5 Reasons to Avoid the Gold Rush

Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.

- Warren Buffett

The reasons why one should sell the cat, pawn the mother-in-law, and use the proceeds to buy gold are well known: the Fed is printing money faster than you can read this, which will result in inflation; the government is borrowing like a drunken monkey, so the dollar will be devalued; this will debase all currencies, so the only thing that will save you is the shiny metal.

However, here are some arguments why one should think twice before jumping in bed with gold bugs, or at least remain sober while determining gold’s weight in the portfolio.

1. For investors (not speculators) it is very hard to own gold, because you cannot attach a logical value to it. Unlike stocks or bonds, gold has no cash flow and has a negative cost of carry- it costs you money to hold it. It is only worth what people perceive it to be worth right now. The argument I commonly hear is, “What about all those Enrons, Lehmans, Citigroups, etc. that either went bankrupt or got near it? What was the value of those?” If the lesson learned is not to own stocks but to own gold, it is the wrong lesson. The lesson should be: own companies you can analyze (the aforementioned companies were unanalyzable) and diversify – don’t put all your net worth into one stock.

2. The gold ETF SPDR Gold Shares (GLD) is the seventh largest holder of physical gold in the world. If its holders decide to sell (or are forced to sell; think of hedge-fund liquidations), who will they sell it to? This is extremely important, as the presence of GLD changes the dynamics of the gold price, both to the upside and downside. If gold keeps climbing, the ease of buying will drive gold prices higher than in GLD’s absence. In the event of a significant sell-off, there are not enough natural buyers of physical gold. It is a bit like a roach motel – easy to get in, hard to get out.

3. In the past, gold had a monopoly on the inflation and fear trade. Not anymore. Now you have competition from Treasury Inflation-Protected Securities (TIPS), currency ETFs, short US Treasury ETFs, government guaranteed/insured FDIC checking accounts, etc. TIPS suffer from the flaw of the CPI being measured and reported by the US government, which has an inherent bias to understate inflation; returns of commodity ETFs are skewed by price differentials between financial derivatives and spot prices of underlying commodities; returns of leveraged ETFs diverge significantly over the intermediate and long run from the underlying index; FDIC reserves are being depleted with the every-Friday-night bank bailout (but believe you me, the US government will not let FDIC go bankrupt, even if it means it has to raise taxes and impose draconian fees on the banking sector).

The bottom line here is this: none of these investment vehicles are perfect, in fact many have significant flaws; but despite their flaws they attract money away from gold, thus undermining gold’s monopoly on the fear/inflation/currency debasement trade. (I’ve discussed it in greater detail in my book).

4. If, because of points 2 or 3 above, gold fails to perform as expected, the perception of what gold is worth may change dramatically.

5. Over the last 200 years, gold was really not a good investment. It may have a day in the sun, but it may not. And the cost of being wrong is fairly high.

Though gold bugs make it sound as such, gold is not the only and not the best alternative if the worst fears come to pass. The best way to deal with the risks of dollar devaluation and high inflation – with a much lower cost to being wrong – is, instead, to own stocks of companies that have pricing power of their product. When inflation hits, they will be able to raise prices and thus maintain their profitability. Also, companies that generate a large portion of their sales from outside the US will benefit from the declining dollar.

Gold bugs look at gold as a currency, but it is not one and unlikely to be one in our lifetime. Here is why: there is not enough of it around, so even if world governments were to adopt a fractional system (currency in circulation as a multiple of gold reserves), they will never go for it, because central banks and governments will never give up their monetary tools – inflation is a very addictive tool to fight growing monetary obligations.

There is a wild card in the price of gold, though: China (John Burbank made that argument at the Value Investor Congress in Pasadena). If it decides to switch partially from owning US Treasuries to owning gold, the price of gold will skyrocket.

Comments

[alexmi:]

TIPS as protection? If dollar goes down 50%, government will tell you people now bike instead of driving etc. and you will get 5% of "protection". Your call for buying natural gas in June was much better advice.

Sep 09 07:56 AM

[Roger Knights:]

This is well-argued, but its conclusion took the words out of my mouth:

"There is a wild card in the price of gold, though: China (John Burbank made that argument at the Value Investor Congress in Pasadena). If it decides to switch partially from owning US Treasuries to owning gold, the price of gold will skyrocket."

I think that central bank net-buying (including European CB non-selling) will be the key. They're big enough to easily move the relatively small gold market. For many decades they've been bearish on gold. That's changing, as systemic risk has grown.

This is especially true of China. Why should they trust, in the long run, in the paper promises of capitalists? Wouldn't it be better to put a bit more trust, in terms of the balance of its holdings, in something solider? (And encourage its populace to do the same.)

With China looking to be a buyer on dips (as Evans-Pritchard's recent article argues), a lot of the downside risk is gone from gold. Even if gold only continues its uptrend since 2001, that's over 12% a year--better than Madoff was paying.

Then there's gold's value as a "beta-blocker" (diversifier) for a portfolio, which will supply a continuing stream of conventional-thinking buyers looking to rebalance their portfolios on dips ....

So there's a bug-free case for gold: A lower-than-suspected downside risk, a friendly (though modest) long-term uptrend, and the possibility of a jackpot down the road.

Sep 09 08:50 AM

[chap08:]

"If it (China) decides to switch partially from owning US Treasuries to owning gold, the price of gold will skyrocket."

Well, they've already said in so many words that they are doing this and the figures back it up. But they've also suggested that they will not buy skyrocketing gold. End result - gold will rise steadily.

I agree with many of your points, but not your conclusion. Investors should be balanced towards inflation and a well diversified portfolio includes some gold. The only good reason not to own gold is if your other investments are in strong currencies. If I lived in Norway, I might not own gold. Other than that, it would be a mistake not to.

Sep 09 08:50 AM

[Avooch:]

I agree with your points - but still have 2% of my employed capital in IAU (gold ETF).

Sep 09 08:58 AM

[cove3:]

Gold certainly does have a cash flow, as do antiques, paintings, etc. It's the dollar amount you plug into some future year for it's sale. This is the number that is discounted to arrive at present value

It's the same with a bankrupt company in Chapter 7. There's no dividends to discount, but there is a future cash flow when assets are sold off, and creditors paid. If there's anything left over, that's the amount to discount.

Sep 09 09:32 AM

[playmobil:]

over the past 200 years gold wasn't a good investment?? it went up almost 30 fold against the USD since Bretton Woods fell down ... is that what you call a bad investment?

I am not a Gold bug but your arguments really dont stick...

Sep 09 09:34 AM

[chap08:]

Looking back to Bretton Woods, when rates were fixed, does not give you a representative figure. If you look back longer you see that the author is (broadly) right on this. In the longer term, gold has approximately compensated you for inflation; whereas stocks, for example, have given you inflation plus real GDP.

On the other hand, return is not the only thing that you should be looking for in an investment. Low correlation is also important and that's one area where gold scores highly.

On Sep 09 09:34 AM playmobil wrote:

> over the past 200 years gold wasn't a good investment?? it went up
> almost 30 fold against the USD since Bretton Woods fell down ...
> is that what you call a bad investment?
>
> I am not a Gold bug but your arguments really dont stick...

Sep 09 10:12 AM

[OldFordTruck:]

If I had any faith that the central bank and the US government would do the right thing there would be no need to own gold. Based on historical data and a continued "kick the can down the road" mentality I see no other option. Our reserve currency status has been on the biggest reasons our fiat currency has been allowed to survive since 1971. It hasn’t been our responsible fiscal policies! The survival of a fiat currency is strictly based on proper management and an economy that is expanding. For continued growth cheap oil is a requirement for the US economy to keep expanding. If the USD is no longer the world reserve currency, economic expansion and low inflation in the US is not in the foreseeable future.

Sep 09 10:24 AM

[NUCLEAR1929:]

i am not against buying into bubble, the most money are made near the peak of the bubble, but you must understand what you do and that this is bubble

Sep 09 10:57 AM

[Dialectical...:]

Saying that "people might decide it is worth less than you thought" is no more an argument against gold than it is anything else in the marketplace. The same applies to the argument "who would they sell to?" Because everything is based on what people will pay and all the cash flow and income models you might design for stocks are based in dollars or some other currency and these suffer from the same subjective valuation that you claim gold has. Currency is actually more subjective. Additionally the argument that we couldn't possibly return to a gold backed money system because there is not enough gold in the world is a point in gold's favor. If this was sand or sea water we were speculating about that might be a problem, because there is plenty of that... Gold quite simply is a great store of value because it is something physical that is likely to have a base value which is a function of its rarity. In these uncertain times, investing in stability is not unwise.

Sep 09 11:10 AM

[Donald Ingram:]

Vitaliy - Do you own physical gold? If your answer is yes - then case closed. Your argument is one of a moot point.
If you answer no - then I suggest you buy some, or get caught holding pockets full of useless paper!

Sep 09 11:37 AM

[badScooter:]

I consider PMs to be a stability hedge more than an inflation hedge. I also would suggest it is a sure form of "voting with your wallet". I'd consider any of the three above reasons to be valid for having gold in a portfolio. Reasons #1 and #3 are why I personally won't touch a bloody TIPS with someone else's 10-foot pole. I don't think much of that instrument vis-a-vis rationale #2 either, also known as "of course the government wouldn't lie about something as important as CPI". Sheesh.

A fourth possible reason would be China, of course...although I'm not inclined to make investment decisions based on what a communist country may or may not decide to do. Contrary to some thinking I've observed, I do not consider China a bromide to our economic state.

Yup, it very well could be in a bubble. Guess we'll find out, soon enough.

Sep 09 11:44 AM

[User 357705:]

More rationalizing the bankster position that gold and gold bugs are 'bad' because banksters can't make money from gold. Banksters would invest in guillotine manufacturing if they thought they could make a nickel a share.

Sep 09 11:56 AM

[blacksilver:]

Alot of people like to quote Warren Buffet,but what do you think would happen if he said i'm putting 5% of my money in gold?I think everyone should own gold.That would cause such a panic in the stock market,it would make the great depression look like a economic boom.Don't be surprized if he owns some thru one of the many companys he owns for one reson or another.

Sep 09 11:58 AM

[Mad Hedge F...:]

iui. The precious metals markets were stunned with Barrick Gold’s (ABX) announcement that it will float a $3 billion public offering to retire its gold hedges in the futures markets. The means that the world’s largest producer is cashing in its downside production and gearing itself for a ballistic move up in the price of the barbaric relic. The timing of the announcement, the day that the yellow metal broke $1,000 for the first time since February couldn’t have been more auspicious. I have been a huge fan of Peter Munk’s ABX all year, cajoling readers into the stock at $27 in January before its 56% run (click here for report at www.madhedgefundtrader...) . South Africa’s largest gold miner, AngloGold Ashanti’s CEO Mark Cutifani says his company put its money where its mouth is, taking off its hedges some time ago. “People are doing what they have been doing for 5,000 years, and that is buying gold as the only hard currency,” opines Cutifani. In the meantime, the Street Tracks gold ETF (GLD) announced that it has $34 billion of gold holdings, making it the largest ETF of all, and the fifth largest owner of gold in the world after four central banks. If you want to buy gold bullion or coins for the tightest spread over spot, check out www.millenniummetals.net by clicking here.

Sep 09 01:12 PM

[jimboy:]

I don't see the rise of ETFs like GLD as a negative for the gold price. By making it easier to buy and sell they make gold's spread as a viable alternative to dollar-based stores of value (everything else pretty much). When Argentina repeatedly trashed its domestic currency in the 20th century, the rich and the middle class moved their wealth into US dollars, hastening the decline of the peso. The existence of ETFs make it more not less likely that their US counterparts will chose gold as an option when they lose faith in their own money.

Sep 09 02:33 PM

[The Recusant:]

When all is said and done, there exists no greater valued asset than gold and it remains the de facto world currency. If a total economic collapse were to occur where paper assets became worthless or a government defaults on its commitments, gold would still be bartered. And it is the volatility of the price of gold that makes it profitable, holding onto it will eventually produce excellent investment results as the last few years testify. Gold cannot go bankrupt, retains worldwide value, and is the ultimate asset of capital preservation going back thousands of years. When one thinks gold, one thinks wealth. And that's why it remains a desirable commodity.

Like any investment, value is determined not just by sentiment but by logic. In times of stability, holding paper investments in gold is fine, but when the solvency and honesty of financial institutions becomes questioned, then owning physical gold and investments in gold producers are wiser choices. Through the ages, gold has remained the greatest icon of affluence. TIPS or gold?...ah, let's see--give me gold!

Sep 09 02:37 PM

[AndrewBaker:]

Right now holding gold is a no-brainer: what else is as safe at a time when the dollar is on the fall, inflation is being held back such that it will really take off when it does start, and stocks are so over-priced if you don't sell now, you'll wait years to get back to your purchase price once the reversal comes (which won't be long)?

Long gold, short dollar (oh, and natural gas is worth a go too, now).

Sep 09 02:52 PM

[daniel3582:]

I love the "cover my butt if I'm wrong" end of the article... what a joke.

Sep 09 02:53 PM

[Fighting Yoda:]

The only argument against holding gold is it has no dividend. Anything that has a cost of carry rather than a dividend will turn out to be a bad investment. (Similar logic is for homes - if renting is cheaper why buy). Even a 3% dividend in treasuries will offset the gold price appreciation (if any). Gold has performed well only in times of panic when panic sibsides- it always does - a new normal is reached- gold falls.

Sep 09 03:30 PM

[odin:]

I think commentators really missed a major point -- the risk of owning gold. Its not that gold is not a good diversifier nor that it shouldnt be a part of your portfolio. But those who advocate a massive overweight in gold are completely discounting the risks of gold investing. Does no one ask why Paulson chose to pay higher fees and invest in the ETF? He's not paid to pick the beauty queen. He's paid to pick what others believe is the beauty queen. There is an exit strategy for the hot money crowd and its when retail goes gung-ho on gold. What really is the outcome -- however remote -- of one of these big holders trying to dump the ETF?

While its nice to think (just because the CCP says so) that China will put a floor under gold to escape the dollar, the exit trade _is_ a risk. The simple truth is China cant exist in a vacuum. The reserve currency is still the prerogative of military and economic strength and China is decades away from overtaking the US in both arenas. They will have to contend with an inverted demographic pyramid thats probably stronger than the one in Japan. They will have to deal with the health impact of two decades of heavy pollution. They will have to deal with a generation of wealth transfers from workers to exporters. China is a big nation -- one with many natural resources and bright people and it has a bright future, but these are real problems that are on the same scale as the ones that plague the US. Its relationship with the US is symbiotic. The moment China stops funding the C/A deficit is the moment it stops accumulating a surplus and its when US stops needing that funding (In a simple two economy model: US imports less, period. Its not a choice, its a tautology). Does it really make sense for China to do anything but make symbolic gestures against the USD unless it wants a domestic crisis on its hands?

Now, if collapse of society is where your bet is, then, by all means, push all chips into gold. (though probably not the ETF)

But inflation? Look at the performance of gold vs. consumable commodities (oil particularly) in the 70s. Gold isnt my first choice when I think of high inflation.

Sep 09 03:41 PM

[Missiondweller:]

I don't see TIPS as a substitute for Gold since the buying of gold is a "no confidence" vote against the same government issuing the TIPS.

Sep 09 04:54 PM

[Gtarras:]

here is my observation: i noticed than folks who argue in favor of gold are usually old school, grey haired kind. my take on that is the younger generation grew up with other tools that the author mentions and simply do not see value in gold as a hedge. well, maybe as one of the many currently available. i personally am on with Buffet on it, and while dollars are fiat, same is gold. i can not eat it, etc etc. but i can easily convert my fiat money into something valuable... in short, i dont get gold bugs. and personally will be using TBT, TIPS etc as inflation hedge.

Sep 09 06:44 PM

[The Recusant:]

Odin -- yes, holding/investing in gold is most definitely a risk. The sentiments of the market alone can push the price down not to mention the influence or manipulation by the banks. But in a deteriorating economy and devaluing of the U.S. dollar, gold is just about the only safe haven that exists. I would much rather put my money in a solid stock than a gold ETF or bullion bar, but given the dire prognostications of many analysts, neither stocks or the U.S. dollar would be as sound as gold. Oil, as seen recently, is just as volatile a commodity as gold and the agribusinesses aren't doing much better. Even if the economy were to shortly recover, although unlikely, and the price of gold was to drop, all one has to do is hang onto it for a future increase. But the added security in gold is, if all heck broke out, I couldn't barter conveniently with a can of crude oil or a sack of fertilizer, but I could with a gold or silver coin. Additionally, gold can't go out of business.

Sep 09 08:05 PM

[Bruce Pile:]

It's true that gold is dug up, melted down, buried again with guards paid to do nothing but watch it, and except for wearing it, that's all we ever see of it. A Martian would be puzzled. But it's also true that we have people amongst us that get paid to do nothing but figure out creative ways to build a debt mountain and endanger and destabilize all the paper assets we all live by and depend on. A Martian would shoot them.

Sep 09 08:48 PM

[Student of ...:]

When you look back at what was going on during the 1970’s, you would have lost wealth if you invested in the Dow from 1973 to 1983 after factoring in inflation. I don’t have a graph of the dow handy from 1973 to 1983. It doesn’t look pretty. Inflation looks even worse for that period.

Scroll down a bit for the inflation numbers at:

tinyurl.com/5pb6pf

tinyurl.com/6b5jm

They quote CPI data which at best was overly optimistic.

Gold went up significantly during this time, even if we disregard the Hunt’s manipulation of 1980. But it also retreated from ’75 to ’77.

www.kitco.com/scripts/...

And yes, oil went up significantly as well. However, the bottom eventually fell out of gold and oil in the 1990’s.

I have no doubt that people who knew when to “get out” did well.

Do you know who did even better…

The ones who held onto their fixed rate mortgages that were issued prior to 1973. They lived in the houses that they bought with those loans which they got at relatively low fixed rates and they also we able to deduct the interest. The more they financed, the more they benefited from inflation devaluing the principle on their loan.

The people who will probably come out ahead of the high inflation that is coming our way sooner or later are the ones who overextended themselves to borrow outrageous amounts of money that they knew they could never afford to pay back if the value of their home did not continue to go up as it had during the real estate boom.

Oh, I almost forgot, the government will also benefit from inflation as well as their massive debts become devalued as well…

Savers and/or people who chose to live within their means (keep sufficient cash around in case of a layoff or illness) will get hammered mercilessly while all of this takes place….

It seems like the safest place to park your money could be in a fixed rate mortgage (present rates of course) when you buy a home to live in. Of course that assumes that you are able to keep a job that will pay enough to make the mortgage payments while the dollar is going down the tubes… You probably won’t make much on the house, but at least it is the bank’s loan that is getting devalued and not your cash.

Disclosure: I’ve never owned a house and I’m not in a hurry to buy one either.

Sep 09 09:05 PM

[Hmm?!:]

I have to have to agree with first commentator (playmobil). Any comparison of dollar and gold values prior to Bretton Woods makes no sense. Prior to Bretton Woods the dollar was a controlled currency pegged to.... and backed by..............GOLD!

However it was Bretton Woods that freed the US government from the gold peg and allowed them to continually borrow and print money. Works great to get governments out of trouble (stick the grandchildren with paying)......and therefore since Bretton Woods....gold has increased in value 30 times that of the dollar.

On Sep 09 10:12 AM chap08 wrote:

> Looking back to Bretton Woods, when rates were fixed, does not give
> you a representative figure. If you look back longer you see that
> the author is (broadly) right on this. In the longer term, gold has
> approximately compensated you for inflation; whereas stocks, for
> example, have given you inflation plus real GDP.
>
> On the other hand, return is not the only thing that you should be
> looking for in an investment. Low correlation is also important and
> that's one area where gold scores highly.
>
> On Sep 09 09:34 AM playmobil wrote:

Sep 09 11:37 PM

[s1ckboy:]

Is there any logic in assigning value to pieces of paper with ink on them? The difference as you correctly point out is what people perceive to be valuable. This is currently perceived as something which can be assigned some paper value to it. Hence the obsession among Gold Bugs about the price of gold hitting US$1000. I couldn't care less about what the US Dollar price of gold is. I only care about how many physical ounces of gold I have. Do you understand the difference between this and holding an ETF? Hong Kong has recently recalled their gold reserves from London. This is another sign that the world of paper values is being increasingly discredited. I'm avoiding gold etfs like the plague, but ignore physical gold at your peril.

Sep 10 04:22 AM

[chap08:]

No, Bretton Woods did not free the government from the gold peg. It was the collapse of Bretton Woods that did that. Under Bretton Woods, the dollar was pegged to gold. It was the unsustainability of this peg that caused the collapse (France insisted on keeping us to our word - we couldn't keep to our word). Consequently, it makes no sense to base your comparisons on an unsustainable conversion rate. You need to look back further. Pick your own date e.g. the start of a new standard - and btw, you are wrong to say that the US has always been on a gold standard.


On Sep 09 11:37 PM Hmm?! wrote:

> I have to have to agree with first commentator (playmobil). Any comparison
> of dollar and gold values prior to Bretton Woods makes no sense.
> Prior to Bretton Woods the dollar was a controlled currency pegged
> to.... and backed by..............GOLD!
>
> However it was Bretton Woods that freed the US government from the
> gold peg and allowed them to continually borrow and print money.
> Works great to get governments out of trouble (stick the grandchildren
> with paying)......and therefore since Bretton Woods....gold has increased
> in value 30 times that of the dollar.
>
> On Sep 09 10:12 AM chap08 wrote:

Sep 10 07:15 AM

[Bright Pink...:]

5 *even better* reasons to avoid RUSHING INTO GOLD...

- There are other Great Big Sales items, like Silver, Platinum, Food...

- Queuing politely is certainly a more pleasant shopping experience than grabbing

- They are not handing out plastic freebies at the Gold Shops

- It will take many many years to unwind The Great Debt

- The Chinese and Arabs and Japanese and conservative Europeans and Indians are STILL taking their sweet time shopping for Gold at bargain price

So, why rush?

Take your time!

I love shopping...

Sep 11 03:17 AM

[Plant the s...:]

Gold has more than its share of emotion, sentimentality and speculation. There is not a lot of gold in this world and small changes can move its price significantly.

Sep 11 06:46 PM

[untrusting ...:]

Don't really know about gold holding it's value since 1913 in comparison to other investments. Maybe and maybe not, really just depends on the investment.

Take 1913 gold at $23 or $35 /oz. and compare it to say GE stock at 1913 prices. It is true that gold has appreciated to about $1,000 oz. over that roughly 100 year period. But it is also true that gold has earned zero other return other than the roughly 30-50x appreciation, and has some holding cost for that period as well. Via a compound interest rate calculator, gold going from $23 to $1,000 over 100 years is only a compound growth rate of about 3.84%. Again, OK performance, but not the hugh home run that gold bugs seem to claim it is.

On the other hand if GE stock was purchased in 1913 and all dividends were reinvested in more GE stock since 1913, one has to guess that the compounded appreciation in the GE stock would be significantly greater than than the appreciation in gold value. Don't know how many shares of GE one could have purchased in 1913 for $23 or $35, but our guess is they would today be worth a lot more than $1,000 for 1 oz. of gold.

Similarily, Berkshire Hathaway would have significantly outperformed gold since inception of Berkshire (about 50 years ago), and by very significant performance amounts. As would a number of other stock investments.

So while on average gold has performed OK over time, there are many many investments that have significantly outperformed gold over the same time frame. As always, the trick is to pick which ones ... easier said than done.


On Sep 09 11:37 PM Hmm?! wrote:

> I have to have to agree with first commentator (playmobil). Any comparison
> of dollar and gold values prior to Bretton Woods makes no sense.
> Prior to Bretton Woods the dollar was a controlled currency pegged
> to.... and backed by..............GOLD!
>
> However it was Bretton Woods that freed the US government from the
> gold peg and allowed them to continually borrow and print money.
> Works great to get governments out of trouble (stick the grandchildren
> with paying)......and therefore since Bretton Woods....gold has increased
> in value 30 times that of the dollar.
>
> On Sep 09 10:12 AM chap08 wrote:

Sep 27 12:01 PM