- The reason for gold's meteoric rise of the last ten years is clearly the fear of fiat currency's demise, which is completely overblown.
- The price of gold should rise roughly along with inflation, not way beyond it. Ironically, gold is one of the most inflated items. Thus gold still needs to correct.
- With every anemic and failed rally in the gold price, the conviction of gold bugs gets more shaken.
- The pendulum that is gold mania should sooner or later swing to gold panic, creating an entry point for longs well under $1000 per ounce and perhaps closer to $500.
- Due to the above bullet points, shorting $1300/oz gold is not as risky as shorting normally would be.
Background and Outlook
During the Panic of 2008 I was buying stocks on the way down with as much cash as I could muster, and recommending for others to do the same. Though I was out of cash well before the Dow Industrials bottomed briefly below 7000 in March 2009 I was not deterred. In June 2009 my conviction was still such that I added to my website's home page my recommendation to buy stock index ETFs for the long haul. The Dow was at 8500.
The double in these last 5 years is great, plus dividends (much more if dividends were reinvested), but it actually makes me nervous. I did not know in 2009 that the market would recover as rapidly as it has; I only knew that stocks were underpriced.
That is no longer the case. With the S&P 500 now trading at a P/E of 16.5 times forward earnings, U.S. stocks are no longer cheap. Not expensive either, but no longer cheap. I suspect that any stock market gains going forward would have to be from simply momentum, favorable macroeconomic data announcements, or significant earnings growth which already seems priced in. That leaves little wiggle room for potentially bad news and in my view makes a continued rally in stocks from these historic highs roughly a coin toss or 50/50 proposition. Not good enough for my liquid assets which I need to live on.
Thus over the last several months I have been gradually reducing my stock overweight and shifting more and more into cash (except for my long term retirement accounts which are invested in stocks). If we get a substantial correction off of the current record highs (Dow 17,000), I will shift more shorter term money back into selected stocks.
However, that may not happen in which case I have to look around and see where else cash can be deployed. In doing so, my goal is to seek high probability outcomes. Not timing bets or outsize rewards but relatively low risk for a roughly 3-5 year horizon. When I ask myself in what investment class am I surest about what will happen in such a time frame, I keep coming back to gold. I am sure I understand why gold has had a stellar decade. Too stellar. It still needs to correct.
Gold's Last Decade
Gold in 2004 traded between a low of $375 and a high of $450 per ounce. That range that looks so quaint now seemed at the time actually rich relative to the preceding decade. (It had always traded below $400 since 1996, and below $300 for much of those eight years.) Then, starting in 2004, gold climbed with heady double digit annual gains (far exceeding inflation rates by any measure) to reach about $1500 by mid 2011, at which time it exploded to peak briefly at $1900 before settling back to the $1600-$1700 range. It has not touched $1800 since 2011 and today it stands at $1304 per ounce.
It's notable that gold fell mightily during 2013 from $1700 to $1200, a year in which global physical demand for jewelry, coins, and bars by consumers reached a record high. How can this be when there was no glut of mine supply?
The 29% fall in the face of record demand could happen because gold exchange-traded funds (ETFs) and gold paper markets sold off. Traders rule the roost. Think about it. Somebody walking into a jewelry or coin shop and buying has zero impact on price because the spot markets and London gold fix are the tail that wags the dog. It's not like classical economics where the price is wherever the physical supply and demand curves intersect. The dealer has to sell based on spot. So don't count on burgeoning gold demand from the expanding middle class in the developing world to boost the price. It doesn't work that way and 2013 proves it.
The second huge problem is that even if you do insist that physical demand ultimately does significantly affect the price, unlike other commodities gold is not consumed. Today's demand accumulates, becoming tomorrow's supply. It's not like oil or wheat where everything is consumed so producers must go get more from the ground. I've consumed literally tons of oil and wheat in my 50 years. I've owned bullion but I've never consumed an ounce. I sold it and thus it all was recycled as supply, as those coins will be over and over again.
Of course the primary explanation for the gold price multiplying several fold over 10 years time lies in the global financial crisis, massive quantitative easings (an unprecedented Fed tool), sovereign deficits that are eye popping by previous standards and the burgeoning of National debts.1 The theory goes that the debt load is spiraling out of control and when this puppy goes down you'd better be holding something other than pieces of paper (currency, sovereign debts, or other bonds which are simply promises of future currency).
The theory is bad and the puppy is not going down. An objective survey of history reveals that this time is not different. The purchasing power of U.S. dollars has held up far better than the gold bugs very vocally predicted during the panic of 2008-09 and before. Orders of magnitude better. In fact, if your friend Rip Van Winkle fell asleep in 2004 and woke up today, and you said, "Rip, it's 2014 now, let's go shopping," Rip would look at current prices and not think inflation over the last decade had been anything out of the ordinary. Rip would see no evidence in average consumer prices of the massive QE, blissfully ignorant that the Panic of the century had even occurred as he slumbered.
I make very few predictions, but I am on the record predicting in mid 2009 that massive Fed money printing would have little if any effect on prices. Compare that to the popular inflation and deficit hawks at the time dropping the words "hyperinflation", "Zimbabwe", and "Weimar Republic" right and left in discussing the U.S. dollar. They've been off by orders of magnitude and will continue to be. That's because they've got a very bad model of inflation. From a policy standpoint it's a 'one variable' model which at one time was known as just a subset of economic theory called "Monetarism" before small-government idealogues such as Milton Friedman trumpeted it so loudly as truth.
What is the 'one variable'? Of course it is excess money printing, their least favorite thing. Most gold bugs make no bones about it, saying that "inflation" in fact is the printing of excess money with proportionally rising prices being necessarily merely the manifestation of the inflation. It's faulty logic borne of mere semantics. Another problem is the evidence is abundantly clear that prices need not rise remotely proportionally to money printing. Ever. Forget P=MV.
Profiting from the Gold Bubble We Are Still In
You can profit from the investors that have grossly overbid gold over the last decade. They are waiting for their scenario to unfold: massive exodus from U.S. Treasuries, yields and interest rates soaring, deficits spiraling out of control, central bank money printing also spiraling out of control desperately trying to keep up, precious metals and commodities soaring providing the assurances that they are right to buy even more, and of course consumer prices roaring. And some think there will be civil unrest accompanying economic meltdown for which in addition to precious metals you'll need a stockpile of food and likely your own power source.
Debunking all these point by point is beyond the scope of this article, but if you are as sure as I am that these are nonsense then shorting $1300 gold looks good. The above points coming true would feed a gold frenzy, but their failure to come true will seem incomprehensible to gold bugs and increasingly test their faith. Over time the continued range-bound or slipping gold price with only anemic and failed rallies such as we've seen since 2011 will undermine their confidence in gold. I thus think an all out panic in the gold market is not unlikely and the pendulum could swing from overvalued all the way to undervalued at some point. Something like the period 1980 to 2002 for gold could be in the making now -- a stretch that was not pretty.
Fundamentals Against $1300 Gold, Especially the ETFs
I actually like gold and silver, probably just as much as some gold bulls and hoarders. However, there is good reason why gold has not been a traditional part of portfolios until recently (unless you are a central bank). That reason is that gold generates nothing: no earnings, no interest, no growth. As such it's not really an investment. If you sock away an ounce of gold in the mattress for a decade, you know it will be only an ounce at the end. No compounding. Nothing. Your only hope is that the price per ounce will be higher.
When you pay somebody else to sock gold away for you, it's a bit worse: the popular physical gold ETF, the SPDR Gold Shares (NYGLD), deducts .4% annually for expenses. A $1300 investment in GLD would thus lose $51 to be worth $1249 after a decade if the price of gold just stayed flat. Certainly not something I would want in my IRA or 401k when I can have growing earnings. The erosion of expenses is a benefit though if you are short. That's just one more reason I increased my short position in GLD last week. Other liquid non-leveraged gold bullion ETFs to short include IAU, SGOL and DGL. DGL has the highest expense ratio at .79%.
1 Additionally, the founding of the physical gold ETFs and their buying of many metric tons of the metal boosted the price during much of the decade.
Disclosure: The author is short GLD. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.