feline called Orlando in a competition to see who would have the most success in picking stocks in 2012.¹

The Observer portfolio challenge pitted professionals Justin Urquhart Stewart of wealth managers Seven Investment Management, Paul Kavanagh of stockbrokers Killick & Co, and Schroders fund manager Andy Brough against students from John Warner School in Hoddesdon, Hertfordshire – and Orlando.

Each team invested a notional £5,000 in five companies from the FTSE All-Share index at the start of the year. After every three months, they could exchange any stocks, replacing them with others from the index.

The professionals used their experience, insights and market knowledge to select stocks. The cat’s method was rather less elaborate. Orlando simply threw a toy mouse onto a grid of numbers allocated to stocks in the index.

The newspaper reports that while the cat was trailing the pros at the end of the September quarter, his feline intuition kicked in the final months. As a result, his portfolio increased to end 2012 at £5,542. This represented a gain of nearly 11% for the year, outpacing the index’s 8.2% rise and shading the professionals’ portfolio by 7%.

While this experiment was hardly scientific, it does provide another reminder about the difficulty of generating consistent above-market returns by picking individual stocks or making forecasts. And it’s something to keep in mind when you are confronted by media and market prognostications for 2013.

In the US context, Bloomberg highlighted this difficulty recently in a piece entitled Almost All of Wall St Got 2012 Market Calls Wrong.²

While many forecasters began 2012 by issuing downbeat calls for equity markets – based on the ongoing Euro Zone crisis, China’s slowdown and US political logjams – the market value of global equities increased by about $US6.5 trillion last year.

As one analyst quoted by Bloomberg noted, many pundits were too wrapped up in the “fear du jour” and failed to keep an eye on the big picture.

So it was in Australia, where one prominent television finance commentator said at the end of 2011: “The conditions are in place for a panic sell-off. It is not certain that it will happen…but the risk is now such that you must take action. I will be significantly reducing my already reduced exposure to equities possibly to zero”.³

More fool him and commiserations to anyone who had the misfortune to act on his advice, because the Australian equity market delivered a total return in 2012 of 20% in local currency terms. Gains in many other equity markets were even stronger.

It should be plain by now that basing your investment strategy on someone else’s forecast is a haphazard way to build wealth. No matter how diligent and expert your forecaster is, unexpected events have a way of messing up their expectations.

As well, those who insist on believing that forecasting is a sustainable investment strategy tend to under-rate the capacity of capital markets to very quickly build all those expectations into prices. You think markets will tank/soar this year? So does someone else and they’re trading off that belief.

The good news is you don’t need a crystal ball to build wealth. You just need a regularly rebalanced diversified portfolio of assets designed for your needs and risk appetite. You also need to keep an eye on costs and taxes.

Most of all you need to keep your cool and exercise patience. Like a cat.

1. ‘Orlando is the Cat’s Whiskers of Stock Picking’, The Observer, Jan 13, 2013

2. Almost All of Wall St Got 2012 Market Calls Wrong’, Bloomberg, Jan 4, 2013

3. Alan Kohler, Business Spectator, Dec 19, 2011

People who make bad money decisions can often rationalise them. Here are 10 common excuses.

Human beings have an astounding facility for self-deception when it comes to their own money.

We tend to rationalise our own fears. So instead of just recognising how we feel and reflecting on the thoughts that creates, we cut out the middle man and construct the façade of a logical-sounding argument over a vague feeling.

These arguments are often elaborate short-term excuses that we use to justify behaviour that runs counter to our own long-term interests.

Here are 10 of them:

1. “I just want to wait till things become clearer”.

It’s understandable to feel unnerved by volatile markets. But waiting for volatility to “clear” before investing often results in missing the return that goes with the risk.

2. “I just can’t take the risk anymore.”

By focusing exclusively on the risk of losing money and paying a premium for safety, we can end up with insufficient funds to retire on. Avoiding risk also means missing the upside.

3. “I want to live today. Tomorrow can look after itself.”

Often used to justify a reckless purchase. It’s not either-or. You can live today AND mind your savings. You just need to keep to your budget.

4. “I don’t care about capital gain. I just need the income.”

Income is fine. But making income your sole focus can lead you down dangerous roads. Just ask anyone who invested in products using collateralised debt obligations*.

5. “I want to get some of those losses back.”

It’s human nature to be emotionally attached to past bets, even the losing ones. But as the song says, “you’ve to know when to fold ‘em”.

6. “But this stock/fund/strategy has been good to me.”

We all have a tendency to hold on to winners too long. But without disciplined rebalancing, your portfolio can end up carrying much more risk than you bargained for.

7.     “But the newspaper said….”

Investing by the headlines is like dressing based on yesterday’s weather report. The news might be accurate, but the market usually has already reacted and moved on to worrying about something else.

8.     “The guy at the golf club/my uncle/my boss told me…”

The world is full of experts, many of them recycling stuff they’ve heard elsewhere. But even if their tips are right, this kind of advice rarely takes account of your circumstances.

9.     “I just want certainty.”

Wanting confidence in your investments is fine. But certainty? You can spend a lot of money trying to insure yourself against every possible outcome. It’s cheaper to diversify.

10.  “I’m too busy to think about this.”

We often try to control things we can’t change – like market and media noise – and neglect areas where our actions can make a difference – like costs. That’s worth the effort.

Given how easy it is to pull the wool over our own eyes, it pays to seek out independent advice from someone who understands your needs and your circumstances and who keeps you to the promises you made to yourself in your most lucid moments.

Call it the ‘no more excuses’ strategy.

* Collateralised Debt Obligations (CDOs) are a promise to pay cash flows to investors in a prescribed sequence, based on how much cash flow the CDO collects from the pool of bonds or other assets it owns. If cash collected by the CDO is insufficient to pay all of its investors, those in the lower layers (tranches) suffer losses first.

Bad news sells. It sells because fear is a more powerful emotion than greed. Newspaper editors know that, which is why the front pages are often so depressing. But sometimes you need to dig inside the paper for a more balanced view.

The bad news has been dominant in global markets in recent years, starting with the banking crisis of 2008 and more recently the sovereign debt crisis focused on Europe.

But other things have been happening. And any investor wanting an antidote for the grimmer headlines might like to reflect on the following recent news snippets:

1. US stocks rose for a sixth week, giving the S&P-500 its longest rally since January 2011, as economic reports beat forecasts and Germany backed the ECB’S bond-buying plan. – Bloomberg, Aug 18, 2012.
2. US consumer sentiment improved in early August to the highest in three months as sales at retailers and low mortgage rates spurred Americans to boost their buying plans, a survey shows. – Reuters, Aug 17, 2012.
3. Germany’s Finance Ministry says the nation’s tax income was nearly 9% higher in July from a year earlier – helped by recent wage increases and underling the continuing strength of the economy. – The Associated Press, Aug 20, 2012.
4. Sweden’s centre-right prime minister has backed a cut in corporate tax for his Nordic state as it defies the gloom of the euro zone. – Reuters, Aug 18, 2012
5. UK jobless claims unexpectedly fell in July and a wider measure of unemployment dropped to its lowest in a year as the Olympic Games created jobs, showing the labour market’s resilience. – Bloomberg, Aug 15, 2012
6. Australia is the new safe haven. Robust tax revenues and restrained government spending have put this ‘AAA’-rated nation on investors’ radars. Government 10-year bonds have returned 17% so far this year. – Wall Street Journal, Aug 14, 2012.
7. Japan has offered its strongest indication yet it sees a way out of deflation next year, after being mired in a corrosive mix of falling prices and weak economic growth for much of the past two decades. – Reuters, Aug 17, 2012
8. Norway’s sovereign wealth fund – the largest in the world – is planning to take on more risk as it seeks to exploit its role as a strategic investor. – The Financial Times, Aug 20, 2012

Now, none of these headlines are news to the markets. And pointing them out this way does not constitute a forecast. But it is worth reflecting on the fact that the economic and financial news is not all bad at the moment.

Sometimes, as citizens, consumers and investors, we can become overwhelmed by negative headlines and can end up making counter-productive decisions about our lives based on historical events that we have no influence over.

The fact is markets quickly incorporate news, good or bad. And for every person who capitulates and sells stocks based on news, someone else with a less negative view and/or a longer-term horizon is on the other side of the trade buying.

Maybe the best approach is to start reading the newspaper from the back page.

¹ The S&P 500 is an index of the most widely traded 500 stocks on the New York Stock Exchange (NYSE)

²The European Central Bank will buy Government Bonds to reduce the effective interest rate paid by struggling Eurozone countries to affordable levels.

Investors are now so risk averse they are willing to pay the German government to look after their money; not a risk-free return, but a return-free risk.

Yields on two-year German notes sank to an all-time low of -0.005% on June 1. Looked at another way, anxious investors were prepared to accept a negative return for the comfort afforded them by parking their cash with the German government. And this was even before taking inflation into account.

This isn’t the first time this has happened. Back at the height of the financial crisis in late 2008, negative yields were observed in US Treasuries – a consequence of investors at that time being willing to pay to park money in a safe asset.¹

The extreme state of risk aversion in global markets is reflected not only in German bunds. In the US, Treasury bond yields have hit record lows, as have their equivalents in Australia, the UK, France, Austria, Finland and the Netherlands.

The causes of this mass shying away from risk are well documented – worries that the euro-zone will break up, concern that the US economic recovery is stalling, signs of a slowdown in China and a loss of momentum in emerging markets. Anyone who takes note of media and market commentary will know that there are a wide range of opinions about the likely outcomes of these issues. The important point for the ordinary investor is that all those opinions and uncertainties are already reflected in current prices.

Here’s how this process works: Security prices are an expression of the market’s aggregate view of future expected cash flows divided by a discount rate (or risk premium) that investors demand for putting their money into risky assets.

When the price of a security falls, it can be due to lower expected cash flows, a higher discount rate or a combination of the two. While we don’t know the exact mix of these influences, we do know that if lower prices are wholly due to lower expected cash flows, expected returns will be unaffected. On the other hand, if it is due to the application of a higher discount rate due to higher risk aversion, we can say expected returns for the risky assets are higher.

Investors’ willingness to pay to park their money in German bonds is an indication of higher risk aversion. Higher risk aversion should be linked to higher discount rates so the probability is that expected return premiums on risky assets have gone up.

Think back to what we saw coming out of the first stage of the financial crisis in March, 2009. Risks were high and prices of risky assets went down. Many investors, overcome by the uncertainty at that time, sought refuge in government bonds. Due to this generalised increase in risk aversion, investors demanded a higher premium before putting their money into equities and corporate bonds. But as risk appetites revived that year, those risky assets paid a very substantial return. Share prices rebounded and the spread of corporate over government bonds narrowed sharply.

The takeaway from all this is that sheltering in what are perceived as the safest government bonds may provide certainty for a time, but also comes at the cost of forgoing the significant increase in risk premiums that may be available.

This is not to argue, by the way, that increasing one’s allocation to risk-free assets is never a legitimate decision. Such a course may well be appropriate for the individual investor, based on his or her own tastes, circumstances, liquidity needs and investment objectives. If possible, however, it is best to develop appropriate asset allocations for individuals based on their risk tolerances outside these periods of distress. That’s because selling risky assets at such times can be expensive.

In summary, it is worth reflecting on the fact that record low yields on government bonds, and in particular negative yields on the safest assets, may be an indication of extreme risk aversion and high discount rates on risky assets. This higher discount rate would have been partly responsible for their recent price decline and will probably be reflected in higher expected returns.

When risk appetites return – and we don’t know when or if that will happen – those risky assets may stage an equally dramatic recovery. Seeking to time those changes can be a very, very expensive exercise. So at times like these, it’s worth reminding ourselves that safety comes at a cost.

The worrying events of recent weeks and months are incorporated into prices. But remember that future events, unknown to us today, can always affect prices in positive or negative ways beyond the expectations built into the market today.

1.At the Berkshire Hathaway annual meeting in May, 2009, a slide depicted a trade ticket from December 19, 2008, showing a Berkshire sale of $5 million of Treasury bills. They were coming due on April 29, 2009. Berkshire sold the bills for $5,000,090.70. If that buyer had instead put their money in a mattress, by April 29 they would have been $90.70 better off. Buffett said: “We may never see that again in our lifetimes.”

If it sounds too good to be true…

Last weekend’s Financial Times reported how investors have suffered losses and problems with bargain properties that they have bought in Detroit and Florida through UK companies. The concept was that an investor could buy a derelict property for $40,000-$60,000 including the cost of refurbishment, which would then be let to tenants under a government backed scheme, giving returns of around 16% per annum – a fantastic chance to buy at the bottom of the US property market.

 The FT reports the experience of some investors where the refurbishments haven’t been carried out, the properties are still vacant, they cannot get their money out, and they have incurred US property tax liabilities. One couple were reported as investing the entirety of a small inheritance which they cannot afford to lose. You can read the full article by following this link; http://on.ft.com/IiRNhP or we can email it to you.

 So where did these investors go wrong?

 1.       If it seems too good to be true – IT IS! An investment paying 40% income year after year does not exist, or not for individual investors at any rate. If such an opportunity did exist, it would be snapped up by investment banks, or even the people promoting the scheme!

 2.       Liquidity – unless you have an investment that can be traded on a quoted market, daily, weekly, monthly, or even quarterly – it is only worth what someone else will pay for it. Often this means an investment is worthless.

 3.       Diversification – this is usually the biggest mistake that investors make when it comes to investing in property. If you own one property in Detroit, and someone decides to strip it of all its copper piping or vandalise it, you will take a big financial hit, even when compared to investing in specialised stock markets. Investors should have exposure to different classes of assets – remember the old adage “Never put all your eggs in one basket”.

 4.       Authorisation – The properties were bought through “Property Sourcing Companies” who are not regulated by the Financial Services Authority. They have brilliant marketing emails and websites full of promises of great returns – you would be stupid to ignore them, right? No! I found one with a stated Code of Ethics which can be “changed at any time without notice”.

 5.       Risk – you cannot escape the following basic truth. You receive capital (or income) returns in exchange for taking risk. The higher the return, the higher the risk. There are innumerable examples of investment disasters where this basic fact was ignored e.g. BCCI, Zero coupon investment trusts, dotcom shares and Icelandic Banks.

 How can clients safeguard themselves?

Look to see who these companies are regulated by, which should be on all communications. If it’s not there, they aren’t regulated, and nor are the claims that they are making.

 When it comes to money, Bluecoat Wealth Management is working in partnership with you. Get in touch and ask us what we think about any proposed investment. Does it fit in with your overall financial plan? What are the risks and potential problems?

 If friends or loved ones tell you about some “wonder investment”, suggest that they contact us about our complimentary Second Opinion Service. Our business has grown almost entirely by recommendation, so do not be concerned about telling friends or loved ones to get in touch.