“Only in a leap from the lion's head shall he prove his worth” -Indiana Jones and the Last Crusade, 1989
I received an email today questioning a recent bearish prediction on gold, so I thought I’d take this opportunity to elaborate a bit on my view.
My 8-Ball told me what would happen…
Since gold is a non income producing asset analyzing it requires more creativity than usual. Cash flow and the prospects of future cash flow are utterly useless, which means you can’t really analyze it in the traditional investment sense. You also have the problem that unlike most commodities, gold has very little practical usefulness and is non-perishable. So annual ornamental demand and industrial usage only accounts for a fraction of the total outstanding stock. So, this is an asset whose stock is always rising, and whose marginal consumption is a limited if not negligible driver of price. How do you value it?
The Magic Gold Cube
In a speech earlier this year the Oracle of Omaha pointed out that if you took all the gold that had ever been mined it would fill up a cube that was 67feet on each side or roughly 5.3 billion troy ounces of the shiny metal. When I heard this quote, I thought to myself the Oracle is either spending more time than usual on Wikipedia reading about gold or he is now paying attention to the World Gold Council.
The numbers he was throwing out there were clearly from the WGC, which often states that according to the best estimates available the total volume of gold mined since the beginning of time equals 165,600 tonnes, and that 65% of this has been mined in the last 50 years. Buffett then provided everyone with some interesting valuation comparisons. This gold would allow one to buy all the agricultural land in the U.S., 8 Exxon Mobil’s (XOM), and leave you with a trillion dollars in walking around money. Since this interview in early March of this year, the price of gold has risen and the price of everything else has pretty much crashed. At the current price of $1680, Buffet’s Gold Cube is now worth just a hair under $9 trillion. This is equal to 75% of the value of the S&P 500 (or 60% of the value of the Wilshire 5000), which has a current market cap of about $11.7 trillion, employs 25million people, did annual sales of about $10 trillion, and generated net profits of about $900billion.
So is the Cube Cheap or Expensive?
Buffett doesn’t help you answer that question. He simply seems to be implying that he would rather own all the agricultural land in the US and 8 Exxon Mobils over a magic cube of gold. Of course this is just Buffett, he also wanted to own a toll bridge when he was a kid so that doesn’t really help you much when it comes to figuring out if his argument makes sense. That is not to say that Buffett isn’t doing something very clever here by making you think about what has more ‘utility’ or ‘value’ in life. But is that the the question being asked here? What if the magic Gold Cube was worth all the land on earth? Wouldn’t Buffett buy it now and trade it for the planet later? Ridiculous right, but realistically this is the type of reality suspension you need to engage in when you are trying to analyze something that is unanalyzable.
Ask a Gold Bug…
Now the Gold Bugs will take a different approach here and tell you Buffett is biased and not framing the picture right for you. They will argue that in 1980 at the high of $850 an oz and with 3 billion oz’s above ground all the Magic Cube was worth $2.5 trillion or nearly 2x the value of the Wilshire 5000 index. For the cube to reach that multiple today gold would need to reach a price of $5,500 an oz or the Wilshire 5000 would need to fall by 75%. So, buy gold right now because it is going higher!! But hold on a second, whoever said gold at 2x the Wilshire 5000 was the right valuation for the shiny metal. A year later it was 1x and two decades later the magic cube was at about .1x the value of the Wilshire. Now here is the interesting thing about this comparison. Over the last 30 years the earnings growth has roughly kept up with the market value growth in equities. Gold on the other hand has produced nothing. The only difference between 1980 and today is that the amount of gold above ground has nearly doubled. So, why does every gold bug use 1980 as a marker?
The honest answer is they probably don’t even know why. It’s just a high point that they think must be revisited, and it has been arbitrarily chosen because they have no real concrete way to value the metal.
It’s like when I hear people arguing the inflation adjusted price of gold since the 1980 peak is X (usually some number between $2000-$4000 depending on whether they want to use the real CPI data or some other measure of inflation if they don’t trust the statistics), and that this means the bull run has much more to go. But wasn’t the gold explosion in the late 1970s about the fear of run-away inflation? And didn’t the price collapse long before that inflation was broken and we entered an era disinflation? So why would I use the peak moment in fear of something to extrapolate the current price on an inflation adjusted basis if the sole purpose of buying the asset is an inflation hedge. Confusing isn’t it?
Spend enough time looking at gold and you can come up with just about any argument. I used to like (and to a degree still do) looking at it from an energy perspective. If crude priced in gold gets really cheap on historical standards I probably should be selling my gold and buying barrels of oil. This way I pay little attention to the fiat factor and just play longer-term trends in global consumption while hoping to dodge the extreme periods where marginal production/demand changes cause the price of crude to spike. But this is again a pretty arbitrary metric.
So, investing in gold is more about faith. Everyone has an approach, and nothing has been conclusively proven. All we know is that there are periods of fear, which tend to lead to speculation and hoarding of the metal. When this fear subsides, the price tends to collapse. There is nothing fundamental about it. I think the fear element is peaking and that the price will correct long before that becomes obvious. But this is more a feel for something than a grounded and well supported argument against the metal. I could be wrong, but if history is any indicator even if I am there will be no break through explanation for why that was the case.
By the way, I am sure after this is posted it is going to result in plenty of bugs screaming blasphemy. So, just to head that off, I was a gold bug for a decade and am quite familiar with all the talking heads around the metal. I can thank Marc Faber for that. Also as a history nut I have come across my fair share of gold stories over the years so it is not like I don't get the longevity argument here or the diversification/tail risk element. I'm just saying that as far as I can tell all the people predicting the future price have no real reliable way to get there, and thus one can convcingly argue that a steep sell-off from here is very possible regardless of what the increasing number of gold holy believers are saying.