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Tuesday, June 15, 2010

The Peculiar Allure of Gold

Anyone who knows me knows that I have a pathological hatred of precious metals so take that into account when I delve into a brief discussion of gold. Let me first get something out of my system by saying that, in my view, metals should only be valued by their relative rarity and usefulness in industrial purposes. At an emotional level, to me, not much else makes sense, but I digress.

In any event, gold has been the investment of the last decade, unless of course you invested in overseas stock markets. Brazil from the lows of 2002 kicked the hell out of gold. "Kicking the hell out of" something is a technical investment term used to discuss relative performance. Yes, it is true that gold blew away stocks in a bad way in the 2000s. Its proponents point to a few attributes that gold has that explain this performance. These are, namely:

1. Gold is the ultimate inflation hedge. Your money will not lose value if it is invested in gold.
2. Gold is the ultimate crisis hedge. When people get scared, they buy gold.
3. Gold is the ultimate hedge against a falling dollar. When people lose faith in "fiat" money, they will turn to gold.

Proponents argue that these are all absolutely immutable laws of the market and that these relationships always hold. In fact, some argue that there is a strict mathematical relationship.

Of these arguments, only the third really holds any water for me, and even that I am slightly skeptical of. Let me address these in order.

More after the page break.

On point one, this only seems to hold true as a hedge against an acceleration in the rate of inflation. In the late 70s and early 80s inflation seemed to be spinning out of control and as a consequence people turned to something that seemed to have a constancy to it as the value of their paper dollars decreased by as much as 13% a year. Once again, in the 2005-mid-2008 era, inflation seemed to be accelerating, eventually reaching nigh 5.5% here on a year on year basis. That was up considerably from the roughly 2% we had been accustomed to. When inflation runs rampant, most financial investments become somewhat difficult to value. Many of the discount rates you have been using don't make sense anymore and people turn to what they can understand. That's all well and good. Throw in some hedge fund manipulations and you get yourself a gold rally. Fine.

However, the increases do seem grossly disproportionate to the threat. Gold increased nearly ten fold in the 1970s. Who knew that all Auric Goldfinger had to do to get the ten fold increase in the value of his gold was wait around for the 1970s instead of irradiating Fort Knox? If you don't understand the reference, shame on you. Inflation cumulatively in the 1970s was nowhere near that. Similarly in the 2000s, inflation was nowhere near proportionate to the increase in gold prices. Maybe compared to raw commodities, yes, but inflation overall, no. Before moving on, here is a good chart I stole from Zeal LLC:

The consequence of the overshoot in the 1970s was that gold was an abysmal investment that underperformed equities, bonds, real estate, and inflation from 1980 through 2000. I can stretch that out a little more, but it makes the point. If you bought at gold's peak in 1980, you were mercilessly slaughtered. If that was your primary investment, you never really recovered. In inflation adjusted terms, you only recently broke even. Even with stocks' lousy performance over the last decade, they have absolutely stomped gold since 1980. Now, it's a closer call if you go back to when the gold standard was ended and the price of gold was finally allowed to float, but those comparisons are silly. Long story short, it really depends on when you buy gold. The changes in prices relative to inflationary expectations seem arbitrary.

On point two, this is clearly not the case. Look no further than late 2008. It doesn't get any scarier than that and gold fell off a cliff. Bonds were, are, and will likely continue to be the best crisis hedge. If the solvency of the government is truly at issue, then we can revisit this, but, sorry to the crazies out there, the solvency of the government is not in question. Now, in the last few months, gold has rallied a bit in response to the European debt crisis, which is in keeping with the idea that gold is a crisis hedge. Similarly, gold did jump just after 9/11.  Now, to be honest, the 2008 financial crisis was a much bigger deal, at least economically, but I will controversially state in every respect, to 9/11 or the present European debt crisis. So, it would seem that for cataclysmic crises, gold is not a good bet, but for smaller periods of anxiety it might be. Of course, I am drawing from only a few data points for that conclusion so shame on me.

On point three, there is some evidence to suggest that this is the case. I ran some correlations back in the day that I can't seem to find any more that did show a consistent, though somewhat weak, inverse correlation between the value of the dollar and gold prices. Obviously, there are some times when this relationship has not held. The mid-1980s saw a massively devaluation of the dollar that did not result in a spike in gold prices and similarly the rally in the dollar versus the Euro lately has not brought gold prices down. In the latter case, broader indices show much less improvement in the dollar's standing and this might be part of the explanation. However, in general, I will give this point to the gold bugs, but the magnitude by which changes in the dollar's value impact gold prices is not at all clear.

Bottom line on all of this, there are no real firm relationships that explain the price of gold. There might have been but for the present elevated prices which are hard to explain via conventional means. Some have tried to say that the jump in the monetary base justifies it, but that's a weak argument. The increase in the monetary base is only relevant if there is a sufficiently high multiplier to translate it into substantially larger money supply. There has not been. Even the supposed constancy of gold relative to other commodities broke down in a big way this year as many commodities have plunged off a cliff since April with the European financial crisis while gold has rallied about 8%. Go figure.

Frankly, I am at a loss on how to properly value gold. Its industrial value is far lower than its price at all times and the actual demand for the physical metal for jewelry is not a compelling driver either. Rather, it is a financial asset simply because some people think it should be. Unlike a stock or a bond, it does not represent a legal claim to a stream of payments or the equity of a company. Because of this, it is an arbitrary price, driven entirely by sentiment. In this respect, you can almost make the efficient market argument that the proper way to value gold is by saying its true value is whatever the market says it is. However, be aware that sentiment on gold can change rapidly. It did in 2008 and it did in 1980 and it was merciless. Does it belong in your portfolio? That's up to you. I do own a $500 gold coin, but that is as a numismatic exercise rather than an investing one. I would, however, never ever endorse it as more than a few percent of a total portfolio.

Anyway, those are my thoughts. If by chance a gold bug makes their way over here they will throw about 580,000 links my way trying to demonstrate the intrinsic value of gold or show me its long term trend. Any honest person would admit that neither exist.


  1. Is it too early for us to get in on lithium investment in Afghanistan?

  2. I would like to see how that will all work out, actually. I suspect that the Afghans will work out some arrangement like the Saudis have with oil where foreign contractors come in and bid on it. It will be interesting to see who does.