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August 26, 2009Where to put your money? Choosing between Physical Gold and Gold Stocks/ETFs?
A frequently asked question by gold investors is “What is the difference between owningphysical gold and gold stocks/ETFs? Between the two where should I put my money?” Before we answer this question there are three points that we would like investors to keepin mind regarding gold.
1.
High Volatility
: One of the most important thing to be aware of in gold investing isthat its price is very volatile and it can go up and down by as much as $20-40$ in asingle day, sometimes even more. High volatility in gold has several causes. Likeforeign exchange, gold is a commodity that is traded round the clock in the globalcommodity markets of U.S., London, Singapore and Japan. Thus its price on anygiven day is determined by a variety of global supply and demand factors. Centralbank interventions (selling gold and buying their local currency) along with IMF goldsales have all caused the gold prices to fall from time to time. In addition, gold pricesare seen by investors as a proxy for strength of the US dollar. Over the years therehas been mounting evidence of manipulation in gold prices (through the futuresmarket) to keep the perception of USD strength going
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2.
Liquidity (Ease of Sale or Purchase)
: Relative to trading stocks/ETFs, physicalgold is a more illiquid investment and this fact is reflected in their respective bid-askspreads. For gold stocks and ETFs, bid-ask spreads are narrow, indicating that itdoes not cost a whole lot to buy or sell. For physical gold purchases bid-ask spreadscan be as much as 9-10% of spot gold prices, which translates to ~$90-$100 per ozif gold trades at $1000/oz. Purchasing coins/bars requires extra work. We need tocall the dealer to get a quote, who will then send us the coins once, he receives ourcheck. Similarly if we wish to sell physical gold, the dealer or jeweler will need toverify the authenticity of our gold before making the purchase. Also demand andsupply of coins will weigh into the bid-ask. In contrast, buying and selling stock ismuch easier and can simply be done with a mouse click at your online brokerageaccount.
3.
Investment Time Horizon
: Because of its relative illiquidity and high volatility,physical gold investments require a long time horizon of anywhere from 2-5 years.So in buying physical gold remember to only put the money that you can see lockedaway, which you do not need in the short term. As a general rule of thumb mostadvisors recommend placing anywhere from 5-20% of your liquid cash assets inphysical gold.So what are the advantages of holding physical gold? Wouldn’t buying gold stocks/ETFsserve the same purpose? The short answer is No. Although the performance of gold stocks1http://firecracker-report.blogspot.com
 
and ETFs is likely to track that of physical gold, there are some major differences thatinvestors should keep in mind:
1.
Physical gold is the Best Hedge
: Holding physical gold outright allows one to fullyremove the risk of paper currency devaluation, bank holidays and imposition of capital controls. These fears are not so ludicrous especially when one considers thefact that in January 2009, Pennsylvania congressman Paul Kanjorski revealed thatshortly after the collapse of Lehman Brothers in September 2008, the U.S. cameclose to a catastrophic collapse of the banking and economic system
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. A massive runon the U.S. banking system was underway; with the Federal Reserve noticing thatclose to $550bn had been withdrawn electronically in a matter of 1-2 hours. In arecent appearance before the House Oversight Committee, former Treasury secretaryHank Paulson testified that the Bush Administration has discussed the possibility of abreak down in law and order should the above have happened.So in the event of a catastrophic failure, whose possibility is definitely not off thetable, despite the green shoot babaganoush offered by the media, holding physicalgold is the only safe option.
2.
Scarcity of physical gold
: Physical gold is a surprisingly scarce asset
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. Accordingto National Geographic magazine, “In all of history, only 161,000 tons of gold havebeen mined, barely enough to fill two Olympic-size swimming pools”. With highinvestor demand particularly by large hedge funds it is becoming more and moredifficult to obtain coins and bars. Several times, between 2008 & 2009 the U.S. minthad to suspend production of the 24K American Buffalo gold coins due to supply notbeing able to keep up with demand
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3.
Gold stocks carry additional risks
: Owning gold stocks exposes one to companyand market specific risks, so one has to do their research. Examples of companyspecific risk include: quality of mining portfolio, strength of company’s balance sheetand its access to capital, ability to grow revenue & EPS and production stability incase of mining disasters (such as floods, fires, and cave-ins). Above this one has toconsider market specific factors such as investor sentiment, liquidity and flight-to-safety trades (like the ones we saw in September-October 2008) where institutionalinvestors are forced to dump good and bad stocks alike.
4.
ETFs
: Have proven to be particularly volatile with many being used simply as daytrading vehicles, so one has to proceed with extreme caution. In an article titledThe Paper Game, veteran gold investor James Turk raises concerns that there is notenough physical gold backing GLD the Gold ETF. Instead, he explains “My view is thatGLD should be compared to futures contracts. Both futures contracts and GLD aretrading vehicles. No one who buys a futures contract thinks for a moment that theyown gold. They understand that all they own is exposure to the future gold price2http://firecracker-report.blogspot.com
 
(through a futures contract). The same logic should apply to GLD. When you ownGLD, you don't own gold; you own exposure to the spot gold price (through a listedshare)”. So if there is sudden dollar devaluation, you may not be able to get a holdof gold coins/bars, but you will still be able to buy stocks.
5.
Physical gold as insurance on the rest of your assets
: Let us assume that weinvest $10,000 in physical gold. Then we should mentally prepare our-self for seeingat least 15-30% volatility in prices. So we could potentially lose $3000 dollars. Thinkof this amount as insurance on the rest of your savings. If the world turns out o.k.then we could lose some money but if it turns out as bad as we think then we areprotected. Given the unprecedented amount of money printing going on around theworld, we feel that there is a significantly higher probability of the latter.Keeping the above in mind, it is prudent to hold at least some percentage of your savings inphysical gold, especially that amount which you can see locked away and whose dailyfluctuations in value won’t cause you to lose sleep at night. After this, those of us that arestock market savvy can allocate an appropriate amount to gold stocks/ETFs as they see fit.
Index
1.
In a well-researched March 2009 article titledThe Pirates of the COMEX, Adrian Douglasof Market Force Analysis, details the futures market manipulation in Gold and Silver. Inhis article Adrian states that “The gold and silver markets have been suppressed for over15 years in order to maintain low interest rates and a ‘strong dollar' to allow the US tolive beyond its means. Lawrence Summers described the blueprint of how to controlinterest rates by gold price suppression in his paper ‘Gibson’s Paradox and the GoldStandard’. This was implemented by Robert Rubin in his strong dollar policy”.
2.
YouTube video of Rep. Kanjorski’s C-Span interview: ‘$550 Billion Disappeared in  "Electronic Run on the Banks’. Also see the Zero Hedge article titled ‘How the World  Almost came to an end at 2pm September 18,2008’.
3.
January 2009 article titled ‘The Real Price of Gold’ published by the National Geographic.
4.
In an excellent article titled ‘Why Own Gold and Silver’ Adrian Douglas of Market ForceAnalysis article describes the scarcity premium of gold.
5.
US Mintsuspendsproduction of American Buffalo gold coins. In addition in a July 13,2009 article titled ‘US Mint AGAIN Suspends Gold Coin Sales - Is USA Really Out of   Gold?’ , The Prudent Investor details the many suspensions of U.S. mint gold coinproduction.3http://firecracker-report.blogspot.com
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