Gold is one of those weird assets that evokes many debates and no one is ever wrong unless your debate is about which way the price of gold will go. Over the last decade, gold as an investment vehicle has demonstrated phenomenal gains. Many want to continue the party and expect it to continue. Many others, including me, are saying the party is coming to an end. And the debate begins. Recently, Bill Gross, the legendary founder of Pimco, along with many other analysts predicted that gold will do well in 2013. This can be true. After all no one can predict the future, although we all try. In this article, I too will try. However, let me start by making my position clear: I think Mr. Gross and all gold bulls are wrong. The party is coming to an end. I believe this for two reasons, but before I get to the reasons, a little historical perspective is necessary.
Andrew Jackson, the seventh President of the United States, did not believe in paper or fiat currency. He believed that government should not be in the business of regulating money; hence, he bitterly fought the formation of a central bank. In fact, one of his last acts as President was to not renew the charter for the Second Bank of the United States. Subsequently, banks and states began printing their own money,leading to hyperinflation, banks and states printing their own money, and of course massive amounts of fraud. By 1850, nearly half of all currency circulating within the United States was counterfeit.
The primary principal behind Jackson's distrust for paper currency was that he believed there should be something fundamental and immutable securing the value of the paper money (i.e. gold and silver). His fear was that if you allow government to print money at will then you're giving government too much power, interfering with private contracts, and placing too much faith on paper that does not have any intrinsic value. Does this sound familiar? If you're a Ron Paul supporter, you live by this theory.
In 1837 after Jackson was termed out, Jackson's Vice President, Martin Van Buren, was elected President. Van Buren took the oath of office in March and on May 10, 1837, he ordered the treasury to accept only gold and silver for payment of land that the United States was selling to pay off the national debt. This becomes the unofficial start of the Panic of 1837. The markets tanked; the country witnessed runaway inflation, and the economy plunged into a seven years long depression. Jackson's theory did not work. Gold and silver did not bring stability. Ending the Second Bank triggered mass confusion and fraud. In essence, Jackson's economic policy was a complete failure, although he is still the only President to have paid off the national debt.
I know what you're thinking: this is a nice history discussion but what does it have to do with anything? The answer is that it has everything to do with how the markets work. It is a lesson on the value of perception. Jackson believed that gold and silver have intrinsic value - a value determined by a force or whatever that common man cannot change. More importantly, he believed that paper money's value was highly specious. Therefore in order to ensure that economic transactions did indeed have value, he in essence mandated that all transactions be conducted in the most valuable element that was widely available - gold and silver. Andrew Jackson wasn't the first and Ron Paul won't be the last person to call for a gold standard. However, this logic is somewhat baseless. The irony is that by eliminating paper currency and putting gold and silver on a pedestal, he brought about massive inflation. In other words, perception is more important than some notion of immutable value, which is also in itself a perception (albeit a more arrogant one). There is a lesson to be learned here.
Over the last ten years, gold has had an impressive run. It's reached unprecedented levels; although when adjusting for inflation, it is still not as valuable as it was in the early 80s. What explains this meteoric rise? Generally, gold is seen as a safe and good hedge against inflation. The theory is that when the value of the dollar is going down, you can count on the immutable nature of gold to keep its value. Of course again, this is just perception and a self-fulfilling prophecy that has been fairly effective over the decades, especially since 1973 when the dollar was officially decoupled from gold. So, this would imply or result in a clear and inverse relationship between the value of the dollar and the value gold. In other words, as inflation goes up, the dollar goes down and you should see an increase in the value of gold. But that's not what we've always seen, especially over the last decade.
The dollar has seen unusual strength over the last decade when compared against other major currencies. After peaking in 2002, the Yen is trading at nearly a 10 year low against the dollar. The story with the Euro is a little different. After reaching parity back in 2002, the Euro gained tremendous strength against the dollar until 2008 when the financial crisis hit. Subsequently, the dollar re-gained the momentum and gained strength; keep in mind, that this momentum was regained during the Fed's easy money policy. The U.S. printed more money and flooded the markets with cheap credit, so by all accounts the value of the dollar should have plummeted. But it didn't, it got stronger. In fact in the context of history, inflation was relatively stable. Although quarterly inflation rates peaked at 5.8%, annual rates never cracked 4%. This is true for the last decade. So, a tanking dollar value wasn't a problem. In fact, in 2009 we witnessed deflation, meaning the dollar was getting stronger because people and businesses were hoarding it. By all measures and conventional wisdom, the price of gold should have been going down - not up. What gives? The answer is again perception.
Remember back in 2009, we thought that the world was ending. The U.S. financial markets had crashed; Japan couldn't get out of decade long recession; China and other developing countries implemented pre-emptive stimulus measures to save themselves from the global collapse, and of course there is and was Europe. It was only a matter of time until Portugal, Ireland, Greece, and Spain (the PIGS) would be forced to default. Again, the world was ending - at least that was the perception. So, every paranoid investor ran to gold and guns (gun sales also went up dramatically) because these were considered the safe destination. In other words, perception ruled. Nice history, but what about going forward? What will happen to price of gold?
Given the above history, there are two ways to predict the future of gold and to at least arrive to some reasonable conclusion. First, gauge perceptions. You can do this by studying all kinds of polls, spending behavior, and elections. The most prominent poll that illustrates national sentiment for the future is the right track/wrong track poll. According to Real Clear politics, about 55 percent of Americans believe that the nation is on the wrong track. That's a big number; however, this number has trended downward (or upward depending on your perception) precipitously since October of last year when it peaked at nearly 77 percent. This means that Americans are feeling better about the direction of our Country.
In regards to personal spending, it has gone up every quarter since Q1 2010; people generally spend more if they feel confident about the future. In regards to elections, Americans felt good enough about where the country is and is heading to reelect President Obama, expand Democratic majority in the Senate, and added more Democrats to the House of Representative. In other words, public perception about the state of the country seems to be fairly positive. This brings us to the second tool for predicting the future - cold hard facts.
In economics, price is, almost always, determined by supply and demand. Low supply and high demand means a higher price. The reverse is also true. This makes intuitive sense and is empirically provable. The price of gold is no different. If there are a lot of people who want to buy it and the supply remains the same or declines, prices will go up. So, let's look at the current supply and demand for gold.
According to the World Gold Council, Q3 2012 gold demand was up 10% over Q2 2012 demand but was 11% lower on a year-over-year basis. More importantly, investment demand was 16% below Q3 2011 levels, led by a steep drop in the bar and coin segments. Furthermore, jewelry and technology demand were down 2% and 6% respectively. Official sector purchases were down 31% relative to the record levels seen in Q3 2011.
The only continued bright spot for gold demand continues to be investors hedging their bets or hoping for gold to continue its price appreciation. Gold ETFs such as SPDR Gold Shares (NYSEARCA:GLD), iShares Gold Trust (NYSEARCA:IAU), ETFS Physical Asian Gold Shares ETF (AGOL), and ProShares Ultra Gold ETF (NYSEARCA:UGL) experienced strong inflows. Otherwise, total gold demand was 2% weaker year-over-year. Accordingly, the supply of gold also contracted by 2% during the same period (see table below for complete gold demand and supply). There are further signs that gold is losing its luster. Over the last decade, China and India have been among of the biggest consumers of gold. However as of Q3 2012, Chinese demand for gold jewelry and investment (bar and coins) has been down, 5% and 12% respectively.
India, however, is a different story. In India, there is a strange cultural fetish for gold. I won't go into the details of this fetish (you can google it); however, it has driven demand higher, especially as more and more Indians have had disposable income. In fact as the rest of the world is feeling the gold fever break, India's appetite continues to grow and was the strongest performing market in the third quarter. Indian demand for gold jewelry and investments grew 7% and 12% respectively. Moreover, India accounted for 30% of total consumer demand - 223.1 tones. The demand in India has been so high, gold imports have heavily distorted India's current account balance. A huge chunk of India's trade deficit has been the result of the importation and rising price of gold. As a consequence, India officials are considering increased tariffs to curb gold imports. As a consequence of this changing attitude among Indian leaders, general change in culture, and the astronomical price of gold, Indians appetite is likely to wane in the coming months and years and place downward pressure on the price of gold.
In regards to supply, gold is a strange animal. The supply of gold increases with the demand for gold. If people want it, prices go up and there enters a crop of prospectors to dig it up. But if demand is low and prices decline, the number of prospectors goes down as well. History illustrates this pattern time and again. In fact, we are sort of seeing that now. Total supply of gold declined by 2% as total demand for gold declined by 2%. The relationship isn't always this clean, but you get a sense of how it works.
Gold prices have increased to astronomical levels because people really believed the world was going to end. So many investors who witnessed the Dow crash and there tangible assets, including their homes lose their value rushed to what human beings have traditionally valued most - gold. But we were obviously wrong about the world ending; it still spins around the sun. The markets have recovered all their losses and are climbing higher. The price of gold seems to have stalled around the $1,650 mark, so the decade long upside of gold may no longer continue to the near horizon. In fact, market and social winds may be telling us that the price of gold is due for a landing back to Earth.
I don't believe that we are witnessing some gold-bubble. A bubble implies that there is some underlying intrinsic value from which we have strayed. Contrary to common wisdom, gold has no intrinsic value. A home has intrinsic value because you can come to some reasonable price using reasonable measures such as income. Gold price, on the other hand, is mostly predicated on the whims, feelings, and perceptions of the times. Unlike food, water, or shelter, gold has no real utility to human life. In fact, it has little cultural utility. When was the last time you saw someone wear gold? So in theory, it is no more valuable than the rocks in your backyard. With that said, there is no gold bubble because there is no real gold price.
I get why Bill Gross and his fellow gold bulls thinks that gold price will continue to go higher. The fiscal cliff and ongoing debt ceiling debate makes our government seem incapable of managing the country. More importantly, any flirtation or consideration of government default would have catastrophic effect on our markets and perceptions. Mr. Gross and gold bulls know this. They are assuming that intractable Republicans will vote for default by not voting to raise the debt ceiling. However, we will likely not default. Calmer and wiser heads will prevail as they have before. However despite this, the debate will not give confidence to investors or potential investors.
So, Mr. Gross is betting that fear will drive these investors into something they perceive safer - i.e. gold. Mr. Gross is also of the thought that the Feds will continue with their easy money policy which will eventually result in higher inflation. The problem with this theory is that we've had easy money for a very long time now and inflation continues to be tame. Old models and ideas no longer seem to apply. This means that Mr. Gross and the gold bulls will likely be wrong. By the way, Bill Gross is also known for a big prediction that never came to fruition.
Given my thesis and reasoning, I believe one of two things will happen to the price of gold. One, we can have a slow decline, or two, a steep drop. Given the above graph and gold's historical price trajectory, slow and steady seems most likely. Besides, no matter how good things are going, there will always be those preparing for the end times, and these people really believe in gold as humanity's saving grace. And no one can tell them that they are wrong.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.