I first addressed my negative views on gold in mid-October, and boy was that a learning experience. I had known the definition of "gold bug", but I was totally unaware of its antonym until I reviewed the 100+ almost exclusively negative comments that article generated. Apparently, the term used most frequently to describe someone who doesn't ascribe to the cult of Gold is "idiot". I also learned of all sorts of conspiracy theories and the difference between "real gold" and "paper gold". I will simplify that as the difference between what Joe Retail is willing to pay so that he can get his hands on his investment vs. the much larger futures market.
I am not here today to gloat despite the fact that gold has plunged since I wrote that article on October 11th. I have given considerable thought to not only gold but also to the more important topic of inflation in general, and I have concluded that inflation is extremely unlikely for a long period of time (anyone seen the Japanese CPI numbers for the last many years?). I am definitely not gloating, as I have yet to short gold and I missed the huge trade in the long bond.
There are two reasons to own gold (absent any change in industrial demand). Most of the advocates of investing in gold cite inflation, and I believe that I addressed that issue in the previous article, where I suggested that the historical link no longer makes sense (and inflation isn't happening anyway). I will review this argument and share my thinking regarding the lack of potential for inflation. The other reason is to hedge against the breakdown of society. While I won't rule out mass chaos, it is probably unlikely. I do believe, though, that we could see a big rise in crime and will be publishing shortly some thoughts on this subject.
In the 8 weeks since I published my first-ever comments on gold, it has fallen 10%. I mentioned in that article that I believed that gold would be more appropriately priced at $600 or so. It touched as low as $700 before rallying and then retreating again.
The chart above for the SPDR Gold ETF (GLD), which is designed to replicate the price of gold bullion, shows the recent decline. Note that the consecutive highs have been lower, while the lows have as well. Additionally, the moving averages have rolled over. Technically, gold looks like every other asset: sick. I included the bottom panel because I wanted to highlight the radical change of late in the Treasury market. Longer-dated bonds have seen yields plunge, a sign of a massive shift in investor sentiment. Rates on the short-end have obviously diminished due to Fed policy and an extreme flight to safety, but this recent sharp decline in longer yields has come during a time of stock market stability (though commodities have plunged subsequently). The decline in yields appears to reflect investor sentiment regarding inflation. While gold has fallen "just" 10%, oil has continued to plunge, falling almost 50% since the October article. The CRB, more broadly representative of commodities, has dropped an astounding 28% in those 8 weeks. It would seem that the market is not telling but yelling that inflation is not a threat but rather quite the opposite. While gold has been doing "relatively" better, if you hold gold, it's time to fold. Here's why: Supply and demand.
On the supply side, I expect to hear about central bank liquidations eventually. According to the World Gold Council, the U.S. has about 8000 metric tons of gold. This may sound like a lot, but at $750 oz, this is "only" $211 billion. According to that same source, the U.S. is anomalous in that it holds over 70% of its reserves in gold compared to foreign currency. The total amount held by central banks and the IMF is approximately 29,000 metric tons, or about 20% of all gold. After the U.S., the largest holder, Germany, France, the IMF, Italy and Switzerland own a combined 12,500 metric tons. They tend to have over 50% of their forex reserves in gold. The general trend in other countries has been to more aggressively diminish the role of gold. The UK, for instance, owns only 310 metric tons representing just 10%. While I am no expert in central banking policy, it would seem politically that converting gold to cash would be feasible in this environment. To put things into perspective, if the central banks decided to decrease gold by 10% (2900 tons), the dollar value would be $76 billion, which amounts to 4X the amount of assets held by GLD. With all of the turmoil around the globe, would it be surprising to see some central bank sales of gold?
On the demand side, Joe Retail has been paying up big for tangible gold. There is a lag - it takes time to produce physical gold. The conspiracy theorists read a lot into this, suggesting that someone is "artificially keeping gold down". As commodity prices continue to fall, I believe that that many who have made the bet could actually reverse it. I would argue that rather than a conspiracy theory keeping "paper gold" artificially low, it is this irrational demand for "physical gold" that has prevented it from collapsing even further. As I mentioned in the original article, almost every commodity or "store of value" is plunging, and it has gotten worse. Art auctions are indicating year-over-year declines of 50% or more recently. Gold bugs like to argue that gold is a "currency", but please tell me where I can use gold to buy things. In the days of nomads crossing borders, gold was a currency, but it no longer serves that role anywhere from what I can tell.
The most compelling reason for demand to fade is that the debate will soon shift from "deflation or inflation" to just "how much deflation". I had been struggling conceptually with what the response will be to the massive measures being undertaken by the Treasury and the Federal Reserve, but it became clear to me today as I read the words of someone who is in stark disagreement with my views. The government is not printing money right now. Simplistically, it may seem like "Helicopter Ben" is dropping bags of cash into the parking lots at the malls, but that isn't the case at all. We are simply replacing private capital with public capital, which isn't in and of itself inflationary. We are increasing federal debt but increasing equity in the financial system. We are shifting the leverage from the private sector to the public sector. The cost ultimately will be higher taxes at a minimum. This could lead to lower economic growth and also potentially higher interest rates. We do run the risk of inflation if we keep interest rates too low after the crisis has passed, but worrying about that challenge now seems extremely premature. Consider the Japanese example, as it seems very analagous to ours. Short-term rates have been low there for quite some time, but there hasn't been any sign of inflation. I believe that ultimately we will come to view the commodity rise that included gold and oil as just the last of the speculative bubbles and will wonder why it took so long for gold to roll over and die. I will slightly alter my prior conclusion and say that if you are considering gold as an inflation hedge, you should take a look around you. If you still are concerned about inflation, learn about Treasury Inflation Protection Securities (TIPS). Gold remains a sucker's bet...
Disclosure: No position in gold or any derivative
