WWPD – What Would Paulson Do?

John Osbon - February 16, 2011

Certain investors and investments take on a mystical aura from time to time. That’s certainly the case today with John Paulson and gold. Paulson is currently the largest holder of gold in ETF form, possessing more than $4 billion of the popular gold SPDR (symbol GLD) through his various hedge funds, and it has brought him great riches.

Paulson is purported to have made $5 billion in 2010, on top of the $3.7 billion he made in 2007, betting against subprime mortgages.  It seems everything he touches turns to gold. Including gold.

It would be easy to take this information and head straight for the GLD trading window. But basing investment decisions on mystical (some would say mythical) auras doesn’t always pay off. Gold seems to many like a sure bet these days, having blasted from $300 an ounce in 2000 to more than $1300 in 2011, far outperforming major stock indices.

But it has not always been so.

source: http://www.goldprice.org/gold-price-history.html

As shown above, from 1980 to 2000 the price of gold barely budged, and lost considerable value over those twenty long years when adjusted for inflation. Following the dot-com bubble and 9/11, the precious metal gained immediate favor as a haven from crisis, a reputation that remains today, even though the dramatic regime change in Egypt failed to significantly move gold’s price.

Gold for everyone

While future gold prices will always be a matter for debate, it is undeniable that gold indexing has quickly matured. GLD is all grown up. Launched in 2004, the ETF is one of the largest in the world, with more than $50 billion in assets. In fact, GLD is now the sixth largest holder of gold, trailing only the US, Germany, the IMF, Italy, and France.

The fund has democratized the ownership of gold in many ways, allowing investors of limited means to own the metal without the need for a physical vault or insurance for gold bars or coins. GLD has truly changed the world of gold.

So where does gold go next? $1800 or $800? Is it a buy or a sell? Many would ask WWPD – What would Paulson do? I would not. As a hedge fund manager he could be hedging his position (shorting) gold in the futures market.  Or he could be shorting other gold related securities, none of which he is required to report. He is about as far away from an individual investor trying to build financial security as one can get. I don’t recommend using him for direction.

In my view, gold’s real value is simply that it doesn’t behave like stocks. Stocks are valued based on future earnings and dividends. Gold doesn’t have an internal rate of return like a company. It doesn’t pay a dividend. It doesn’t pay interest. It is valuable because it is scarce, and because people perceive it as a desirable alternative to stocks, especially in a turbulent economy.

Gold’s price is not directly determined by how much comes out of the ground each year, but by the most basic market mechanism – at what price will a buyer and seller freely arrive. If its price moved in concert with stock prices, there would be no reason to buy gold. But it doesn’t. As this chart depicts, since its inception GLD has struck it own (highly profitable) course, while the Dow and S&P have tracked so closely they can barely be discerned as two separate lines. This pattern may continue, or may reverse. No one can know which.

The availability of asset classes that move independently from one another (in math lingo: are not correlated) creates the opportunity to shape the expected risk and return of the overall portfolio by adjusting allocations. That’s how we see gold working in a portfolio – not as a dominant holding, but as an ingredient in a recipe that connects overall portfolio risk and return, and preserves capital when other asset classes may flounder.

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