Busting 3 Myths About Gold (And The Bull Case For It)

Includes: GDX, GLD, NUGT
by: Macro Investor

The gold market (NYSEARCA:GLD) is a strange place.

All markets move on rumors, of course, but gold bulls, in my experience, are more creative than others in coming up with a rationale on why gold prices should strengthen. In this article, I will examine some of the recent gold bull cases that are, for lack of a better term, plain bizarre. It should become clear, I hope, why no one should pay any attention to people who actually take these cases seriously.

1. Did you hear the one about Iran?

This is relatively old news, but I've seen this mentioned in the Seeking Alpha gold cognoscenti circles way too often lately. This is from an old article from the BBC:

Iran is to accept gold instead of dollars as payment for its oil, the country's state news agency has said.

The move comes as U.S. and European Union sanctions against Iran have made it difficult for buyers to make dollar payments to Iranian banks.

Apparently this is supposed to be bullish for gold, as countries have to buy gold with U.S. dollars to pay Iran. Problem is, it doesn't make any accounting sense from an international trade perspective.

It may indeed be true that countries like China, India, Turkey, et al. have to buy gold to pay for Iranian oil. (They may just pay out of their gold reserves, but let's assume that they don't want to touch the reserves.) But that's just one part of the equation. What is Iran going to do with the gold?

Well, any rational person would say they would do exactly what they would have done if they were paid for with U.S. dollars. They would import stuff that they need by using the petrodollars. With gold, they would first sell the gold, get U.S. dollars, and then import stuff with the U.S. dollars. So, all we have is a circular dollar to gold and back transaction, with no net new demand for gold. This cannot make prices go up, now can it?

The answer, of course, is no -- for anyone who understands how international trade works. Of course, as expected, this did nothing for gold prices the last 12 months, as gold stagnated.

2. But what about India?

As we all know by now, the government of India is clamping down on gold imports by raising duties. This will cut down demand for gold in India, the largest gold importer in the world. Gold bulls believe that smuggling will substitute for legal imports and gold demand will remain strong.

I must say that as far as grasping at straws goes, this is actually somewhat well thought through. In general, whenever laws are enacted to prevent consumption of a commodity in active demand, illegal channels do tend to substitute for legal means -- witness the utter failure of the War on Drugs, for example.

The problem, though, is a bit more subtle. Let's say yesterday gold prices in India were 104, inclusive of import taxes, and the true international price of gold was indexed at 100. Today, they will become 106. When the government applied the 4% import duty in 2012, gold demand in India promptly dropped by 20%, which shows that the price elasticity of gold is rather high. What have the smugglers been doing to fill the gap in 2012? Were they not supposed to fill the gap and keep demand stable? Why did they not become active when duties went to 4%, and why would an incremental hike of 2% suddenly light a fire under them and prompt them to get to work?

The problem, of course, is that the smugglers have not been slacking off in 2012. They have been, well, smuggling. But being smart businessmen and women, they likely priced smuggled gold just a tad below the 104 mark so that they gain market share at the expense of the legal market, while keeping profit margins high. In 2013, they will be good smugglers again and smuggle a lot of gold, but they won't price it at the pre-import price level of 100. They will likely price it, once again, at slightly below the 106 level, being the greedy outlaws that they likely are. So, the price for the public will still go up, and with that demand would fall in India in 2013.

3. And then there was Germany...

This one, I must say, was a real shocker to me. As we all know, Germany is repatriating gold from New York to some German city. This, I am told, is massively bullish for gold prices.

Now, I am an old-fashioned guy. I believe that price ultimately is a matter of supply and demand. If there is no additional demand, prices are not supposed to change. So, I had to think hard why the physical location of gold matters when it comes to supply and demand, and hence prices. It seemed so bizarre to me that for a while I thought I must be missing something, as even gold bulls could not have come up with something so irrational.

Think about it: Let's say we have three countries in the world. Country 1 holds some part of Country 2's gold, Country 2 holds some part of Country 3's gold, and Country 3, being the good country that it is, holds some of Country 1's gold. Now, all we have to do to make gold prices go up is have Country 1 ask for one unit of its gold from Country 3, Country 2 to ask for one unit of its gold from Country 1, and Country 3, again being the good country that it is, to ask for one unit of its gold from Country 2.

Now, all three of the countries end up with exactly the same amount of gold that they had before. According to gold bulls, however, this would be massively bullish for gold. So we have a perpetual money machine. All we have to do is move gold from one country to another and keep doing it in a loop, and gold prices should go to infinity.

This was such a bizarre logic that I really had to think it through to make sure I am not missing something obvious. After a long thinking process, I was convinced that I was not missing anything, other than the sheer absurdity that's usually passed off as sound logic in the gold bull circuit.

So there you have it, some mythbusting about gold and the bull cases for it. This should really not be necessary. Anyone with common sense should figure it out. It is clear that the market did, as gold has dropped like a stone in the new year. Still, the rationale persists. I hope investors read this article and realize not to pay any more heed to those who peddle such nonsense as a good reason to buy gold.

The demand for gold remains weak as the government of India keeps clamping down on gold imports. There is no real alternative to counter that trend, creative rationale as described above notwithstanding. My projection for gold prices in 2013 remains unchanged, that shorting gold -- especially via the miners (GDX and NUGT) -- remains the play for 2013. For more details, please check out my other article titled "How Best To Short Gold - Miners Or Metal?"

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.

Disclaimer: This is not meant as investment advice. I do not have a crystal ball. I only have opinions, free at that. Before investing in any of the above-mentioned securities, investors should do their own research, consult their financial advisors, and make their own choices.