Why Goldman Sachs Is Mistaken About Gold

APR 14, 2020

By: Steven Feldman
CEO, Gold Bullion International ( www.bullioninternational.com)
CEO, Auvere ( www.auvere.com)
Retired partner, Goldman Sachs
Current Wealth Management Client, Goldman Sachs Private Bank

As a former partner of Goldman Sachs (GS) and current gold industry executive, it came as no surprise when dozens of customers and colleagues reached out to me this week to get my take on the latest research note from GS’s Investment Strategy Group (ISG).  In its note, ISG responds to a number of GS’s wealth management clients who had inquired about adding gold to their portfolios during these unprecedented times. In short, ISG stated that GS does “not recommend gold as a strategic asset class in a well-diversified portfolio.”

I have great respect for GS. Having worked there for 23 years, I experienced the firm in a way that is not appreciated by most people. GS’s long-standing commitment to both philanthropy and small business is undeniable. GS has put aside funds to support small businesses, particularly those owned by women and minorities. Moreover, in response to the current pandemic crisis, the firm donated to the local healthcare community its stockpile of masks accumulated post 9/11. As much as I respect GS and cherish the relationships that I have built with many of its former and existing partners and employees, I strongly disagree with ISG’s views about gold – particularly ISG’s enduring supposition that gold is not a strategic asset. Before I refute the thrust of ISG’s arguments against gold, I would like to provide some context for my own point of view.

How I Arrived at My Own Views About Gold.

My relationship with, and appreciation for, physical gold for investment purposes started in 2008.   I was still a partner in the Merchant Bank at GS when the financial crisis hit.  Immediately after the crash of Lehman Brothers, I received a call from an operating partner I worked with in the farmland space. As a macro trader and historian, he concluded that the Fed would confront the 2008 financial crisis in the same way that it had dealt with prior economic crises:  it would unleash a barrage of monetary stimuli into the economy. As a result, my partner felt strongly that we would be well served to buy physical gold for two important reasons. First, physical gold has no counterparty risk. Lehman had just failed, and the other major financial institutions would now require government support in order to avoid the same fate. Second, physical gold is the only money that cannot be printed. The Fed’s massive quantitative easing was about to debase the fiat US dollar in a way that was unprecedented.

In 2008, obtaining physical gold was easier said than done. With some effort, I eventually secured some bullion; however, my search for physical gold to fortify my portfolio served a greater purpose. It inspired me to write the business plan for what would eventually become Gold Bullion International (GBI). The plan set forth a simple mission: build a business that would allow investors to protect and grow their wealth by purchasing physical gold as easily and safely as buying a stock or bond. Ten years later, GBI’s physical precious metals capabilities are now integrated into the platforms of the largest wealth managers in the United States, two of them even larger than Goldman Sachs, as well as numerous e-commerce shops.

GBI Knocked but GS Closed the Door.

GBI first inquired about getting on the GS platform in 2008. At the time, the price of gold was half of where it is today – about $850/ounce. I spoke to the senior managers at ISG. They said no. ISG’s argument against gold at that time? They thought gold was a “fringe asset”.  Undaunted, I kept trying to engage GS in a conversation about gold. I even reached out to the most senior executives at GS – people who started the careers as gold traders. Notwithstanding some encouraging responses from time to time, I was never able to overcome ISG’s intractable stance on gold.

I am not sure why the label, “fringe asset”, matters to ISG. The goal of a wealth manager should be to have open architecture – one that provides its clients with a wide array of choices, especially hedges with a long history of efficacy. To be fair, GS provides its wealth customers with access to a number of non-core assets such as MLPs, hedge funds, private equity and emerging market bonds. It certainly permits a wealth customer to invest in ETFs, which is one of the “paper” forms of gold investment.  Gold ETFs are nothing more than an investment in the price of gold, as you own a share in a trust, but not the actual gold. Yet ISG continues to deny GS’s wealth customers access to the real thing – physical gold. Notwithstanding ISG’s edict regarding physical gold, many of GS’s high net worth clients have opened brokerage accounts elsewhere (as well as direct separate accounts with GBI through “GBI Direct”) in order to access physical gold.

Even now, as the United States and the rest of the world struggle through dual black swan events (the COVID-19 pandemic and oil crisis) and are certain to face a global recession, ISG remains intransigent in its anti-gold position. ISG has doubled down against gold even as equity and oil values have evaporated. ISG has doubled down against gold in the face of a looming $5T deficit, a national debt that will soon grow to $28T, and the Fed’s addition of another $5T to its balance sheet in massive quantitative easing. ISG has doubled down against gold even though virtually every central bank has added physical gold to its stockpile in the last 18 months – a sure sign that gold now shares the stage, alongside the US dollar, as the world’s reserve currency. ISG has doubled down against gold knowing that mass unemployment and economic uncertainty resulting from these black swan events will likely result in American investors reducing stock ownership as they did after the 2008 financial crisis. What gives?

Gold is Money. Stocks are Something Else.

Gold is a store of value. It is the ultimate form of money. Unlike stocks, gold is not supposed to be an income producing asset or a dividend-generating security. Therefore, comparing gold to stocks is akin to comparing apples to oranges. As ISG points out, gold is more appropriately compared to the US dollar. Like the US dollar, gold is a medium of exchange that is accepted around the world. Like gold, the US dollar pays no dividend.

The biggest difference between gold and the US dollar is that unlike US dollars or any other fiat currency on the planet, the supply of gold is limited. On April 6th, 2020, the Financial Times released a projection that puts this difference between gold and the US dollar in stark relief: the projected Fed balance sheet will increase $5T to $9T by the end of the year. That balance sheet figure, in and of itself, is nearly as large as the value of all the gold that exists in the world. Moreover, the Fed will continue to set or drive interest rates to zero. While the relationship among balance sheets, interest rates and money supply are complex, the net effect is that the Fed will add more supply of US fiat dollars into the market, as compared to a virtually fixed amount of physical gold ounces.

Consequently, gold will likely maintain its multi-millennia status as the only form of money that maintains its absolute purchasing power over time. As demonstrated in the chart below, gold will likely outperform all major fiat currencies as it has for the last 120 years.

With this understanding about the value and function of gold, let’s review ISG’s arguments against gold:

ISG Argument #1 Against Gold: Gold is Not a Reliable Inflation Hedge.

ISG contends that gold is not an effective inflation hedge. ISG makes this argument even as it admits that “we do not expect inflation to increase in any meaningful way when the US and other economies recover from this pandemic.” It is true that inflation is not today’s concern – especially with oil prices at $25/barrel and demand destroyed by the global response to the COVID-19 pandemic. Nevertheless, long-term inflation is difficult to predict, especially when the global economy is in the midst of a dramatic transformation.

Putting aside  for a moment the risk of short- or long-term inflation, the question remains whether ISG is right about the relationship between inflation and gold. The historical record provides a clear answer: gold outperforms rising inflation. Gold even outperforms periods where a fear (rather than any reality) of rising inflation exists. ISG admits as much, writing that gold “does have an attractive risk premium above inflation to warrant an allocation.” But then ISG claims that gold’s “slight edge” over inflation is not attainable due to physical storage or insurance fees and requirements. As a Wall Street veteran, I got a chuckle out of that line. If ISG is going to base its aversion to physical gold investment on storage fees, then I would be remiss if I did not point out the myriad of fees that are loaded into most investment choices. Let’s assume that a hedge fund does in fact hedge risk (a dubious claim for many hedge funds, which are merely leveraged long equities), then hedge fund investors are paying 2% plus 20% of the profits – a huge multiple of gold storage costs.

The results of a long-term study show that the gold price has historically risen during periods of high inflation—and the higher the inflation, the more gold rises.

During stretches of inflation that exceed 3%, the return on gold per annum is 8%. That return clearly outpaces the rise in inflation. In fact, gold’s two biggest climbs in modern history occurred during periods of high inflation or the fear of inflation. Gold rose 721% during the high inflation period of 1976 to 1980. It rose 170% from 2008 to 2011, when most investors feared inflation would rise from QE efforts.

In short, gold hedges inflation. Thus, ISG’s claim that gold does not respond to inflation flatly ignores the historical record showing that the opposite is true.

ISG Argument #2 Against Gold: Gold is Not a Reliable Hedge Against Disinflation or a Downdraft in Equities Should Economies Fall into Recession.

First, ISG argues that US Treasury Bonds have served as a more reliable hedge against equity downdrafts. The study below shows that has not been the case.

While the 10-year Treasury Bond logged a positive return during some of the stock market’s worst declines, gold has done better in two of the four selloffs by a large factor. We also saw a similar positive response from gold during the most recent selloff, up 5.6% for the year at the end of the first quarter in 2020, and up nearly 12% on the year on April 9th.

We agree that 10-year Treasury Bonds performed better than gold for the first quarter in 2020, but how much more room do they have to run given the new low in rates. Today’s 10-year Treasury yields a meager .73%, compared to 2.48% a year ago and a 10-year average of 4.48%. What happens when 10-year Treasury yields are at, or under, zero? Can an investor expect the same performance and/or protection from Treasury Bonds in that environment? When you take that likelihood into account, wouldn’t it be reasonable to reallocate some of your equity and/or real estate exposure to gold going forward?

Second, contrary to ISG’s argument, gold has historically offered strong hedging abilities during recessions. Since the 1970s, the gold price has risen during most recessionary periods.

ISG trots out the tired and pedestrian Warren Buffett line that “gold has no utility”. That is simply not true. Gold serves as money and a global medium of exchange. Gold is arguably sharing the stage with he US dollar as a reserve currency. Moreover, gold looks great when turned into jewelry! The irony, of course, is that gold has outperformed Berkshire Hathaway (class A shares) in each of its past six crashes.

Once again, historical data does not support ISG’s argument that gold is not a reliable hedge. Indeed, historical data shows that the opposite is true: gold offers near-consistent hedging abilities.

ISG Argument #3 Against Gold: Equities Offer Greater Upside.

ISG reports that “some clients have asked why we don’t prefer gold instead, given the lingering uncertainty around the virus.”

ISG’s response is based on this prognostication: “… our year-end S&P 500 price target implying a 20% gain from current levels, compared to an 11% advance for gold based on GIR forecasts.” While ISG’s prediction may come true, the historical record  (as set forth in the chart below) informs us gold has meaningfully outperformed the stock market over the past 20 years. Gold certainly outperformed the stock market since the beginning of 2020, since March 1, 2020, and since last week. The simple fact is that gold has outperformed equities in the short run, the long run, bear markets and bull markets. Not bad for a “fringe asset”.

ISG concludes that “a tactical allocation to the S&P 500 is a better long-term use of clients’ risk budget.” But what about a client’s non-risk budget? Why wouldn’t ISG consider forgoing some incremental projected return for real downside protection? Are we really having all that much fun on the roller coaster of equities as it lurches toward the next crisis?  If not, then note that gold has served as a far superior hedging asset during periods of crisis. As shown in the chart below, gold provided a stronger hedge than Treasury Bonds in nine of the eleven major crisis events.

Conclusion: Portfolios Are Stronger With Gold Than Without It

Back testing shows clearly that portfolios with gold outperform portfolios without gold. The 20-year study below reduced the 60/40 stock/bond portfolio in equal amounts by adding increasing percentages of gold (55/35/10). The results show that portfolios with a 10% weighting to gold outperformed those with less or no exposure to gold.

This outperformance results from combining a steady long-term return with solid hedging characteristics. To claim otherwise blatantly ignores historical data and investment results.

The Bottom Line: Gold Offers Resilience

Like most Americans, I am an optimist and that optimism allows me to hold a healthy allocation of equities in my portfolio. But when it comes to protecting myself from the downsides of equities, I stand away from many of the worn-out and overused narratives espoused by some of my former Wall Street colleagues.  I didn’t achieve a 10% gold allocation in my portfolio all at once. I legged in over a decade. I accepted less risk in exchange for a better night’s sleep.  Now, a decade after my first investment in physical gold, I am better off than I would have been had I used that 10% allocation for stock, hedge funds or private equity.

As I have explained above, an allocation of physical gold in one’s portfolio provides many benefits but ultimately it provides protection and resilience.  It’s time to rethink portfolio allocation and to discover how gold can both protect and enhance wealth while helping investors to weather inevitable economic crises. History has been whispering this very thing in our ears for thousands of years (even if ISG hasn’t been listening).

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