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Gold has become a bigger and bigger story over the last several years as it’s steadily surged toward new peaks above $1,200 per ounce. This has dovetailed in perfect synchronicity with increasing fears about long-term inflation, concern about the strength of our national currency, and uncertainty about our collective economic future.
Now’s as good a time as any to drill down and separate myth from reality. As usual, what we have to say may not be what you’ve heard elsewhere. We like to take a contrarian perspective on the world, though certainly not just for the sake of being contrarian. Fundamental correctness is absolutely paramount to any contrarian viewpoint. We are firm believers that when it comes to macro investing, the best way to make real money over the long run is with a stance that is both contrarian and fundamentally correct. Being contrarian is easy (though not as easy as you might think), but being correct is hard. There is a lot of money to made from situations where most of world has it wrong and you have it right.
Gold is probably the one thing we get asked about the most. When we meet people out in the world that find out that we trade commodities, they almost invariably ask us what we think about gold. Most people that you talk to tend to have an opinion about it. Unlike stocks and especially bonds, investor sophistication has little to do with an individual’s opinion of gold. Quite simply, everybody wants it. They have for millennia. What’s more is that they understand it innately. The want is almost primal.
Gold has been demanded and desired by basically every civilization in history. It’s been used as a store of wealth throughout the ages. At various times in various economies in history it’s been used as a medium of exchange, either directly, or indirectly as a hard asset backing a paper currency.
Understanding all this historical and psychological context is important before we get down to the nitty gritty. When we begin looking at gold, and more importantly, begin using gold as a tool, it’s important to keep all the noise at bay.
So here we go, what you need to know about gold:
1) It’s not the inflation hedge you think it is.
In the past gold hasn’t actually correlated very well with inflation. Gold went pretty much straight down from the frenzy peak in 1980 until about 2001. That was a period of unquestionably positive, albeit modest, inflation. If you bought gold in the 80’s to hedge against future inflation, you lost money on both sides – not exactly the kind of result one is looking for in a hedged trade. Even if you waited years after the bubble before buying, it still declined while inflation rose.
Over the long, long run gold has worked as an inflation hedge. But a lot of things have gone up in value over the last century and have thus have correlated positively with inflation. In the 20th century, just about everything that was denominated in dollars went up in value as the value of the dollars denominating them went down. So over the long, long run, it’s not really much better a hedge against inflation than equities or real estate or other physical assets (except during bouts of hyperinflation).
You might also be curious if gold can predict future inflation.
The below chart looks a little confusing at first but it really isn’t so bad. All it does is run back through history, stopping at each month to look back at the previous 12 month change in the price of gold and chart it against the next 12 month change in the inflation rate (as measured by the CPI).
So each dot represents one month and it measures the prior year’s change in the gold price versus the coming year’s change in inflation. I also did it for a 6-month interval as well.
Make sense? We now can ask:
The answer is… sort of.
It’s pretty clear to see that the slope of the regression lines are both positive which means that there is indeed a positive correlation between past movements in gold and future movements in inflation.
But during normal times i.e. annual inflation between zero and 5%, movement in gold does a very poor job predicting the rate of inflation. Perhaps because normal times are boring. Nobody cares about inflation in the low single digits. That is what the Fed is actively shooting for, after all. Central bankers around the world sleep soundly and have happy dreams if inflation is positive and low.
What investors want to know is if there’s a way to forecast hyperinflation. And here you can see that when gold has really gone wild, increasing by 100% or more in 6 months, it has usually meant that high single-digit or double-digit inflation has followed in the next 6 months. It does a little better job as a predictor here, but keep in mind that just about all of those data points towards the top right corner in that chart were from the late 70’s and early 80’s. The gold market was held in the grips of a speculative frenzy and the country had already been experiencing double-digit inflation for years. So none of those data points would have been particularly useful in practice.
The take-home point here is that one should be careful when looking at the gold market and using its movement to divine the future. Yet again, we bump up against the ubiquitous conclusion that past performance is not indicative of future results.
Gold’s up over 30% in the last 12 months which is a gigantic move, but nobody in their right mind expects significant inflation in the coming year. Even without that economic forecast, very little should be excluded from our expectations of the change in coming the inflation rate. Pretty much any outcome is in play.
2) It’s best thought of as a “neutral currency”.
The most important thing to understand about currencies is that they are a relative value proposition. Currencies don’t have an independent, absolute value the way other assets do. Instead they are globally priced in terms of other currencies. Or even other assets, which can be a little counter-intuitive. Last Halloween I went to the grocery store yesterday and there was a big box of pumpkins outside where they were strangely pricing dollars in terms of pumpkins. The sign said $1/4lbs pumpkin. Apparently one dollar is actually worth 4 pounds of pumpkins. How many pounds of pumpkins does one ounce of gold cost? About 5,000 pounds of pumpkin!
As I’m sure you’ve noticed, economists have a strange sense of “humor” and one thing we like to do for fun is price one thing in terms of another thing.
It’s especially interesting to use gold for this. For example, let’s price the stock market in terms of gold. The first chart is log scale, the second is linear scale:
There are a lot of ways to interpret those charts.
When priced in terms of a “neutral currency”, the dot-com market bubble really stands out. That was an epic bubble, folks. What’s interesting is that the stock market’s second run back towards new highs in 2007 wasn’t really an equity bubble at all. It wasn’t even really a bull market. To somebody that used gold as their currency – or even a lot of other foreign currencies – the highs in 2007 were just another stop on the way down in a gigantic bear market. That second little peak in the stock market was actually due to dollar weakness!
Here’s a chart of the Dollar Index (DXY) which measures the value of the US Dollar against a basket of foreign currencies:
In the summer of 2001 I went backpacking through central Europe, pretty much at the exact peak in the USD. At the time I was astonished at how cheap everything was over there. Hostels in Germany and Austria were only $5-10 dollars per night, while a very nice bed & breakfast in Venice cost me about $60. Greece was ridiculously cheap and the (wonderful) food was only slightly more expensive than “free”.
I returned to Europe in the summer of 2007 – not quite the low in the US Dollar, but pretty close. Needless to say, the experience was substantially more expensive. My dollars didn’t take me nearly as far, but fortunately I had a couple more of them to offset their loss in global purchasing power.
Unless you traveled beyond US borders, you probably haven’t noticed such a drastic change in your own purchasing power in the last decade. Most people don’t have a very good sense of how valuable the dollars we hold in our bank accounts are relative to other currencies and assets. But if you’ve owned gold, effectively a neutral, global currency, you’ve noticed it trend straight up and a big reason is the decrease in value of the dollars in which it’s denominated.
The point here is that since it’s priced in dollars, gold is very dependent on the relative value of those dollars and the future price of gold is inextricably linked to the fate of the world’s paper currencies. Dollar-denominated gold will perform much better when the US Dollar is under substantial pressure. Dollar strength typically tends to be a fairly large headwind for gold.
The difference is subtle, but Gold is your hedge against dollar weakness, not inflation.
3) Trading it will drive you bonkers.
Like I said a few months ago: Gold never moves the way you think it will. It never tells you what you think it’s telling you. And it does strange things for even stranger reasons that no sane person can hope to understand. Investors who own gold for the long haul love it, but I’ve yet to meet the trader who hasn’t been driven completely insane by the gold market at some point in his career.
The reason why it’s so tough to trade is that it’s so difficult to predict where gold is heading over the short run.
Does that chart keep moving higher over the next few months? Do you really trust gold to adhere to follow pattern? It looks like an easy answer, and were it anything other than gold, I might take a shot at answering it.
Over the long run, it’s easy. Gold will exhibit inverse correlation with the dollar and over the long, long run the dollar is a sure bet to get weaker relative to the amount of goods (or other currencies) that it can purchase. I think the single best bet an investor can make today is that 100 years from now each US Dollar will buy substantially fewer goods & services and be worth substantially less against a hard asset like gold.
Check this out:
The red lines measure the trailing 1-year inflation rate. The green line, measured on the right axis, shows the purchasing power of the dollar. Today each US Dollar is worth about 96% less than it was worth in 1900. You can see that dollars are a bad investment over the long run, and incidentally, this is why people demand interest when holding dollars on deposit at a bank. If I’m going to let you hold one of my dollars for the next year, you’d better give me more than my one dollar back a year from now because I can be fairly confident that that one dollar will be a little less valuable relative to what it can purchase.
The more inflation that’s expected, the more interest that’s demanded. This is why it’s usually a little better to look at something like the bond market to get a read on future inflation than the gold market.
Gold doesn’t necessarily go up when inflation is expected and it won’t necessarily rise to the degree to which inflation is expected. Sometimes it does. But usually it doesn’t.
Interest rates are a much better indicator here. They typically go up when inflation is expected, and the more they go up, the more inflation the market’s expecting. Predictable reactions like this make bonds a whole lot easier to trade than gold.
4) We’re nowhere near the real peak back in 1980.
One of the most famous events in the gold market was its run to $850/oz back in 1980.
Almost three decades later, gold finally made a new all time high, but it was an all-time high in nominal terms. Adjusted for inflation, we’re still nowhere close to what we saw in 1980.
Here’s a chart adjusting the price of gold for inflation (using today’s dollars):
That being said, it’s important to keep in mind that the 1980 peak was a speculative bubble and comparing today’s price, in either real or nominal terms, to that speculative peak is nearly worthless. It’s like saying that home prices can go up another 100% from here because that’s where prices were in 2005. Or like arguing that JDS Uniphase stock could go back to $1,000 per share because that’s where it was trading during the heights of the dot-com bubble.
The price of gold is, however, at the high end of what has basically been a 40-year trading range. Movement beyond this range will be contingent upon steadily increasing demand or a weakening dollar which, given the mess we’ve got up ahead, is certainly within the realm of feasibility. There are much better theses on which to base a bullish case for gold than clinging to a prior peak.
As for what might happen to gold should another speculative bubble develop, the below chart may give you some idea. I’ve charted some of the major bubbles in history against each other, using the beginning of each bull market as a starting point:
It’s important to understand that what we’ve seen in the gold market since 2001 is not a bubble. Not yet, at least, though we may be getting close. Nearly every super-bull market in history has concluded with a final phase of speculation and hyperactive demand, and whether or not we’re currently in that phase seems to be the debate du jour.
That’s not to say gold is empty of short-term upside. Should another speculative frenzy develop, that chart may give you a sense of how crazy things can get. Gold could double from here, or triple. It’s up to you whether or not you want to make that shaky bet, and whether you think you can get out at the top and avoid the nastiness that follows each one of those bubbles in the chart above.
Keep your eye on both the investing public for hints at speculative demand and the Federal Reserve for guidance on monetary policy. Should the Fed start taking some of these dollars out of the system and tightening up monetary policy to bolster the strength of the dollar, it would very likely be very bad for gold.
Since Europe started freaking out about its sovereign debt, the Dollar has grown stronger. Despite that, gold has powered forth. Is that indicative that we’re now in the bubble phase, that nothing can drive down gold prices until we make it to the end of the line where the world wakes up from its collective hysteria and says, “whoah, maybe this has gotten out of control?” Perhaps.
All those gold ads on TV are probably another indicator that we’re moving into that realm.
5) Sorry, Tea Party. We’re not going back to a gold standard.
And take away Obama, Bernanke, Geithner & Co.’s ability to keep printing more dollars on demand? puh-lease!
They might be fighting a noble fight, attempting to combat the effects of a nasty recession, but know that each dollar that gets printed or pumped into the system via quantitative easing runs the risk of decreasing the relative value of all the other dollars in the system. It’s simple supply and demand.
There’s been substantial easing already, but we haven’t seen many signs of price inflation. One of the big reasons why is frequently overlooked: there has been a total collapse in monetary velocity.
The velocity of money is just the average frequency with which a dollar is spent within an economy. For example, if I have $1 and use it to buy a cup of coffee from you, and you then take that $1 and use it to buy a donut from me, we’ve created $2 of Gross Domestic Product for the little economy that exists between you and me. Our $1 of total money supply has turned over twice. With this, we can actually rewrite GDP another way:
GDP = M (the money supply) * V (the velocity of money)
So when the velocity of money in a big economy like the US drops because people slow down their spending, The Fed needs to increase the money supply to prevent a subsequent drop in GDP. It typically does this by purchasing government bonds out in the market which increases the reserves at banks which means they can turn around and loan more money to people.
Here’s a monetary velocity chart for M2, which consists of things like paper currency, bank checking deposits, traveler’s checks, savings & time deposits, and money market funds:
The big reason for that sharp drop in velocity has been banks’ unwillingness to lend out money because of shakier capital foundations and stricter lending standards. There’s a reason the banking system in particular has been so aggressively targeted with stimulative efforts. Imagine a giant network of gears – the banking system is the big gear in the middle that turns a whole bunch of smaller gears around it and so The Fed has spent the majority of its efforts getting that central gear turning again.
This is all relevant for gold because, as you can see, we’ve needed to aggressively grow the money supply lest that collapse in velocity seriously impact GDP. But the great economist Milton Friedman warned we shouldn’t ever increase it by too much. Increase the money supply by too much and you do get inflation. It’s a tight rope act. And like any tight rope act, it’s incredibly captivating because so much is at stake – the life of the rope walker or the fate of our currency.
There’s a very common false argument out there that simply “printing money” (via quantitative easing) will destroy the dollar, create inflation, and therefore drive the price of gold sky high. This isn’t always the case. There are times when good old fashioned money printing is what’s called for, especially when we want to make a nasty recession a little less nasty. A gold standard would throw a monkey wrench in The Fed’s ability to do that. It also would make it much more difficult for the US to pay back its creditors, but that’s a whole ‘nother can of worms. We’ll explore that rabbit hole in another letter.
The US paper dollar has value because we can always use these dollars to settle our debt with the government (aka income taxes). So long as everybody needs to pay taxes then paper dollars will have some sort of value. I know that if I offer my services in exchange for your dollars, I will accept your dollars because I can use those to settle my tax bill next April.
That being said, the track record of fiat currencies throughout history is very poor. Many have involved spectacular collapses from the late Romans to John Law’s 18th Century France to Weimar Germany to more recent collapses in the Mexican Peso, Thai Baht, and Russian Ruble. There has never been a major fiat currency that has lasted very long. I’d like to think our track record will be better here, but really bad things have happened in the US before and really bad things will happen again.
A currency crisis could be one.
Which brings me to…
6) Every investor needs to own gold.
If you have an investment portfolio of significant size, some of that portfolio needs to be allocated to gold.
If you’ve ever met with a financial advisor, you’ve surely heard something about building a “balanced portfolio”, something like 60/40 or 70/30 stocks and bonds depending on your age. Target Date funds are very popular now with mutual fund companies; these are funds that start out aggressively with allocations to riskier equities and then slowly get more conservative and add more fixed income as they move towards a “target date” at which one will presumably retire. They’d be a neat idea if that was the way investors actually invested.
But how many financial advisors have seriously urged you to add gold to your portfolio? Where’s the 40/40/20 portfolio? Or where’s the “six dimensional portfolio” that allocates across cash, equities, bonds, gold, real estate, and alternative funds? That’s real diversification for you.
Anyway, let me be clear: own gold.
The reasons for owning gold are numerous, but only one reason matters. The only reason that should ever matter when adding any new investment to your portfolio. Gold is different and it moves in totally different ways.
And I’ve got good news. It’s a lot easier to add gold to your portfolio than you might think.
The easiest way to get it is through a gold ETF. There are several gold ETF’s (exchange traded funds), but GLD is what I use. You can learn about The SPDR Gold Trust here, but the key thing to know is that it holds physical bullion. A lot of commodity ETFs – you might be familiar with UNG (natural gas) or USO (crude oil) – just hold or trade the futures contracts which is problematic because futures contracts expire and before they do, new ones need to be purchased.
Without getting too technical and dropping crazy terms like “backwardation” and “contango” (two of my all time favorite words) you simply need to be aware that the values of these ETFs won’t perfectly track the underlying commodity. Sometimes they’ll go up more than the underlying commodity, but because of the nature of commodity markets, they usually underperform.
So if you buy GLD, you’re technically buying shares of a trust that holds a whole lot of physical bullion. GLD will move in almost perfect lockstep with the actual price of gold.
Owning gold through a trust is cool, but owning physical gold is really cool. Show someone a 1oz gold coin and watch how they react. It’s a great party gimmick and is guaranteed to impress your friends. You can buy gold coins through the US Mint or through a local coin dealer or an online dealer like Monex. You can even buy gold coins on eBay. There are all sorts of places to get it, but the most important thing here is that you should always expect to pay a premium for physical gold. When you see the price of gold on the news expect to pay a bit more than that for some coins or bars.
Another way to own physical gold is by buying jewelry. No joke! It’s definitely not the most efficient way to get it, and it’s probably one of the least liquid forms of gold, but it does happen to be the most fun. Your wife will thank you for it, too. And surely that’s worth the extra cost? Wives, if you’re the one reading this – kudos, by the way – have your husband study this newsletter top to bottom and tell him it’s a good way to diversify your investment portfolio. Really!
Just make sure the jewelry is of good quality – as an investment, more pure gold is better, but my mother-in-law has informed me that 24 carat gold (99.9% pure) doesn’t make for the best jewelry. So the two of you will need to compromise. But hey, that’s marriage.
If you’re looking for a little more kick, try picking up some stocks of companies that mine gold.
These are familiar names here in Nevada. Most of you, especially those of you between Lovelock and Elko, are familiar with the Newmont (NEM), Barrick (ABX), and Coeur d’Alene (CDE). You can also check out Randgold (GOLD), AngloGold Ashanti (AU), Agnico-Eagle Mines (AEM), Goldcorp (GG), or Kinross (KGC).
Traditionally, these have been a more “leveraged” way to invest in gold; these gold stocks typically go up more than gold if gold’s rising, and fall farther than gold if gold’s going down. They don’t typically move with the broader market to the extent that other economically-dependent stocks do, so if you’re building a simple portfolio of stocks, gold miners are a great way to get equity diversification. I’m not a mutual fund manager, but if I were, I would absolutely own gold stocks in my fund. You can buy a straight basket of all the gold miners in one easy purchase with GDX, an ETF that mirrors the NYSE Arca Gold Miners Index.
If you don’t mind the extra layer of fees, you can also pick up a gold mutual find like Tocqueville (TGLDX) or Gabelli Gold (GOLDX). They’ll hold a mix of actual gold and gold stocks and sometimes some related positions. Sometimes it can be worth it to have a professional fund manager’s expertise.
I feel as though I need to make one final thing clear. It’s subtle distinction, but when I say that every investor needs to own some gold, I’m not saying that I think that gold is necessarily going up in price.
I do think that a decade from now it will be higher than it is today, but I’m a lot less sure about where it’s headed over the short run. Unfortunately, that’s a call you’ll need to make on your own. But if you’ve made it this far in this article, you’re certainly equipped to do so, and with confidence.
As you’ve listened to me pontificate about gold, you need to understand who I am in order to put my comments into proper context. As with any advice you hear dispensed from any fountain of so-called expertise, you need to develop an understanding of the source before blinding accepting its ideas as your own. You need to be aware of my biases and predilections.
I am a second generation native Nevadan. I was born here, raised here, then ventured out into the world only to return here. I love living in Nevada, and not only that, feel spiritually bound to the region. As a kid I spent many a summer vacation in the South and would later live and work for 6 years in Los Angeles. So I understand powerful local cultures, to be both a part of them and exist within them as an outsider.
Nevada is who I am, and Nevada itself is a composite of others like me, individuals from present and past.
Gold is a key part of our state and our history.
Nevada produces a whopping 80% of all the gold mined in the United States. Those of you readers from other states or outside the country might not understand how proud we are of our mining heritage. The discovery of the massive Comstock Lode underneath Virginia City was one of the most influential factors in Nevada being admitted as an official Union territory. Abraham Lincoln saw the opportunity and welcomed us to the Union, ensuring that our silver riches would assist their cause and not the Confederate’s.
As a state of no-frills pragmatists, Nevadans understand mineral wealth. To us these metals are not “bling”. They’re not a fad, nor are they for speculatin’. These metals are practical, useful. Necessary, even. They are hard assets.
What kind of person holds gold through a 40-year rollercoaster from $100 to $850 back to $250 and onward above $1000?
Like Tolkien’s Dwarves of Moria, we are transfixed by gold’s eternal, timeless worth. We are the ones who work so hard to pull it up from deep in the earth only to re-bury it in our vaults for subsequent generations.
Perhaps we do have an innate understanding of gold that others don’t. But we couldn’t possibly be considered objective – which isn’t to say you should regard this aspect of our regional culture with complete skepticism.
All I’ve really given you thus far has been facts.
Disclosure: Long GLD, long TGLDX, GOLDX