The Wall Street Journal comes through as expected…
We knew this would happen of course, but it is still quite amusing. After explaining in the first part of its series of articles on gold 'why gold may become a bubble', the Wall Street Journal's Brett Arends informs us why, after all, 'he doesn't trust gold' anyway. Now, the title itself is already quite humorous in a way. If you don't trust gold, then implicitly, you rather trust a piece of paper that the government has devalued by slapping some ink on it.
We wonder which of these choices requires the greater leap of faith. Consider the pie chart below, which depicts the fate of 786 paper currencies that have been issued in the course of history (excluding Chinese paper currencies prior to 1935):
The fate of 786 different paper currencies. The chart is taken from this interesting article by Mike Hewitt: '
' – click chart for higher resolution.
Arends then launches into the usual litany of non-arguments that has marred the debate on gold in the mainstream press for the entire past decade. Not surprisingly, he starts off by invoking authority.
He quotes Warren Buffett's famous 'gold is useless' declaration and as Arends tells us, 'Buffett puts it well', or so he thinks, anyway:
|„Gold gets dug out of the ground in Africa, or someplace," he said. "Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.“|
Clearly, no investor worth his salt would want to be caught dead with something that causes the little green men from Mars to scratch their heads. Stuff that got dug out in Africa or someplace, and now gathers mold in a vault! Waste of time, obviously – and if good old 'awe shucks' Warren tells us so, it must be true. We would argue that Warren Buffett, while certainly a legendary and highly successful long term investor (albeit one who had the wind of the long bull market/mania in stocks at his back for most of his career – ever since that has turned into a headwind, his performance has become a little less inspiring), is most definitely not an authority on gold.
Strange as this may seem for someone who chose investing as his career path, Buffett professes to be a supporter of socialism. He is by his own admission what is referred to as a 'liberal' in the US (The term 'liberal' is not used in its classical sense in the US, but rather denotes allegiance to the Democratic party, the US equivalent of the socialist democratic parties of Europe).
He has for instance frequently argued in the past that ' '. We wonder if anyone has pointed out to him yet that he is perfectly free to gift some of his loot to the State voluntarily. We're sure the IRS would be more than happy to relieve him of some of it.
Ah, but higher taxes are not about paying voluntarily after all – if there's no coercion involved, then they wouldn't be 'taxes'. In our view, WB is probably still rebelling against his conservative father Howard Buffett – who in turn was a noted supporter of the gold standard and eloquently argued in his time as a Congressman that 'without honest money' – this is to say, gold – 'there can be no economic freedom' (See: 'Human Freedom Rests on Gold Redeemable Money' by Howard Buffett). And as we know, without economic freedom there is no freedom, period.
Even Alan Greenspan knew it, as evidenced by his well-known late 1960's essay 'Gold and Economic Freedom'. We're not even sure that the putative aliens would be 'scratching their heads' as it were. There's a good chance they'd be using gold as money too – for the simple reason that of all commodities, gold appears to be the most useful for this purpose.
Since the distribution of the elements is probably pretty uniform across the universe, we'd argue that this notion could easily occur to alien tentacle wielders as well. We can imagine the headlines already: 'Warren Buffett shocked by revelation that mollusks from Rigel II try to pay their way with gold, same as the Ganymedian slime-molds (link broke on July 17th 2010) that dropped by last year.'
However, the witty condemnation of gold from the oracle is 'not even half of it', Arends informs us. What could be worse than the sight of aliens scratching their heads? 'It is volatile.' Volatile! Unlike, say, the stock market?
13 years of gold (black line) vs. stocks. Gold is too volatile, argues the WSJ – click chart for higher resolution.
From a special report by Erstebank on gold:
|“Both the past few months and a long-term look into historic time series show that gold is substantially less volatile than equities (e.g. MSCI World). Only the shares of junior explorers with low market capitalization deserve the label “highly speculative”. In the past ten years, the volatility of the Dow Jones index has been 16%, whereas that of gold has been 12%. The correlation of gold and the S&P 500 index has been -0.15 since 1990, as confirmed by a study of the World Gold Council. The volatility of gold has been substantially lower than that of oil, other precious metals, the GSCI commodities index, and most equity indexes in the past 20 years.”|
Oh well, so much for that. Next he says:
'It is hard to value'.
Now, the 'hard to value' argument is certainly debatable. Of course Arends doesn't inform us about how one might go about valuing gold at all. There are however a number of valid approaches – for example, one can compare the amount of outstanding gold to the amount of outstanding fiat currency.
It then becomes mostly a matter of which money supply measures to use, or whether one should compare the outstanding money stock of individual nations to their official gold holdings. Another method is to compare the gold price to that of a basket of goods and services, such as the official CPI attempts to measure (note here that such measures are really not very sensible, as the 'average price' of a basket of disparate goods is by its very nature a nonsensical number – but this is a discussion for another time).
However, almost regardless of which approach one uses, gold comes off as either fairly valued or still undervalued at present, in spite of having risen for ten years running. Below are a few charts illustrating this point.
A chart made by our friend Bart from the excellent site 'Nowandfutures.com'. It compares the price of gold to TMS (broad Austrian money supply), AMS (narrow Austrian money supply) and M3. For more details on the various money supply measures take a look at 'Monetary conditions in the US' and follow the links posted there. By these measures gold certainly doesn't look overpriced – click chart for higher resolution.
Gold vs. two CPI measures – the official and the 'shadowstats.com adjusted version', also by Nowandfutures.com. Using the shadowstats CPI (which excludes the massaging of this statistic that was introduced by the Boskin commission), gold is now roughly at the price level of 1900 – click chart for higher resolution.
So there seem to be a few methods to value gold. For a lark, one can also consider the 'Shadow Gold Price' calculated by QB partners. The theory behind this gold price calculation is based on the idea that in the (gold standard) past, bank reserves held at the Fed were in the form of gold. So QB Partners asked, what if the Fed's liabilities had to be backed by official US gold holdings once more? One would then arrive at the 'shadow gold price' by simply dividing the former through the latter. Here is the result of this exercise:
Using the 'shadow gold price' calculated by QB Partners – the Fed's liabilities divided by official US gold reserves – one arrives at a rather heady price for an ounce of gold – click chart for higher resolution.
We hasten to add that this latter method is probably exaggerating gold's potential, but it is not entirely without merit. As QB Partners note with regards to this calculation:
|“To identify the intrinsic value of the dollar today, we examine the corollary – the intrinsic value of gold in dollar terms, which we dub “The Shadow Gold Price” (SGP). To do so we assume that Federal Reserve Bank liabilities are again exchangeable into gold (recall, FRB reserves are bank assets – the stuff that used to have to be gold). As we discussed in “A Not-So Modest Proposal”, one would simply divide the dollar amount of current Fed liabilities by official gold holdings. This calculation, while simple, is intellectually honest and produces a breathtakingly large “equilibrium” gold price of approximately $9500 per ounce today ($2.5 trillion divided by US official gold holdings of 8100+ metric tons). Egads! What has the Fed been up to since 1971? Since “you can’t fight the Fed” we’ll simply whisper that gold seems to be “worth” substantially more than the $800 an ounce or so it trades on the COMEX paper futures exchange. Is this just an academic exercise? We don’t think so. In the movie Trading Places, Bo Diddley’s pawnbroker character didn’t care what Louis’ watch was worth in Gstaad; “in Philadelphia,” he said, “it’s worth fifty-bucks.” And we care less about where gold is priced today in the futures pit than we care about its objectively true monetary equilibrium – the price to which it will likely gravitate over time. “|
As we noted in Part One of 'Some thoughts on gold', it is mainly a mixture of direct investment demand and reservation demand that drives the gold price – in short, the evaluation of gold by myriad individual investors that either intend to invest in gold (resp. wish to exchange some of their savings from fiat currency to gold) or decide whether or not to sell the gold they currently hold at the prevailing price. In the end, it is the collective judgment of these individuals that determines the price of gold in terms of fiat money.
Nevertheless, it is certainly not impossible to get some idea of what gold might be worth, and how its current value compares to the past. It may be 'hard', but not too hard – all the valuation yardsticks presented here can be found on the web for free after all.
Next Arends says:
'It doesn't generate income'
To which we reply: 'So what?' The stock market's yield isn't anything to write home about either after all. Nor is the US dollar's yield especially enticing, with the Federal Funds rate pegged at 0% – 0,25%. In any case, while gold may have no yield, it certainly performs its function of preserving one's purchasing power.
Consider gold as the currency issued by the most secure of all debtors – in fact the only 100% safe one. Since gold is the only form of money in the world that is not at the same time someone else's liability, it is only natural that it should have no yield (or rather, an exceedingly low yield, the gold lease rate).
Since the creation of the Federal Reserve in 1913, the US dollar has lost over 96% of its purchasing power (more than 80% since 1971 alone, when the official dollar-gold convertibility was abandoned by Nixon). During the same span, the price of gold has increased by a factor of 60. We would argue it compensates rather well for not 'generating income'.
A collection of old canards
We were not surprised to find that yet more old canards are thrown our way next by the WSJ. Arends continues:
|“As for being a "store of value," anyone who bought gold in the late 1970s and held on lost nearly all their purchasing power over the next 20 years. “|
We're really tired of hearing that one. It's a favorite argument of gold bears – take the spike high of early 1980 (when gold traded at $850 for about one second), and presto, you can 'prove' that gold has been a bad investment – right, for anyone who bought in a period lasting about two months in late '79/early '80 it probably was. Just don't mention that it was at $35 in 1971. The starting point makes quite a big difference, obviously. In late 1979, the world panicked over high inflation (or rather, a sharp rise in prices for goods and services) the Iran revolution and lastly the Soviet invasion of Afghanistan.
Meanwhile Paul Volcker had begun to raise rates into the stratosphere and begun to target money supply growth in order to save the dollar. It was rather obvious to any seasoned market observer that gold had become a hysterical bubble in the final months of 1979. Of course the gold bear argument makes absolutely no sense unless that time period is taken as the starting point.
As a recent report by noted, gold has outperformed every major asset class over the past 20 years, regardless of the time horizon one cares to look at.
Gold's return compared to other major asset classes over five different time horizons. Gold has outperformed over every one of them – click chart for higher resolution.
Next Arends begins to quote the World Gold Council's supply-demand data, which as we have mentioned previously are exceedingly useless in evaluating gold's potential as an investment.
|“If the price rises you'd think there must be a shortage. But data provided by the World Gold Council, an industry body, tell a remarkable story. Over that period the world has produced—or, more accurately, recovered—far more gold than anyone actually wanted to use. Since 2002, for example, total demand for gold from goldsmiths and jewelers, and dentists, and general industry, has come to about 22,500 tonnes. But during the same period, more than 29,000 tonnes has come on to the market.”|
Let's clear this up once and for all: there can never – repeat, never – be a 'gold shortage'. What the WGC does here, and Arends unthinkingly repeats as if it were some great revelation, is to analyze gold as a commodity that get's 'used up', like oil or copper. Just as there can be no 'dollar shortage' or 'euro shortage' can there be no 'gold shortage'. All the 160,000 tons produced in mankind's history still exist, and some percentage of that (a good guesstimate may be two thirds) is available for investment – at the right price. Arends continues:
|“So if supply has consistently exceeded user demand, how come the price of gold has still been rising? In a word, hoarding. Gold investors, or hoarders, have made up all the difference. They are the only reason total "demand" has exceeded supply.”|
Well, duh. There was no reason to put 'demand' in quotes there, since investment demand is the only demand that actually counts for the price of gold. Then follows what a friend of ours referred to as the 'executive summary' of the article:
|“Lots of people have been buying gold in the hope it would rise. But the only way it can rise is if still more people buy it, hoping it will rise still further. And so on. What do we call an investment scheme where current members' returns depend entirely on new money brought in by new members? A Ponzi scheme.”|
So there you have it. The Wall Street Journal says gold is a Ponzi scheme. That makes the dollar and the euro what, exactly?
What is really important for the price of gold
As we have mentioned, gold should be evaluated as a currency – i.e. it should be treated analytically as if it were money, even though it is not used as a medium of exchange at present.
The relatively high market price of gold indicates that the market indeed treats gold as money as well. Since investment demand (or if you will, monetary demand) is the only important driver of the gold price, the factors influencing investment demand are what one needs to analyze. Among these we find:
1. the yield spread between long and short term interest rates – a wide or rising spread indicates either easy monetary policy, or rising fears of inflation or both and is bullish for gold (conversely, a tightening spread – when short term rates are rising relative to long term ones – is considered bearish)
2. Real interest rates – this is to say, interest rates relative to inflation expectations (see explanation of the latter below). Low or negative real rates are bullish for gold.
3. Inflation expectations – market-based inflation expectations can be measured by comparing the yields or prices of inflation-indexed bonds (TIPs) to 'normal' bonds of the same maturity. When the TIP (TIPs-ETF)-TLT (bond ETF) ratio is rising, inflation expectations are rising, and vice versa when the ratio is falling.
4. True money supply growth – when money supply growth is high and/or rising, the gold price tends to reflect that – usually more quickly than other inflation-dependent asset prices. It is best to use the Austrian measure TMS for measuring money supply growth.
5. Liquidity – gold's real price (gold measured in terms of other items such as commodities or stocks) usually does best when market liquidity is falling, resp. time preferences are lowered, such as tends to happen during secular downturns. Gold is a counter-cyclical asset. 6. Exchange rates – specifically the dollar exchange rate – when it is falling this often tends to be bullish for gold, but this is not a sine qua non, since gold tends to rise in terms of all fiat currencies during bull markets.
In fact, total gold demand is inverse to jewelry and industrial demand, so that it would be quite correct to state by inference that falling jewelry and industrial demand is bullish, resp. a hallmark of a gold bull market. You can find some charts illustrating this in an article I wrote under the pen name 'Trotsky' at Mish's blog in 2007, 'Misconceptions about Gold'. Lastly, there are of course leads and lags between the factors influencing gold prices being bullishly or bearishly configured and the gold price itself. Investors have to correctly estimate future developments, which in the current situation is quite easy as it were. The main question is really, will there be more government spending and money printing? The answer to that is probably 'yes'.
Better get some of this …
… before this happens.
(Dilbert, Credits to Scott Adams)
Charts by: Nowandfutures.com, shadowstats, QB Partners, BigCharts.com, DollarDaze.org.
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