Season Investments


A Golden Life Raft

Posted on February 26, 2013

“In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value.” – Alan Greenspan

The price of gold is off to a bad start in 2013. As of last Friday’s close, spot gold prices were down around 6% on the year. This move is particularly painful when comparing it to returns in global equities, up close to 4% over the same time period. We discussed how stocks have recently been “the only game in town” at our investment forum, The Certainty of Uncertainty. This theme has continued to play out in 2013, and has made for a particularly frustrating environment for firms like ours who take a broad view on portfolio diversification. Streaks of poor relative performance always cause us to question our thesis on an investment, which is why we have decided to revisit our position on gold which we first wrote about back in the spring of 2012 in Three Fundamental Tailwinds for Gold.

One of the strongest reasons for owning gold has been “the fear trade” which stems from investors’ fear that their savings will be confiscated through inflation as Alan Greenspan aptly stated in the opening quote. The developed world is drowning in debt which is dragging down GDP growth. In response, central bankers around the world have decided they need to flood the markets with liquidity by increasing the money supply through various forms of quantitative easing. In the United States, the Federal Reserve is creating a trillion dollars a year in liquidity and growing its balance sheet at an unprecedented rate.


The logical next step to a growing money supply is a devaluation of existing purchasing power otherwise known as inflation. We have yet to experience any meaningful levels of inflation because the velocity of money (how many times a dollar changes hands every year) has decreased and mostly offset the increase in the money supply.

But this utopia where central banks can print ad infinitum without paying the inflation piper will not last forever. Eventually, slack capacity in the economy will be absorbed and the velocity of money will pick back up. At that point, central banks will be faced with the problem of an exit strategy (which some have argued can never happen). The decision to fight inflation by unwinding the balance sheet will cause interest rates to rise, which will put pressure on what is most likely to be a very fragile economic recovery. This in turn could lead to a severe recession where central banks have already exhausted most if not all the tools in their tool kit. In this case, gold demand could spike as it is one of the last remaining safe haven assets. The other option for central banks is to not unwind their balance sheets, which will lead to higher levels of inflation and a robust “paper recovery” where nominal growth looks good but real growth is poor. Investors looking to keep up with inflation and protect their purchasing power will be drawn to gold and other stores of value.

All in all, the fear trade is still alive and well, but the inflation risk of this thesis has yet to be manifested. As such, the market has begun to discount this risk and buy-off on the “goldilocks recovery” which has decreased the demand for gold. A recent report published by The World Gold Council, showed that total demand for gold in 2012 fell by 4% versus the previous year. The decrease was primarily due to a drop off in the demand for gold bars and coins as well as jewelry. This was partially offset by increased demand for gold from central banks.


Jewelry and physical gold demand are far and away the largest sources of demand so a drop off in these sectors is concerning, but not unexpected. Some of the drop off can be attributed to new regulations in India which increased taxes on imported gold. On the margin, this weakens the “love trade” thesis we wrote about before, but China and other developing countries continue to increase gold consumption which offsets this somewhat. In addition, these same sources of demand have dropped off year over year multiple times during the most recent decade long bull market in gold prices so one could argue that the recent drop off was nothing more than a breather in a longer-term bull market in gold demand and price.


In addition, central bank demand continues to increase ever since it turned positive in 2009. Most developing countries are resource rich and are growing by exporting these resources to the world. When a nation is a net exporter, it accumulates currency reserves in the form of the currency of their trading partners. For example, a country that sells the United States oil receives US Dollars in return for their oil. The World Gold Council argues that there is an ever increasing demand to diversify these foreign currency reserves as developed nations continue their race to the bottom.

The list of countries actively adding to their official gold holdings remains heavily concentrated in developing markets, which partly reflects the scale of growth in the reserves of these markets over recent years. As the official reserves of these countries swell, with their heavy emphasis on U.S. dollars- and euro-denominated assets, the need for diversification also increases. With a focus on high quality, liquid assets as desirable alternatives, gold is a natural destination for a proportion of these increased reserves.

The price of gold is reflecting the tug of war between near-term (decrease in demand) and long-term (devaluation of fiat currencies) expectations. Based on the recent weakness in the gold price, sentiment has turned extremely bearish on the yellow metal. Sentiment Trader, a research firm we subscribe to, pointed out the following statistics on gold in last Friday’s report:

  • “Large speculators in gold futures are holding the least amount of net long contracts since December 2008…”
  • “Public opinion on the metal has plummeted to the 2nd-lowest level in a decade.”

Clearly sentiment, which is most useful as a contrarian indicator, is washed out on gold. Extreme bearishness is why now might be the perfect time to be adding exposure to gold. Last week, we shifted our allocation by reducing our exposure to gold ETFs (tickers: GLD & IAU) while increasing our exposure to a gold closed-end fund out of Canada called the Central Gold Trust (ticker: GTU) which holds nothing but physical gold bullion and a little bit of cash. Unlike ETFs which trade pretty much in line with the value of their underlying assets, the price of a closed-end fund can drift from its net asset value (NAV) due to sentiment shifts (a topic we’ve discussed in the past here and here). Last week, GTU traded at a discount to its NAV for the first time since June of last year. GTU typically trades at a premium to NAV and rarely trades at a discount as shown in the premium/discount chart below from CEF Connect.


If sentiment toward gold were to change and start to become more bullish, something we’ve seen over the past two trading days, we would expect the GTU premium to revert back and possibility overshoot its long-term mean of around 5%. A shift in sentiment will most likely be coupled with rising gold prices, so an investor in GTU will see appreciation from the rise in the underlying asset (gold) as well as the increase in the premium of the stock price and thereby outperform spot gold. By the same token, if the discount increases than GTU shareholders will underperform spot gold returns. We think there a greater chance of the former occurring than the latter scenario.

We remain long-term bulls on gold prices as long as central banks continue to expand their balance sheets to record levels. For now, the US enjoys its favored status as the world’s reserve currency, but this will not last forever. Developing countries will not sit by and export real goods to the developed world in exchange for fiat currencies which aren’t maintaining their purchasing power. As the old saying goes, “gold is no one’s liability” which makes it the perfect life raft for investors faced with a global economy that is drowning in debt.

elliott_headshot_bw.jpgAuthor Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.

Subscribe to our Weekly Insight via email!


Transparency is one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.