But, whatever: gold is in a bubble right now.
I can hear all you gold bulls getting ready to fire off an angry e-mail right now, but hold on a second before you do.
Today, we're going to assume that you are right. Let's assume that the classic gold thesis - that gold is a hedge against inflation - is correct. We're going to assume that I am wrong, and let's face it, I really can't see the future any better than any other hedge fund manager with a blog.
So let's assume it's NOT a bubble. Let's assume that the money-printing is out of control and our future is a heavily inflationary one. Let's assume that everything you hear from the gold commercials and Glenn Beck and the commodity bulls is correct.
What has to happen from here? What has happened? What are the facts?
To lay the groundwork for this investigation, let's start with a chart, one that I'm a little surprised doesn't get more play:
click to enlarge
I do a lot of charts, but this is one of my all-time favorites. 140 years of gold adjusted for inflation. Beautiful, isn't it?
Most of the gold charts I see nowadays are decade charts. They start around the year 2000 and show how awesome gold has been since then. It's undeniable. Gold has been awesome in the last decade. I and many others have made a lot of money on it since 2003-2004 when it started to look like the 20 year slide was finally over.
But to understand gold and what it's doing today, you have to understand the history of gold. As you can see from the chart, the history is long and rich and dramatic. But for investors like you and I, one bit of history stands out above all others.What happened in 1980.
We know that in 1980, when gold hit $850/oz in nominal terms, it was a bubble. At the time there were plenty of arguments that the price action in gold was real and justified. Inflation was out of control, running over 10% per year after a decade averaging in the high single digits. People were angry. Gold, after peaking and crashing in the early 1970's, bottomed out around $100/oz in 1976 and laid the foundation for a phenomenal run towards that famous top.
But it was a purely speculative bubble. We know this now.
Gold spent the next two decades going down.
The classic gold thesis failed. It didn't exactly protect you from inflation during that period, did it? Gold lost 70% of its value while the CPI more than doubled.
I'll admit that I'm cherry picking here with the dates. Someone may have bought at the $850 top but the odds are it wasn't you. So let's say you bought somewhere in the $600 range where it spent the rest of the year trading after things settled down, or maybe you got lucky and bought on the first dip when it went into the $300's. The value of your gold still went down for a long time and inflation still went up.
There are a billion reasons why I'd like to rewind the clock to 1999, but one of them would be to get a read on the gold market. How many people were running around back then saying that gold was a great hedge against inflation? How depressed was that market, really?
I know that over the long, long run - the run in which Keynes quipped that we are all dead - gold does hedge you out against inflation. But clearly, when you buy gold matters. Is your time horizon 30 years? A lot can happen in 30 years.
Anyway, that's really neither here nor there. All that's important today is that we understand that 1980 was all speculation. Gold today is sky high in nominal terms, and as we saw from that chart, the only time in history when gold has been this expensive on an inflation-adjusted basis was in the middle of what we know now was a speculative bubble.
That's not exactly the same thing as saying that gold is in a bubble right now. That's like, an opinion. My opinion. But it is a fact to say that the only other time in modern history that gold has previously traded hands at these levels was during a speculative bubble. Go ahead and do with that fact what you will. Or ignore it.
(Incidentally, I think it's ironic that Alan Greenspan, a man reviled by gold bugs everywhere, would provide them with the only real, non-speculative argument that gold isn't in a bubble, the argument that bubbles are difficult or impossible to identify while they're being inflated. We don't truly know until after the fact.)
So let's go back to our assumption that it is NOT in a bubble and that the "inflation & money printing thesis" is correct.Justifying $1400/oz.
Gold doesn't grow, it doesn't generate earnings, and it doesn't pay a dividend. You can drape it around your wife but you can't rent it out. Gold is dug up from the ground, turned into jewelry or bars or coins, and then it is bought and held. A little fraction is for industrial use, but most gold doesn't really do anything productive. As Jim Grant says, the price of gold is a concept, not an investment.
Since it is nothing more than a store of value, simple supply & demand will move the price around over the short run, but over the long run its value will be linked entirely to the relative value of the U.S. Dollar (and conversely, the rate of inflation). Any price above this represents a premium and any price below represents a discount to its fair value. The difference is an opportunity for arbitrage, but it's not an easy arbitrage because calculating this fair value is complicated. It's not a quick arbitrage either.
Here's a simple chart comparing the price of gold to what it would be priced at were it to act as a perfect inflation hedge, an asset that appreciated at a rate identical to the change in the CPI.
Based on this it should today be trading somewhere around $225/oz. The CPI would need to increase about 20% per year for the next decade to justify $1,400/oz. Or about 9.5% per year for the next twenty years.
But that's crazy. That's called "telling lies with charts". Gold was probably cheaper than it should have been in 1968. Or was it?
So let's use some different dates. It's totally arbitrary when we choose our starting point, so we'll cherry pick a date that better supports the argument for a high gold price. Let's start the clock in 1985 after the bubble had burst and after the inflation had settled down.
That's a little more like it. On this basis, it should be trading somewhere around $640/oz. The CPI would need to increase by 8% per year for the next decade to justify today's prices. And that's assuming the price of gold stays constant throughout. It would take twenty years of 4% inflation rate to justify $1,400, a much more likely outcome. But that still assumes that the price of gold goes nowhere for two decades, definitely not the thing you're looking for from your investments. How long can gold grow at a rate in excess of inflation?
To cherry pick even more dramatically, even if we started the clock at one of those peaks in 1983 or 1987 the story is pretty much the same. This tells you the price should be in the $700's which would mean that gold is "overvalued" right now by a factor of almost two. Again, assuming that the thesis of owning gold as an inflation hedge and to protect you from dollar devaluation is correct, we'd need to see 6% inflation per year for the next decade.
That's painful. That also could happen. Even if it does it's not a guarantee that gold goes higher. Gold would have to travel further into "overvalued" territory and the risk of bubble breakdown would continue to increase. And if it appreciates less than the inflation rate to normalize towards fair value, you're angry because you're not being protected from inflation.
With this kind of analysis we can choose any dates we want, really. But it's hard to pick a date that supports gold at or below anywhere close to fair value.
Before we move along, let's have some fun and reset the clock to 1870:
Pretty cool, huh?
I could spend all week writing about that chart. I'll let you draw whatever conclusions you wish from that.Some caveats
Look, I know a lot of you guys hate the CPI. You all think that it understates inflation. I respect that.
What index do you want to use?
The Dow Jones / UBS Commodity index has increased just over 6% per year since it started tracking in 1991. Is 6% closer to your "true" rate of inflation? That index is based strictly on commodity futures prices, volatile stuff like wheat and rough rice. It totally ignores all the other components of calculating true inflation, focusing entirely on the stuff that people complain most.
Anyway, if we run that same study using the DJ/UBS commodities index that gets us to around $1,200/oz from a starting date of 1991, the oldest on record for that index. You can argue that the CPI understates inflation, but this index almost certainly overstates it. Not even the nuttiest of the tinfoil crowd thinks we've had total national inflation of 6% per year since 1991.
Or do they? I don't know. Maybe the Shadow Stats guy does.
Perhaps you want to use median family incomes as a proxy for inflation? Those have gone up about 3% per year over that window, very close to the CPI. Or home prices as a measure of inflation? Robert Shiller has a housing index that goes back over a hundred years. It's risen at an average annual rate of 3.4% The hundred year average on the CPI is 3.04%.
Even with those alternate measures of inflation, the charts will still look the same as above.
What to do about it
The reality is far more complex than all of this. There are a lot of moving parts in the gold market. But there is a simple truth at the heart of it all: since gold doesn't have any intrinsic earning and growth potential, it should be priced entirely on two factors:
- The relative value of our currency (historical inflation)
- The expected relative value of our currency (future inflation)
The supply & demand components of price simply push that intrinsic pricing farther in either direction for discrete windows of time, but over the long run things regress towards the historical trendline driven by our currency.
After today, we can see that on a historical basis, it's almost impossible to justify the current price of gold. So I think that all of us - gold bugs and deflation bears alike - can agree that gold is priced today as though something really dramatic is going to happen down the road. That, by definition, is speculative. And assuming that the bulls are correct, inflation has to be crazy in the future to justify gold's current price and it's still entirely possible that gold doesn't keep up.
Gold has pulled back a bit lately and sort of stalled out here in the mid $1300's in search of some support and resistance. I don't think it chops around here much longer and I think it breaks out one way or another. This bubble could absolutely keep running or it could blow up tomorrow.
To express a a slightly-more-nuanced view like that, you have to go to the options market. Let's consider a simple long straddle on gold (GLD).
A June 133 straddle will run you about $10 ($5 for both put and call), so that's $1,000 per contract. Gold has to move 9% either up or down by June to break even, and after that it's leveraged gravy. If it moves 20% either direction by June that's a doubling of your money. Yow.
If you want to give yourself a little more time for that short-term thesis to play out, look at the September 133 straddles. Those run around $14 right now, which means that gold has to move about 11% either direction for you to break even. Beyond that, the profits really start to rack up.
And the December 133 straddles are around $1,800 per contract. GLD has to move 14% either way for that trade to make money but if gold moves big - if the bubble bubbles on towards and past $1,500, or if it collapses below $1,100 - this trade can make a lot of money. A lot can happen in a year.
This is a relatively low risk way to play a big move in the price of gold without taking a high-conviction, directional stance.
If you want even more bang for your buck and are comfortable taking a little more risk, check out something like a June 143/123 long strangle. That'll run you about $300 per contract and GLD has to move around 10% either direction for that trade to break even. But if it does do that, then you get some heavy-duty leverage the further in either direction it goes. A move to $1,490/oz on gold is a doubling of your money. Don't forget the time component, that has to happen by late June. Worth the risk? Perhaps.
The worst case scenario in all of these situations is if gold goes absolutely nowhere and your options expire worthless or close to it. But nobody still reading this article thinks that gold is going nowhere this year, do they? Everybody has an opinion.
Feel free to find some other trade that expresses that specific opinion. There are countless ways to do it.
If you're a gold bull, you already own gold. You own some coins or GLD. Good for you. If you own it because you are speculating on increasing speculative demand and momentum, that's fine. If you own it because you need to do something with that final 5-10% of your portfolio, that's fine too.
But if you own it because you want to hedge yourself against inflation and guard against dollar depreciation, why not express that view another way? Why not own some other real assets that aren't so overvalued based on the historical influence of inflation and dollar depreciation? Why not own other commodities, or farmland, or distressed real estate? Buy some art. Or a big barrel of natural gas. As the dollar goes down over the long run, this stuff will go up in price too.
There are other ways to store value in non-dollar places. Own some foreign currencies or a currency ETF like Canada (FXC) or China (CNY) or Switzerland (FXF). Heck, even own some stocks via something as big as the SPDR S&P 500 (SPY) or energy stocks via the Energy Select Sector SPDR (XLE), which is more sensitive to and correlated with inflation.
Even if the gold bug thesis is correct, gold may not necessarily guard you the way you're expecting it to.
When you buy matters.
A final word.
I'll admit that I am the son of a gold bug and it was drilled into me from an early age that gold was something that everybody needed to own. He had his reasons, but I have mine: it's different and it moves in different ways than the other stuff in your portfolio. This may help you understand my perspective as a portfolio manager and as author of this article. But more importantly, you need to understand who YOU are as an investor. I write about that all the time. It's the single most important lesson about investing. If you're feeling a little touchy-feely, you can learn more about all that right here.
So understand that I'm not here to rain on the gold parade. I could be spectacularly wrong about all of this.
I just think that everybody who owns gold or wants to own it needs to ask themselves a very deep and important question. There is no right answer and you need to answer it honestly.
Are you really worried about the dollar or do you just love gold?