Gold has been a media and investor darling of late. But the foundation on which the current bull market is built is unsound. Investors (and by that I mean those market participants with a time horizon of one year or more) who buy gold today will almost certainly regret their decision. The core argument for gold is that the dollar is being debased by the Fed’s printing of money. Gold is supposedly the last form of “real” money and the only store of value with integrity. Let me explain why I believe that view is flawed.
I was a relatively novice trader the last time we had a true frenzy in precious metals in the late 1970s and early 1980s. At that time there was very real structural inflation and headline inflation was in the double digits. Commodities of all kinds were in vogue and gold traded to a high of over $800. However, as we know, under Volcker’s leadership the Fed quashed inflation and the precious metals collapsed. The gold market was relatively listless in the ensuing two decades, never coming close to that early 80’s high. In 1999, I recall buying gold as it was being divested by central banks at prices as low as $260 an ounce. The calls of gold being a “barbarous relic” of history with no intrinsic value were then loud and rampant and, of course, wrong. Gold last traded $255/ounce in 2001. In the ensuing decade, gold has risen 500% without a single down year. Now many pundits and gurus are shouting to bring back the gold standard. Their claim is that the dollar is being systematically debased and that the traditional rules for valuing precious metals, i.e., supply and demand, no longer apply. Gold is the only REAL currency.
The facts do not support these claims. Headline inflation as measured by the CPI is not even above 3%, well below that of the late 1970s. TIPS indicate that ten-year inflation is expected to be about 2.5% and while the DXY has been weak recently, it is only back to levels seen in 2008. The idea of a gold standard is deeply flawed. The reason that it was originally abandoned was that money supply growth (which directly impacts economic growth) would be dependent upon gold production rates. In the late 1800’s the boom and bust economy was driven rather
capriciously by periodic gold rushes and subsequent monetary growth, e.g., California in the 1850s and the Alaskan and Yukon gold rushes later in the century. Technological advancements also influence the supply of gold such as the MacArthur-Forrest process implemented in the late 19th century which allowed more gold to be extracted per ton of ore. Much as democracy is the least-bad form of government, an independent central bank which can lean against the natural cyclicality of the free-market credit cycle – while flawed – is almost certainly the least-bad monetary option.
Even if we were to adopt a gold standard, gold prices would still be governed by the same laws of supply and demand that govern all commodities. Over the long-term, commodity prices trade cyclically around their marginal (meaning the highest-cost producer’s) cost of production. Today in gold that cost is somewhere around $700/ounce. In the short term this price has only marginal relevance but over the long term it is critical. Think of gold as having a gravitational pull toward this price. Given how small annual production of gold is as a percentage of above-ground stocks, this gravitational pull is rather light compared with some other commodities. Thus when the animal spirits are high as they are now, the yellow metal’s price can far exceed its natural price just as in 2001 when it traded far below this natural fair value. But the force is still there and it is inexorable. Miners and scrap dealers and collectors are just too incented to find or produce more of it at $1,500/ounce.
Gold has many currency-like characteristics relative to most commodities. It is not truly consumed in the same way that crude oil or soybeans are. The industrial uses for gold are few and much of the demand is for decorative purposes. Demand for gold tends to follow circular logic – we value gold because we are told that gold is valuable. However, the basic laws - supply, demand, and marginal-cost-of-production - still apply. As I recall driving by a former drive-thru coffee shop now boasting a “WE BUY GOLD” sign this week and I hear the ads for gold blaring on CNBC, I fear that many an unwitting investor is going to lose his or her shirt. While gold could easily accelerate higher in the near term and could conceivably even double or more as reflexive characteristics take hold, the tenor of the market reminds me of the early 80’s in gold or the more recent tech bubble of 2000. These periods did not present good buys for the longer-term investor. Eventually the forces of supply and demand will matter.
One thought on the chaos thesis for gold – for those of the dried food, bottled water and guns mentality. I doubt that a hoard of gold will do anyone much good if we ever do get social chaos. If you have it in a Swiss bank, there will be no way to get it. If you have it in your backyard you will need guns to defend it and it still won’t buy you food at Walmart. It will be very hard to carry much of it on your person to bribe the border guards. You’re better off buying a farm, farm equipment and huge tanks of water and diesel and mapping your getaway route.
What to buy now with an investor’s time frame? High quality stocks have gone nowhere over the last decade while gold has quintupled. Stocks have historically done quite well in inflationary environments in case we do get that much feared malaise. If hard assets are more to your liking then why not consider land. Land has collapsed in price. Even raw land at least has the prospect of future income (unlike gold) and they are not making any more of it. But if instead you are going to play the gold game now, just understand the game you are playing — and that is one of musical chairs.
– John Helmers has been active in the markets since the late 1970s. He has had stints trading or managing money for JP Morgan, Goldman Sachs, Tudor Investment Corp and Citadel. He currently is the principal of a private investment firm, Swiftwater Capital.