The Western Investor's Perspective
During an interview with Becky Quick in CNBC in May, 2012, Charlie Munger said,
"I think gold is a great thing to sew in to your garments if you're a Jewish family in Vienna in 1939, but I think civilized people don't buy gold."
At the time Gold was priced at just above $1600 per ounce. Shortly afterwards, it peaked again over $1700 per ounce and then has steadily fallen to a recent low of approximately $1060 per ounce.
GLD data by YCharts
GLD chart used in lieu of Gold.
The situation has changed since Mr. Munger's remark. We have stalling world growth, low to negative worldwide bond yields, and a stock market that has peaked and may be entering a bear market of undetermined ferocity. While Mr. Munger's advice may have been appropriate for 2012, there may be some very good reasons for a civilized person to buy some gold.
Negative Interest Rates
The Bank of Japan - BOJ - recently shocked the world by charging overnight deposits rather than paying an extremely low interest rate. Sweden, Switzerland, and Denmark are also following this policy but even more aggressively. The concept behind this policy is to encourage the banks to lend money rather than hoarding capital.
As yet, bank depositors are not being charged to keep their money in the bank, but this has been proposed by economists as a way of stimulating money flow and investment. For those of us who remember when passbook savings accounts used to pay 7% interest, the idea of paying to keep money in the bank is difficult to accept. In fact, we were paying at least 3% (inflation was over 10% in the early 1980's) for that savings account, because of the eroding effect of inflation. In this current era the cost will be overt rather than masked. This will cause some to look for an alternative to bank deposits and one of those is physical gold.
George Soros, Kyle Bass, and other macroeconomic investors have expressed the opinion that China will not be able to achieve the "Impossible Trinity":
- Monetary Autonomy
- Free Exchange Rate
- International Free Flow of Capital
China has been spending its much vaunted foreign exchange reserves to try to stabilize the yuan's exchange rate while Chinese citizens and companies are moving capital out of the country. George Soros and the hedge fund barons have done well with this kind of bet. His success in 1992 against the Bank of England and in 1997 against the Thai Baht is legendary. In Mr. Soros' words:
"The financial crisis that originated in Thailand in 1997 was particularly unnerving because of its scope and severity.... By the beginning of 1997, it was clear to Soros Fund Management that the discrepancy between the trade account and the capital account was becoming untenable. We sold short the Thai baht and the Malaysian ringgit early in 1997 with maturities ranging from six months to a year. (That is, we entered into contracts to deliver at future dates Thai baht and Malaysian ringgit that we did not currently hold.) Subsequently Prime Minister Mahathir of Malaysia accused me of causing the crisis, a wholly unfounded accusation. We were not sellers of the currency during or several months before the crisis; on the contrary, we were buyers when the currencies began to decline-we were purchasing ringgits to realize the profits on our earlier speculation. (Much too soon, as it turned out. We left most of the potential gain on the table because we were afraid that Mahathir would impose capital controls. He did so, but much later.)"
(My emphasis in bold)
While China may be forced to resume capital controls, it has been reluctant to do so. The People's Bank of China - PBOC - wants the yuan to enjoy the benefits of being a "Reserve currency" similar to the US dollar, yen and euro. In November 2015, the International Monetary Fund recommended the yuan for inclusion. Inclusion was not immediate. "The addition will take effect Oct. 1, 2016, with the yuan having a 10.92 percent weighting in the basket." My prediction is that China's central bank will do everything in their power to keep their currency fairly stable without imposing capital controls until October. That is a long time in this world of finance. "The world's largest currency hoard decreased by $99.5 billion in January to $3.23 trillion, according to a People's Bank of China statement released on Sunday." A simplistic view of this figure would be that China could maintain this level of spending for almost three years. Unfortunately for China, and world markets, it is estimated that they need Forex reserves of about 2.7 trillion to balance their unprecedented credit expansion over the past 7 years. Even if they could cut the capital flight to half of last month's rate, the likelihood they could keep the exchange rate the same until October is improbable. While they fight this battle, the money supply in China will tighten, increasing the risk of economic implosion.
Just as in the USA where the very wealthy can use dummy corporations and real estate purchases to effectively circumvent taxes, the wealthy Chinese have been using similar techniques to move money offshore. Those with lesser resources have been buying gold.
While Western investors have shunned gold since 2012, "Flows into four nations alone - China, India, Russia, and Turkey - have often exceeded monthly (mine) production in recent years." Other non-Western countries have siphoned off the remainder of supply as prices have fallen. In comparison, the liquid portion of potentially marketable gold in the UK has fallen from 3414 tons in 2011 to 1122 in 2015.
Residents of Asia, South America, and Africa have lived through numerous cycles of currency devaluation. Even if it is foreign to our western sensibilities, owning gold is a practical policy in their world.
The Eurozone refugee crisis may result in the end of open borders in the Eurozone. This issue seems to get little traction in US media. Chancellor Angela Merkel is facing some real challenges. Although the ongoing Greek credit crisis was an issue for the German voter, the business community understood the benefits of paying to maintain the EU. Their support was more influential than the average taxpayer. The influx of 1 million refugees is another matter, since it burdens not only the financial resources of the country, but also threatens the social fabric.
I witnessed the difficulty West Germans had integrating the East Germans during reunification. Outside of Berlin and Frankfurt, German life is remarkably stable. As Americans we assume mobility, to pursue jobs or just better weather, is the norm. This isn't the case in Germany, or in most European countries. Natives of the Saarland, a portion of Germany that was annexed by France after WW II and returned in 1957, are the butt of many jokes even today. Prospects for integrating refugees from the Middle East are poor. With the concerns about Deutsche Bank - Credit Default Swaps - CDS - and other financial stresses, the likelihood of some major disruption in the Eurozone is growing. A threat to the euro currency would be a huge stimulus to the price of gold.
Gold Mines Will be Less Productive
Exuberant investment in gold mines leading up to the peak in 2012, was fueled by credit. Much like the oil industry, the mines have struggled to produce earnings to pay their debt. Unfortunately, the corresponding cut back on capital investment and tendency to "high grade" (go after their most productive ore) will lead to difficulty increasing production. This will make it hard to increase production if demand increases.
A Short Squeeze
A profitable trade for the past three years has been to sell Gold short. Until one month ago gold speculators were net short. The argument against gold was:
1). In a deflationary world, commodities should decrease in value.
2). In a rising rate world, interest rates in bonds should go up making bonds a better investment than gold.
3). If the dollar strengthens, and gold is priced in dollars, gold should weaken.
But, since the beginning of the year, bond yields have dropped and the dollar has weakened. Perhaps these moves are temporary and the US economy will strengthen, resulting in falling bond yields and a strengthening dollar putting pressure on gold. I suspect any weakness in gold as a result of such moves would be an opportunity for gold shorts to close their positions. I am not alone.
Money managers increased their gold net-long position last week by 49 percent to 35,620 futures and options, according to Commodity Futures Trading Commission data released Friday. Just a month earlier, the speculators were net-short, or betting on declines.
Charlie Munger's advice is based on a preference to invest in a productive asset. By this he means a farm (farmland prices are high and falling) or a business (stock prices are falling.) Over the very long term he is probably correct. But over the short to intermediate term gold may be a better store of value than anything currently available to investors. Americans have embraced an Eastern mindset when it comes to yoga. Perhaps it would be a good idea to embrace some gold as well. We might find it an enriching experience.
How to Buy Gold Now
Gold has had a nice run. I started buying after watching large volume trades show up on my options platform and have benefited nicely.
You could buy gold coins. You will pay a commission of 4-5%. You could put the coins away for a disaster with your canned goods and guns. In a disaster, you would need the latter more than the gold.
Other than the end of the world scenario, the primary benefit would be that your coins would not show up on a statement from a bank or brokerage. The March 2013 ECB action in Cyprus, where portions of depositors accounts above a threshold of 100,000 Euros were confiscated to bail-in the banks, could be a template for future actions in a financial collapse. There is a limit to how much one could protect with physical gold. FDR outlawed private ownership of gold in 1933 with Executive order 6102. It would probably be more effective to pay off your mortgage if you were truly worried about this scenario. The final argument against a large position in physical gold coins or bullion is that you have to secure it from theft. If this still interests you other sites can give you further information.
The CEF - Central Fund of Canada - is a closed end fund that holds Gold and Silver bullion. As a closed end fund it trades at a discount to net asset value - NAV- and at the end of day February 8, 2016 this was still 6.1%. If gold rallies, this discount will narrow giving you some leverage for even better returns.
GLD data by YCharts
For most of us, an ETF in gold bullion offers the best solution. The largest and most liquid is the GLD. The chart of the ETF GLD shows an exponential curve over the past week. I tend to sell these kind of rallies in stocks [I sold an upside out of the money - OTM - call on my long position in Facebook (NASDAQ:FB) when it hit $117/share] because they are rarely sustainable. Much of my position in Gold is in the form of option spreads in the GLD. I believe this is preferred for an initial position in the GLD in light of the recent run.
While the GLD has broken through the down-trending line from 2012, it has not broken through last year's 114/share. This may take some time, but if it does then technical traders are going to push the GLD much higher. By the same token, the recent floor of the GLD has been 100/share. The GLD is trading at $114.55 as I write. Consider buying a GLD call April 100 strike currently priced at $1480/contract. (A contract controls 100 shares) Simultaneously sell a GLD April 114 strike for $392/contract. This vertical spread will cost you a total of $1087 plus trading costs which should be minimal. If the GLD drops below $100 you will lose all of your trade. If it trades sideways or goes up you will make $313 or 28% in a couple of months. An annualized return would be over 150%. If the GLD continues to go sideways for a while, you could buy back the short call after it depreciates and benefit from the long call if it soars and make an even better return.
Gold miners - Market Vectors Gold Miners - GDX - are often promoted as a better way to trade gold appreciation. The stocks in the sector are certainly beaten down despite a recent run. If you think about the damage to their business that occurred over the past three years as mentioned above, they will lag the GLD from this point forward.
Special Tax Considerations
Avoid doing trades on Gold in your taxable account. Gold is taxed as a collectible, which for most of us would be at 28%. Consult your tax professional, but gains on options may not depend on the underlying equity or element.
Despite my cautious outlook as expressed in Hope And Denial: 2 Sides Of The Same Coin , Gold may give you a way to find some alpha. Just remember to limit your risk, never trade on margin, and always be a Calm Investor.
Disclosure: I am/we are long GLD.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am not a financial advisor. Do your own research and consult with your advisor before making any investment.