Let's talk about gold: January 6, 2011

This paper begins with an excerpt from a recent Wall Street Journal article and is followed by my comments.

……..Gold’s historic run-up was spurred by uncertainty about currencies, fears of inflation and continued monetary easing by the Federal Reserve. Like dot-com stocks in that bubble, which were difficult to value because many companies generated no earnings, gold is hard to value because it produces no earnings or revenue and costs money to store.

“It doesn’t do anything but cost you charges and stare at you,” billionaire investor Warren Buffett said in a recent interview.

There are other gold bulls, of course, including prominent hedge-fund manager John Paulson, who has predicted gold could go to $4,000 an ounce by as early as 2013.

For his part, Mr. McGuire says gold is no longer only for those who think financial Armageddon is near. He expects gold to soar amid rising inflation, among other things. “The world does not need to end for gold to go hyperbolic,” he says.

In his book, Mr. McGuire reasons that $10,000 gold is possible if enough other pension funds and big investors jump-start buying and move as little as 1% of total global stocks and bonds holdings into the metal. Such a migration into gold would equal enough demand to push prices up tenfold from their current level, he calculates.

Of course, the same argument would be true for nearly every other investment class. Mr. McGuire has confidence in his argument, however, because he believes inflation will return, which typically pushes gold prices higher.

He said he expects a series of fiscal crises to hit around the world. And then there is China, where he says that gold is “widely regarded as a basic savings asset.”

Gold prices also are rising because of the ascendancy of exchange-traded funds, which are funds that track an index but are be traded like a stock. The largest ETF, under the trading symbol GLD, now invests $50 billion, an amount that Mr. McGuire believes could grow far higher if investors shift a small percentage of their investment funds into gold. At its current level, the stock-market capitalization of all gold ETFs is about $80 billion, roughly that of McDonald’s Corp.

“Now that the value of modern money is becoming highly questionable, more and more people are turning to gold. It’s not the new thing; it’s a return to normal,” he says.

October WSJ Article Featuring a PM from Texas Teachers that Runs their Gold Portfolio: ‘The World Does Not Need to End’

My Comments:

I agree with Warren Buffet that gold is not an investment. The only way I can justify owning it is as a hedge. Anyone who tries to forecast prices of gold has gone off trail. Justifying its value by saying others will want to own it is folly.

It is relatively arbitrary that the marketplace has agreed to call gold a store of value. And at what level is gold properly priced? Hang with me as I try to articulate what I’m asking, let’s assume there were no abnormal inflation expectations and monetary and fiscal policies were sound (hard to imagine, but please try)…….where should gold be priced? In other words, where is base camp? Where is the equilibrium point that we can adjust away from as our expectations change?

The incremental retail buyer has no clue. So they have no way of knowing how much of the future expectations are already priced in by the ‘professional’ money. For example, If you buy gold now and we have 2% inflation for the next 3 years and then 5% inflation for 10 years, and the dollar depreciates by 20% over that time relative to a global basket of currencies…..how will gold perform? Explain to me why you believe what you believe. Most assume it will keep pace with some combination of inflation and dollar depreciation…..but what if the scenario I just drew up is milder than what the current price assumes? What if the state of the world that the bulk of new money to gold is hedging against is much worse than what actually happens? Then gold should lose value as many holders will decide the world isn’t as bad as they were afraid of and there are better things to invest in—the opportunity cost of owning a non-yielding asset will become too great.

As they begin to sell gold the price will head back to base camp….I’ll call historical base camp $400/ounce, which is roughly the average price of gold for the 25 years leading up to 2005. There will likely be a support level which is materially higher than pre-2005 averages as new retail and institutional clientele will now have gold as part of their long-term asset mix. Much money will be lost as investors who missed out on the gold run of the last ten years scramble to catch the falling knife. So, I’ll arbitrarily call the new base camp $800. That is double the 1980-2005 average, and still more than 40% below today’s current price of $1400. Let’s be clear…THIS IS NOT A PREDICTION…I don’t do such things. This is me giving airtime to a likely scenario that is largely ignored. Gold could indeed go to $4000/oz. there’s no predicting crowd behavior. Gold at these levels is a VOLATILE transaction. And volatility is exactly what many buying gold are trying to avoid, it is extremely important that you understand this.

And though I won’t predict, I will argue this: for those who bought gold 2005-2009 as a hedge against bad monetary policy and global currency debasement, it’s more than done its job–nice work, good trade; and while doing its job it has attracted momentum traders who are not long-term holders and will run for the door as soon as the trend slows or stops. In 2005-2007 the gold trade was asymmetric in favor of those who were worried that not enough people were worried, now I would say the asymmetry has flipped as plenty of people are worried and gold has become a trade (much as oil did in 2007-2008). I still hold gold but at the bottom of my hedging range…1%. 90% of my hedging basket is committed to other exposures…for example, with the VIX at 17 buying insurance on equity risk is reasonably priced.