With gold entering a bear market with the recent decline to under $1,400 an ounce, many investors are asking "what's wrong with gold"? Actually, there isn't much wrong with gold so much as there is something wrong with the hype and hysteria that often surrounds gold. Whether gold is merely taking a pause after a multi-year winning streak or has entered a new multi-year bear market or perhaps a long trading range, investors want to know what the Barbarous Relic is going to do. I present below 10 important factoids to help you navigate what is currently happening with gold, shedding some light on why gold has not been the panacea the gold bugs have forecast, and how to play a gold rise in the future.
I hereby present my David Letterman-inspired Top 10 Things You Need To Know About Gold If You Are Going To Avoid Losing Your Shirt:
*Gold does not pay interest and has been flat for years/decades at a time.
At a time when everybody is hunting for yield in both stocks and bonds, it is imperative that you remind yourself that gold does not pay interest. If gold doesn't appreciate, you don't make any money. If it declines in price, there is no reinvestment of dividends at lower prices; you have to dollar-cost average on your own (more on this later). With most American retail investors fixated on dividends, income, and yield, the attraction to a stagnant (since 2011) gold price that pays nothing has been dramatically lessened.
* There has been no inflation relative to previous bouts of price increases.
You can talk all you want about central bank money printing, retail buying, monetary debasement, currency declines, and QE1, 2 and 3. In the end, it all boils down to gold's mainstay in the 1970s: inflation. And since 1980, inflation has been on a downward trajectory with the rate in recent years approaching 2% annually:(click to enlarge)
What is also forgotten is that other global central banks have learned the same lesson as the United States under Paul Volcker some 30 years ago. Many countries that used to have hyperinflation or high inflation rates have since seen their rates of inflation collapse to the single-digits in the last decade. While considered high by our standards, inflation rates of 4-8% are historically low for many of these countries including Brazil, and other South/Latin American countries, Russia, and Mexico.
So the citizens of these countries that used to purchase large quantities of gold have found that in a globally interconnected financial system they no longer need to protect their wealth and savings from overnight destruction by buying gold. Yes, these countries' growing middle-class want gold for jewelry and as a collectible and as an investment. But the panic buying of yesteryear has not taken place to the same extent.
* The 1970s were a unique period not likely to be recreated anytime soon.
This is not to pooh-pooh the major changes that are currently happening in the United States, the EU, or in the Far East. But check out this list of what happened in the 1970s:
- The Bretton Wood currency system came to an end after 35 years dating back to the post-World War II era.
- The convertibility of the dollar into gold was ended in 1971.
- Inflation reached stratospheric levels compared to previous decades.
- 2 oil shocks, with skyrocketing gas prices, gas rationing, and gas lines.
- Vietnam, Watergate, and Jimmy Carter's 'malaise.'
- Soviet intervention in Afghanistan.
- A revolution in Iran, the second-largest producer of oil in OPEC and a U.S. ally under the Shah.
- Global financial liberalization commencing with a system of floating exchange rates.
Is it any wonder that gold during that decade went up nearly 25-fold? (click to enlarge)Conversely, gold's rise from 2001-11 was the beneficiary of a number of events not likely to continue for much longer, including:
- A collapse in real interest rates as the Fed Funds rates fell to 0.25% from 5.25%.
- A rising U.S. equity risk premium, the byproduct of two cyclical bear markets in which the S&P 500 lost 50% each time.
- A new long-term downtrend in the U.S. dollar.
- Reversal of hedging by gold producing companies.
- Coordinated European central bank gold sales (which basically restricted supply).
- Rising geopolitical risk compared with the quiet 1990s (Iraq, Afghanistan, 9/11, Madrid and London bombings, Bali, etc.).
- The rise of precious metal ETFs, an efficient means to gain quick exposure to the underlying gold price.
While some of those trends may continue or re-appear, they are not all likely to be present to assist gold's price in coming years. Gold may have to move up strictly based on normal supply and demand, not on exogenous forces from outside pushing it higher.
* Gold Was The Only Game In Town In 1979 - Not So Today.
Gold was not only an inflation and crisis hedge in the 1970s, it was the only hedge. The financial and currency markets had just been liberalized, and were in their infancy. Without much liquidity or innovative products to protect against wealth destruction or inflation, gold had the market all to itself. In 1979, the gold market and the foreign currency market each traded about $800 million in daily volume. Today, the gold market trades about $80 billion daily on the CME/COMEX, but the foreign currency markets trade almost $4 trillion a day. You don't need a suitcase full of Krugerrands or a direct line to the COMEX to preserve your wealth, you just need to be able to buy U.S. Treasury bills, notes, or bonds (or even stocks).
Gold has performed much worse since the 2001 bottom than in the 1970s. Again, one reason is that there are multiple avenues to protect wealth that are faster and more reliable than investing in gold. Suppose you are a billionaire who wants 25% of your net worth in gold. To accumulate $250 million in gold, you are either going to have to store it in a bank or off-site. This partly defeats the purpose of investing in gold if you believe in monetary collapse - why entrust your scarce commodity to a bank when you don't know with 100% certainty that you can access it or that it will actually be there for you (i.e., MF Global). And unlike someone fleeing war-ravaged Europe in the 1930s or 1940s with a suitcase full of gold, our billionaire friend will need a nice-sized U-Haul as $250 million in gold is approximately 4.5 tons. Who wants to transport or store that (besides the University of Texas)?
Also, in the 1970s you needed to actually call a broker and execute a trade that would sometimes cost 2-3% of the value of the trade. Today you can execute trades without a person, online, in total anonymity, at a fraction of the costs 35 years ago. You can move your money around domestically or internationally quite seamlessly. Beats packing a suitcase or driving a U-Haul, right?
*"Inflation is always and everywhere a monetary phenomenon" - Milton Friedman
I know what you are thinking: if inflation is related to monetary printing presses going haywire, all the more reason to own gold, right? Well, not exactly. Dr. Friedman was absolutely correct to focus on the money supply, but he also gave us the monetary key to decipher inflation trends. Remember the formula:
M x V = P x Q or MV=PQ
Which translates into:
M(oney supply) x V(elocity of money) = P(rice level, inflation) x Q(uantity of GDP)
This is the E=MC2 equivalent of monetary economics. The money supply [M] times the velocity of money [V] is equal to the price level [P] times the quantity of good and services [Q, aka real GDP]. Gold bugs have been fixated on the "M" part of the equation and realizing that a big increase in "P" must be just around the corner because there has been no surge in real GDP ["Q"]. Except…(click to enlarge)
The velocity of money has collapsed and offset the rise in "M." So the left-side of the equation has been balanced out without having to see a big rise in inflation , since we know we are not going to see it on the output/real GDP side [Q].
Now, it is highly unlikely that the velocity of money will continue to fall forever. At some point it will stabilize and/or reverse. When that happens, if the Fed still has its foot on the gas pedal, then you will see a rise in inflation. It might be from 2% to 4% or 2% to 10% -- but the increase will be a positive for gold. Unfortunately, as even hedge fund master Kyle Bass has said, nobody knows when that day will happen, two years from now or 20 years from now.
The deflationary aspects of the huge surplus of cheap Chinese labor will be coming to an end within a few years. China will have a labor shortage and unless it is met by an influx of cheap labor from India, other Asian countries, or Africa, a huge disinflationary tailwind disappears. The productivity-adjusted wage gap between U.S. and Chinese workers has closed by more than half in recent years as cheap energy in the U.S. leads to 'in-sourcing.' So cheer up, gold bugs, the rise of the global proletariat may be an inflation spur to gold in coming years!
*Just because you know the direction of a trend does not mean it is an investable trend
You had a 35-year bear market in bond prices, or conversely, a 35-year bull market in bond yields. However, so long as you did not invest in the longest-duration bonds of that era (20-year Treasury bonds or long-duration corporates) you still did pretty well and achieved positive returns over most time horizons. It was only in the late 1970s - during the final melt-up in yields - that bonds became 'certificates of confiscation' even at the short end. Rates shot up 500 bp. or 50% in absolute terms from mid-1979 through September 1981. Treasury, CD, or other rate investments - so long as duration was not extreme - did very well for over 30 years of that bear market.
But capitalizing on 35 years of falling prices/rising yields was difficult for most of that period. Unless you made a very large wager on rates moving up (bond prices moving down) and/or employed leverage, it was very tough to make money on the short side during this time.
I use the example of interest rates because it is possible that gold is in a new bull market - just like bond yields were in a bull market from 1946-1981 -- but we are in a lengthy pause. If the gold bull market started in 2001 then we are 12 years into the bull market. Twelve years into the bond bear market (or yield bull market) would put you time-wise at about 1958, which meant you still had 20 years of relatively safe investing in bonds before things got treacherous. It was only in the last 18 months of the bond bear market when yields really skyrocketed. We may see something like that with gold in future years.
Gold might not be in quite the same slow-motion movement that interest rates were from 1946 through the early-1970s. But if gold is in a multi-decade bull market it would not be surprising to see a multi-year pause where the price declines or flat-lines. That could be where we are now.
*Peak Oil Is Here - Peak Demand, That Is !!
Gold's performance is not only tied to inflation in the general economy, but to that of other commodities like oil. It is no fluke that gold's most spectacular decade was the 1970s when the price of oil went from $2 to $34 a barrel. But the technological revolution (fracking, horizontal drilling) in the oil industry has helped find huge shale deposits in the United States and is now starting to be deployed around the world. More importantly, this surge in supply is being met by slack global demand. Increased fuel efficiency in cars, utility plants, and appliances filters down through all GDP inputs to render today's economies much less dependent on energy per $1 of GDP. Global oil demand is slowing and in entire regions like the United States and Europe it is actually down from the previous decade's peak.
If oil supplies are plentiful for the next few years, perhaps decades, and if oil demand is slack, then the predictions about 'peak oil' and $300 per barrel forecasts are going to have to wait a very long time. This is one less inflationary headache and global economic disturbance available to help underpin a big rise in gold.
*A Strengthening Dollar Will Be A Big Headwind For Gold
The collapse of the dollar in the 1970s - first, in August 1971 as the convertibility into gold was ended and then again in the late-1970s under G. William Miller's Reign of Errors at both Treasury and The Fed - helped spark gold's ascent. But the dollar moves in long cycles and when the Fed decides to start normalizing monetary policy - even if rates are still low by historical standards - it is likely that the Fed will be among the few global central banks embarking on a monetary tightening. The dollar's recent long-cycle stretches are seen in this chart from Deutsche Bank:(click to enlarge)
While a strengthening dollar does not mean it is impossible for gold to appreciate, it will be a noticeable headwind. Certainly, U.S. investors will have a hard time discerning the end of Pax Americana if the financial talk is all about King Dollar. On the bright side, a rising dollar means that other currencies are losing ground so they will see the price of gold rising in their local currency terms.
* Buy Gold Coins And Avoid Numismatics If You Like Gold
While there are many fundamental, technical, and cycle reasons for believing that gold may need to pause even if it is still in a bull market, there is nothing wrong with having 'disaster insurance' in the form of physical gold. I am not talking about making a speculation or gamble with a significant portion of your investment portfolio, but rather small additions, over time, to a slowly-growing precious metals collection.
I believe the popular mint bullion coins - American Eagle, Canadian Maple Leaf, Chinese Panda, etc. - are perfect for most American investors. The volume is also 1/50th that of silver, which requires a much larger commitment in terms of space and storage. A significant monetary stash in gold will not require a U-Haul for storage or transportation needs. You can store them in your own vault or hide them in your home with minimal space requirement. You can take them out, show them to friends and family, and when you pass on your kids or grand kids can inherit them.
Buy the coins periodically, monthly or quarterly or even annually - whatever you can afford. Avoid buying fractional coin sizes since they drive up the premium above the spot bullion price. Some states, like New York, do not charge sales tax on bullion purchases above a certain threshold like $1,000. As for numismatic coins, my philosophy has always been it's like a piece of art or a baseball card from your childhood: you better like it if you buy it. Always assume that the premium above the gold content might fade away over time.
As an example, I recently purchased an historical gold piece from the 1857 ill-fated SS Central America voyage. When the pieces were originally sold years ago, they sold at a 500% premium to the spot price of gold, thanks to all the hype. When I purchased mine recently, it was at barely a 10% premium to the spot price of gold. Despite gold going up nearly 6-fold, an investor in the original gold pieces ended up losing money. Caveat Emptor with numismatics !
* What about the gold stocks?
Investors have been fascinated with gold stocks because of the inherent leverage in the stocks if the price of gold skyrockets. Newsletter writers like Howard Ruff and others made fortunes for their clients in the 1970s using this strategy. Unfortunately, the economics of gold mining have many more multiple levers today: higher extraction costs, expensive mining equipment costs, environmental regulations, foreign and domestic permitting, expropriation threats, etc. The net result is that increases in the price of gold in recent years did NOT lead to increases in the price of gold stocks.
When you own a gold stock, you own a piece of paper. Presumably, investors in gold want tangible (real) assets and not financial (paper) assets. So consider gold stocks a speculation and not an investment. If you do, you won't be disappointed if the metal doubles but the stocks are flat or only go up 30%.
Of course, during some future panic a much-enlarged global middle class could go on a gold panic buying spree, moving both the metal and the gold stocks like in the 1970s. Need a few names in case that happens? Here are five blue-chip, liquid, large-cap names all significantly off their 52-week and two-year highs that will likely survive any additional plunge in gold's price but give one upside leverage should gold once again resume its ascent:
Newmont Mining (NEM): Newmont is the second-largest gold company in the world. NEM has operations in the U.S., Australia, Peru, Indonesia, Ghana, Canada, Bolivia, New Zealand, and Mexico. NEM also produces some copper. NEM recently replaced the CEO and CFO after several years of falling production and rising costs, so presumably the new team is properly motivated to avoid a repeat. NEM pays a gold-linked dividend that is currently yielding 4.1% but will reset to about 2-3% based on current gold prices. Debt/Equity is about 30% and Newmont has survived previous gold downturns so unlike some debt-laden junior minors, Newmont should be around for a while. Several projects are coming online in 2014-16 and CAPX is getting trimmed in high-cost, nonproductive mining areas.
Agnico-Eagle Mines (AEM): Agnico has paid annual dividends going back to 1990 and has been paying quarterly dividends since 2011. Shares yield 2.8%. AEM is not a low-cost producer, with cash costs at about $750/oz. and all-in costs closer to $1,100/oz. But AEM has long-lived assets, heavy CAPX lifting for mine expansions and projects is largely behind it, and debt/equity is under 20%. AEM has well-respected management and has navigated previous gold cycles.
Yamana Gold (AUY): Yamana is one of the lowest-cost producers around, with all-in costs of under $800. Cash costs in Q4 2012 were just over $500/oz., among the best in the industry. Yamana also has a sterling balance sheet, with debt/equity under 5%. With three projects coming online in 2013, production should show sequential growth throughout the balance of the year. Gold production should rise from 1.2 million ounces in 2012 to 1.4 million in 2013 and 1.7 million in 2014. Like other gold companies, AUY has trimmed unnecessary CAPX on higher-cost, low-ROE projects. Yamana trades at a significant NAV premium to other gold stocks but management's track record, the balance sheet, and the projects coming online near-term make paying up worth it.
Freeport-McMoRan Copper & Gold (FCX): FCX engages in the exploration of multiple mineral resource properties including copper, gold, molybdenum, cobalt, silver, rhenium and magnetite. The company holds interests in various mines located around the world notably the huge Grasberg mine in Indonesia, along with operations in North America, South America, and the Congo. FCX has lots of international exposure; good for low-cost production, bad for preservation of mining and private property rights. To date, it has not been a problem for FCX. The company is much more dependent on copper than other gold companies, which means it is tied to everything from the U.S. housing market to Chinese GDP growth, both of which greatly impact the price of copper. Long-lived assets let CAPX stay under control during tough times. The stock currently yields 4.2% though the dividend could be cut in any global downturn.
Goldcorp (GG): Goldcorp has five mines in Canada and the U.S., three mines in Mexico, and two mines in Central and South America. Goldcorp also sells some copper, silver, lead, and zinc, but these are marginal relative to gold sales. Goldcorp does not hedge the price of gold. As of 2012 year-end, total proven and probable reserves consisted of 67.1 million ounces of gold, 1.2 million ounces of silver, 5.8 billion pounds of copper and lead, and 14 billion pounds of zinc. Goldcorp pays a 2.1% monthly dividend. The stock sells at a premium valuation based on EBITDA and cash flows, owing largely to stellar growth in production during the last decade. The company was founded in 1954 so it plans on staying around a while.
I believe that if you want to play a long-term bull market in gold (if you believe we are in one or another one will re-appear) the best way is through actual physical gold, like bullion coins, rather than through paper assets like ETFs or gold stocks. But if you want a little Las Vegas in your gold portfolio, the five stocks above should do very well if gold were to reclaim its old highs.
Just remember what they say: a gold mine is just a hole in the ground with a liar standing next to it !