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Gold's Recently Emerged Competition

TIPS may turn out to be the key challenger to gold’s store-of-value supremacy status in the future. Aside from being issued by the U.S. Treasury and therefore backed by the full faith of the U.S. government, they also protect investors from inflation—one of gold’s most valued qualities. TIPS’ principal is tied to the CPI: The principal value increases with inflation and falls with deflation. When the security matures, the original or adjusted principal is repaid, whichever is greater.

Though TIPS appear to have superior financial properties to gold, they still lack one of gold’s main attractions—tangibility. After all, they are still just bytes and bits on a brokerage firm’s or bank’s mainframe, or pieces of flammable paper stored in a safe. In addition, the inflation component that goes into TIPS pricing is calculated based on the CPI, which is calculated by the U.S. government. Many investors argue that the CPI calculation is outdated and that it chronically understates inflation.

Any cash-flow-generating asset, like a stock or a bond, can be valued on the future cash flows that it is expected to generate. Predicting gold prices is extremely difficult, as gold is not a cash-generating asset. In fact, it is important to note that gold actually has a negative yield (cost of carry). Gold is a cash-consuming asset (it’s safekeeping and transportation cost money), whereas TIPS as well as any bonds and dividend-paying stocks have a positive yield—they pay investors for holding them.

Gold is also considered a good currency hedge, especially for the U.S. investors who are concerned about the declining dollar. Again, our financial ingenuity is stealing gold’s long-held exclusivity on that trade, providing options that were not available a few decades ago. To protect themselves against the declining dollar, U.S. investors can use currency futures and options, foreign-currency-denominated mutual funds, and certificates of deposit (CDs); they can buy foreign stocks on foreign exchanges or through American depositary receipts (ADRs); and of course there is a most recent development—currency exchange-traded funds (ETFs).

In both the long run and the short run, gold prices are driven by fear of the world coming to an end and investors’ expectations of future inflation. Although gold has some industrial applications (in jewelry, dentistry, computers, jet engines, electronics, as a superconductor, etc.), linking its intrinsic value directly to its price is difficult. Perception of its ability to store and preserve real value (especially in an inflationary environment) is the key driver of gold’s price. As long as investors perceive gold to be a refuge in times of uncertainty, gold will act as such. It is important to note that gold’s monopoly as an instrument of choice at the time of fear and uncertainty has been undermined by other very capable and often superior financial instruments.

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Excerpted with permission of the publisher John Wiley & Sons, Inc. from Active Value Investing - Making Money in Range Bound Markets Copyright (c) 2007 by Vitaliy Katsenelson. This book is available at all bookstores, online booksellers and from the Wiley web site at www.wiley.com, or call 1-800-225-5945.