Thursday, December 23, 2010

All That Glitters Is Not Gold

You have no doubt seen one of the many TV ads lately, offering to buy your old gold jewelery. Or how you should buy gold coins to protect yourself from the coming "economic collapse". You can even buy gold from vending machines like this one in the Frankfurt Airport.

News about gold's rise to new highs has been in the main stream media for the past 2 years. The gold bugs are out in full force predicting economic doom and gloom. Does this mean we should rush out and buy gold stocks? Actually, it's the opposite. Gold appears to be in bubble territory, so buying gold or gold stocks may well prove hazardous to your financial health.

One of the problems with buying gold is that it has no intrinsic value. It does not produce income and is priced in the market based on people fear and emotion combined with poor supply/demand fundamentals. So if we can't figure out what it's really worth, then how can we buy it?

If you do a quick google search on "gold as an investment", you will see hundreds of sites offering to sell you gold. They all use the last ten years of data to show how gold has trounced the S&P 500. But, what they forget to tell you is that gold's long term returns are lousy. While it is true that gold has had periods of out performance, the fact remains that it is extremely difficult to predict when the next period of out performance will be. See the chart below and you'll see why owning stocks is clearly been a winner over the long-run.

So, since 1900 stocks have returned 9.5% compound annually. Gold has returned 3.5% annually. So, after inflation you would have a near zero return on gold. Ask someone who bought gold in 1980 how their return was. In fact several investment heavy weights have recently commented on gold. George Soros, the famous hedge fund manager recently commented about how gold is in a bubble. Also, Warren Buffett was recently quoted in Fortune magazine about his thoughts on gold. The following excerpt is a classic Buffettism - the ability to simplify a subject to which Wallstreet makes complicated;

"You could take all the gold that's ever been mined, and it would fill a cube 67 feet in each direction. For what that's worth at current gold prices, you could buy all -- not some -- all of the farmland in the United States," Buffett said. "Plus, you could buy 10 Exxon Mobils (XOM, news, msgs), plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?"

In the short-term gold could still actually move higher as the euphoria continues and people clamour to buy gold and the plethora of gold related investment products, to protect them from the "doom and gloom".
However, the party has already started and is well underway. In short, gold is a crowded trade.

Do you remember anyone in 2001 wanting to sell you gold coins when gold was $300/oz? I don't.

Merry Christmas to all,


Disclosure: I currently have a small short position on gold.


  1. I would counter this one by saying that gold is not typically considered a "buy and hold" investment. It is a "store of value" investment like cash at times when even cash is regarded as too risky (i.e. high, or anticipated inflation). Smart investors don't buy gold to make money, they buy gold to refrain from losing money.

    Also, the supply/demand fundamentals of gold are actually very, very strong. The rapid growth in the middle class in India, a historically massive gold consumer, and more recently China, have been stoking gold demand.

    Furthermore, now that the USD is on shaky ground and the Euro's future looks dicey, there is no truly safe reserve fiat (i.e. paper) currency for central banks to hold so gold has once again become a preferred store of value. This could take decades to change given the reputational damage to those two other currencies in recent years.

    On the supply-side, big finds are few and far between these days. There isn't much by way of new supply coming to market so you're not going to see a supply glut cause gold prices to fall.

    Unless the US recovers very strongly in the next 2-3 years, I think you are more likely to see gold hitting $2000 per ounce than you are seeing it hit $700 per ounce over that time frame.

  2. I was simply going to post that every $10 move in the price of gold is equivalent to the market cap of Bank of Nova Scotia. That is significant becuase how many new "BNS" in a sense has been created by the recent and continued run in gold? It's not sustainable.

    Secondly, I have to comment on what Franco has said. Please do not take this personally, but rather as the other side of the coin. First, Gold is only a "store of value" if you and everyone else considers it to be. In a sense you have to have as much faith in Gold as you do fiat currencies. Gold serves very little purpose, and as Buffett has said if aliens are watching what we do with gold they would be scratching their heads.

    Beyond this the supply/demand fundamentals are not very strong. The only person I have seen quantify this is Vito Maida of Patient Capital. If you read his most recent newsletter, he says supply/demand is in equilibrium and furthermore the price of gold far ahead the marginal cost of new production. What is driving the price of gold is futher belief in a rise in the price of gold.

    Most everyone cites China and India as examples for growth/demand. Obviously they have to find someone else, a "greater fool", to increase demand for the price of gold. In a sense everyone who owns gold has to become a salesman for gold. Just don't be caught being the last one holding the gold. I would much rather own hard assets that will always be in demand and have actual utility.

    Lastly, the comment that the USD is on shaky ground. I have heard one Gold bug say the US should default on their debt. This is simply the stupidest comment I have ever heard. Either millions of people are wrong to buy treasuries at current yields (implying the lowest risk in the world) or they are right that the risk of default is almost nil. The US financial problems are no where near problems levels. Canada was in much worse shape in the past.

    Lastly, these gold bugs cite underfunded pensions, underfunded healthcare liabilities, etc etc. Listen, you can not simply make up a imaginary total for US liabilities and then assume those are all the current liabilities today. Either the US will have the funds to pay for those promised programs or they will not. If they don't those programs won't happen. Simple enough.

    Capitalism works and it works well. To bet against the US has never and will never be a bet you will want to take.

  3. Hi Kevin,

    I agree with many of your points. I haven't read Vito's letter yet, but I will. I read some time ago, a document, about various commodities and how over the long-term (20 years cycles)their market prices trade VERY close to the marginal cost of production. So the large spread in commodity prices (oil, gold, copper - you name it) won't last forever. However, oil and copper may hold up better as they have true industrial expanding demand. That doesn't mean i'll dump Hudbay/Ensco/Lundin tomorrow-i'll just be cautious going forward.

    I find it interesting that the dooms dayers are writing off big/deep liquid currencies like the USD and clamouring for gold. Even though they loved the USD during 2008 during the meltdown. At the same time central banks and the IMF have been selling gold. The IMF just finished selling 400 tonnes of gold in exchange for paper. I am no currency expert... but my point is that the trade seems crowded and lop-sided. I realize I may be early in my call, and my short could go against me ( in fact it is, i'm down 9% on the pos'n) but I think it will work.

    I can't help but to think, if I am a rational investor, and if the economy is getting better (which it is, as you know) why do I want to own gold. I want to own paper - stock certificates of good and cheap companies.

    I don't think a bet against the US is wise either. WEB wouldn't have bought BNSF if he thought America was circling the drain.

  4. Kevin, a rebuttal:

    1. For anything to be a store of value, someone has to consider it to be, so I don't know what you're getting at there in isolating gold. Securities, real estate, and cash only have value because people consider them to be valuable. Gold is no different. Utility and value are far from being synonymous.

    2. I don't know who Vito Madia is and I've never heard of Patient Capital. Anne-Laure Tremblay of BNP Paribas, one of the largest financial institutions in the world, said on Dec. 31st, "The gold price remains well supported by a weaker dollar and solid investment demand. We expect the gold price rally to continue into 2011 on the back of strong fundamentals, including inflationary pressures (notably in China), ample liquidity and concerns about the value of the dollar. (

    Goldman Sachs, another one of the largest and most reputable financial institutions in the world, has set a price target of $1690/oz for 2011. Many other major institutions are similarly bullish (

    3. Don't take this personally, Kevin, but your analysis of the US treasury yield situation is just simply wrong. It is way, way too simplistic to suggest that low treasury yields imply that the USD is not on shaky ground. Indeed, some of the same factors driving treasury yields downward are also driving the USD downward. Low yields only imply low risk to US-resident investors holding short-term (i.e. <2 year) treasuries. Low yields say little about the USD, particularly in the current environment.

    4. Under most standard econometrics, Canada has actually never been in as bad a financial shape, outside of the Great Depression, that the US is currently in at the moment (Debt/GDP, Deficit as % of GDP, etc...).

    5. The "imaginary" liabilities you refer to are actually extensively researched by, among others, the US government's own Congressional Budget office (see eg. Many smart people in that Office work long and hard to build models projecting these liabilities (and assets, and revenues, and expenses) forward.

    Again, it's too simplistic to say that the US government will simply cancel programs it can't afford. If this were the case, they wouldn't be in a massive budgetary deficit right now. What is more likely is that they will continue to issue treasuries to fund their deficits. Eventually, this will cause high inflation and a weak US dollar (a very weak dollar).

    Capitalism certainly works well - just ask all those new gold-sporting middle-class Chinese and Indians. And let me know how those US equity investments pan out, in Canadian dollar terms, if something hugely positive, indeed nearly miraculous, doesn't happen to the US economy in the next two years.

  5. Hi Franco,

    Nice post. I think all of these issues are very complex and it's hard to predict how they will turn out. There are so many inputs. Do you think that the recent news that the Euro could be on shaky ground, will provide some additional support for the USD? You're last note about US equity investments in Canadian dollars, definitely hits home. Although my results have been good over the years, our rising CAD has been quite painful to watch as it chips away at my USD holdings. It would be nice to see a stable USD for a while. I have read that based on PPP the CAD should be around .85-.93.
    With the strong commodity market, I doubt we'll see this PPP fair value for the CAD.

  6. Hi Andre - I had posted yesterday, but it looks like it disappeared somehow. I'll give it another shot....

    I think you make an interesting point about the troubled Euro proping up the USD, but I'm not sure how much investors are willing to trade one for the other. It seems both the Euro and the USD have been exchanged for gold and other hard commodities, though the Euro to a larger extent. This is in line with my comments about people being skiddish about fiat money. Poeple are more comfortable holding gold, silver, copper, paladium, platimum, potash, wheat, corn, soybean, etc.. than they are holding paper which is being devalued in a way somewhat analogous to the way a company dilutes its EPS via share issuances.

    The OECD pegs the CAD/USD cross at the mid-80's using their PPP model. The problem, however, with PPP is that it only holds in the long run. Currencies tend to overshoot their PPP values, sometimes by a significant amount. They can also deviate from PPP for ten years or more, only to swing to another extreme for a long period of time.

    With a huge debt overhang, a massive deficit, a poor housing market, a poor labour market, increased global competition, a Fed conducting open-market transactions because they can't lower rates any further, and a lame-duck legislative branch, I just don't see any triggers that would cause the USD to climb signficantly.

    That being said, if jobs come back quickly, and if they are full-time, good-paying jobs, then perhaps you can count on at least some modest improvement in the US economy over the next two years.

  7. Kevin - By the way, wasn't it "WEB" who bought up 20% of the world's silver supply some time ago? I guess he though he could fashion it into robots that would build something of "value". ;)

  8. Gold has great intrinsic value, especially when you compare it things like dollar bills which are printed on paper. So here's a question. If gold has no intrinsic value, then why don't we print (i.e., mint) the US dollar on gold instead of paper?

  9. Hi Peter,

    We don't print dollars on gold because it weighs too much, LOL :)
    My point about gold is that it's a commodity, which historically has been priced at a small premium to it's marginal cost of production - except for a few periods of irrational pricing. So gold does have some "value", but with producers mining gold at $400/oz, I'd argue that gold's "true or intrinsic" value is no where near current prices.

  10. It's not weight that stops minted gold coins from being used to represent dollars--its meltdown value. Take for instance the US copper penny minted between 1909-1982. The value of the copper is 2.8 cents. If even a copper coin is worth more than the face value, you can't afford to mint money on precious metals like gold and silver--because this will not allow central banks to devalue their currencies.

    Your assumption that gold has no intrinsic value is incorrect--now even by your own admission. You should have said, Gold is worth no more than the $400 per ounce that it costs to mine it. But even that is wrong. Gold has the intrinsic value, if measured in dollars, of its market price on a given day. If the market price goes down, it has less--against the dollar. But the fluctuation of the gold price is not related to the value of gold which historically remains relatively stable, but to the high volatility of the value of the dollar. For as long as the supply of US currency continues to increase, while Bernanke monetizes debt and eases quantitatively, and interest rates remain low, I don't see how gold is going to come down from its secular bull. When debts are monetized and governments try to dig out of fiscal nightmares through quantitative easing, people begin to remember that gold and silver are real money--not symbolic, but highly sought and valuable with true intrinsic value. When the current US dollar and all other paper currencies cease to exist, gold will still be money.

  11. Franco, several rebuttals to your rebuttal:

    1) You're right that for something to be a store of value, someone has to consider it to be. But in order to make a profit, or break-even rather, on any investment, someone ELSE has to consider it a store of value as well, and that's where utility factors in. You're wrong to compare securities & real estate to gold because the former two are both income producing (given you choose the right ones). They have value because of utility, not only because people choose to value them. IBM is not a $200 billion company because people merely "choose" to store their money there, rather it is an income producing business which pays people for owning it. When people merely "choose" to value something, that often ends in disaster. Examples of this include all bubbles such the tulip bubble and the tech bubble. I'm not saying gold is in a bubble, but am only saying that it shouldn't be compared to assets that are backed by consumption. There's something troublesome about the fact that 31% of all gold demand comes from investors.

    2) This is not a strong argument. Just because BNP Paribas is one of the largest financial institutions doesn't mean that it's opinion carries much weight. Are you aware that there are many, many bad calls that have been made by some of the largest financial institutions over the years? Furthermore, 2011 is too short of a time horizon, and there is nothing in the BNP quote you posted that's nearly convincing enough of a reason to buy gold. The fact that Goldman Sachs has a high price target also means nothing. The fact that many other institutions are bullish, not only doesn't support your "buy gold" argument, but it's is actually a bearish sign. See: Internet Bubble, Real Estate/Mortgage Bubble.

    3,4,5) While the U.S. Government liabilities may be real and they may not be able to quickly cut expenses, this country is never going to go bankrupt. Why? Because it has the ability to print money. So while the currency may (and most likely will) get inflated over the years, the U.S. is not going to default.

    I think those who are bullish on gold mistakenly believe that gold agnostics/bears are bullish on currencies. I haven't heard of any value investor who is betting on the U.S. dollar. Just because an investor chooses not to own gold doesn't mean that they must own the dollar. The best thing to do in an inflationary environment is to own strong businesses with good pricing power. Gold may very well provide good returns, but it isn't nearly as reliable as these types of businesses are.

  12. Arpan, A rebutal to your rebutal of my rebutal:

    1. As I clearly stated, utility and value are far from synonymous - ask your wife how much utility she gets out of her diamond ring, then ask her how much value it has. ;)

    What you and others are missing is the fundamental truth that gold is both a commodity with utility (as you point out, 69% of gold is used in manufacture or consumption) and, more importantly perhaps, gold is a currency. What you are trying to argue is the equivalent of saying a $100 bill is not worth $100 because it`s just a piece of paper.

    2. I`ll take Goldman and BNP over a bucket shop that I`ve never heard of any day. They`re huge because they`re doing something right. They also attract the best and the brightest talent. Are they always right - of course not. Do they have massive reputational risk on the line whenever they make any kind of call - absolutely. That alone makes me more confident in them than in small independent shops.

    3,4,5. I never said the US would go bankrupt.

    Your argument regarding holding `strong businesses with good pricing power` in an inflationary environment is not sound, or it is at the very least over-simplified. Some inflation is good for all businesses. High inflation is bad for all businesses. That is basic supply-demand economics.

    Another basic economic principle: inflation is inherently tied to FX rates. The higher the inflation rate in one country relative to another country, the more likely the currency of the country with higher inflation will fall relative to the other country. So, unless you intend to move to the US, I suggest you strongly consider how robust your US investments will be in Canadian-dollar terms as the US continues to print money to fund its massive budgetary deficits.

  13. Hi Andre, I made a comment last night but I don't see it here, did it go through? :)

  14. Hi Arpan,

    Not sure why your post didn't post. I have no control over that. It's all in the hands of google. Try posting again.