Gold’s 'Grand' Illusion

Includes: DGL, GDX, GLD, IAU
by: Dan Perkins

Imagine that you, the reader, are aboard a private jet with George Soros, Marc Faber and Jimmy Rogers, headed for a gold symposium in Darwin, Northern Australia. Your plane crash-lands on an island in Indonesia. You seek out the local chieftain, who controls all the food on the island. You tell him that you are in desperate need of food and he asks what you have to trade. The three amigos each have gold bullion and you, as I typically am, are in possession of two fives and three ones.

The chief indicates that he has no need for paper and that gold is too soft and too shiny for arrowheads and as it attracts the attention of tigers, rendering it attractively unattractive as ornamentation goes. Additionally, he indicates that due to the energy required to transport it, he has no use for it, and that the local currency is pigs. As George, Marc and Jimmy’s luck would have it, the chief later recants slightly: It appears after some contemplation that he would like a tiny amount of gold to make a trinket for his wife, in light of the tiger theme, but none for his girlfriend. But, he tells the four of you not to worry as there is plenty of work to do and he believes that they may have actually had some leftovers available, once.

OK, so what’s the point?

The point is this: when things get really nasty, gold is, does one say this diplomatically…um…worthless. You dang sure can’t eat it. So why then would one invest a thousand dollars of his or her hard earned money for a gumball sized nugget of it? This is the little gumball were talking about, the one that loses its flavor in about 15 seconds, assuming normal chewing, and not the jawbreaker size.

Gold is typically a scarce metal versus jewelry demand and has relatively limited industrial uses. At the height of the internet boom when we were creating a millionaire a minute (think jewelry purchasers) and what small uses gold has industrially (think conductants), gold was selling from $250-$450 an ounce. Somewhere therein was gold's perceived intrinsic value versus jewelry and industrial uses.

Occasionally, as now, gold is viewed as a hedge against inflation and/or a hedge against uncertainty: On inflation, Gold is up about 42% per year since 2001 with US inflation somewhere between 5 and 9%, making gold light years ahead itself as an inflation hedge. If one is buying gold for this reason, then one is buying an asset that has appreciated 300% since 2001 to hedge against 5-9% inflation annually. Gold hit $850 per ounce in the mid eighties and $250 in 2001, so, as inflation hedges go, something is out of whack here! Common sense wise, it would appear a better proposition to be selling gold, given the data.

Per gold as a hedge against uncertainty, if things get really bad, gold may lose its shine, so to speak. Both Hyperinflation and Hyper-deflation suggest major economic turmoil. Hard assets in hyperinflation, yes, gold, I’m not so sure! How does gold become currency when there is so little circulating gold and how is it’s value determined? I don’t see jewelry as particularly glamorous as a bread line fashion statement, except to attract tigers of another sort. Worse yet, hard assets in times of deflation spells broke.

Additionally, what if, at the moment, real estate, stocks, commodities and soon bond prices (as rates must rise) are falling. Oh, wait a minute, they are! Assume for a moment that food prices are rising at a micro level, but that is simply a lag effect of past increases in the money supply. What if at the macro level they are falling, which will filter down as all commodities continue to drop, as world economies slow dramatically. What if we have already had inflation and things are now deflating. Perhaps wealth is and will be destroyed faster than money is created.

The USA Today posted an article on 13APR08, indicating that in 2001, then Federal Reserve Chairman Alan Greenspan, lowered interest rates to 1% because he was concerned about deflation. If deflation was a threat then, we are now in big, big trouble. Perhaps that is why Uncle Ben is so panicked at the thought of the trillions of dollars worth of derivatives all set to implode at any minute. Relatively speaking, who is left to borrow the $2B per day needed to keep the gravy train rolling, following seven years of free money turbo charged by derivatives? And, isn’t the deleveraging of hedge funds that caused the recent 10% pummeling in gold prices actually deflation?

What if gold mania, like tulip mania, is all imaginary and fueled by collective energies? After all, gold has very little intrinsic value! It is simply ornamental because we have collectively agreed that it either looks cool or implies status, and when most of us are not starving. Gold mania, plain and simply, feeds upon itself. Folks jump on the gold train as it begins to move and more and more folks pile in until it can no longer budge. The problem is that nobody really knows how much steam the engine has because the steam is all of our collective imaginations. The steam is pure illusion making gold's movements even more transparent than with most other investments.

However, the known entity at the moment is that the track got real steep and/or the train got real heavy at around the 1000 foot mark, in the face of massive uncertainty (Bear Stearns (NYSE:BSC) potentially taking down the entire global financial system), and is now around the 900 foot mark, metaphorically speaking. It looks to me at least that something around $1000 an ounce is the max folks were willing to pay as a risk premium for virtually unlimited uncertainty. Knowing that, folks are now exiting the train. Curiously, I’ve read a couple articles of late, in reputable publications, that the IMF is evidently considering selling vast quantities of gold.

In this sense, trying to convince folks to remain on board a train heading down the mountain, in hopes of eventually getting them to the top, when the very real threat of an implosion of the entire world financial system could not get it above the $1000 mark would appear misguided. “Um, da y'all give any king of refunds or anything like that, cause I got on here at 975 expecting to ride to the top and we seem to be going backwards?” Sorry sir, but you ride the bubble express at your own risk!

When the pendulum really starts to swing, I think I am going to fill half my house with canned goods, dry goods and peanut butter so that when the new currency is known, I can just trade for it, in case it's pigs or something. Sounds ridiculous doesn’t it? Except for the fact that this is precisely what his happening with wheat in Egypt and rice in Asia at the moment, otherwise known as hoarding. It would seem to me at least that when things get really ugly, the guy with the food dictates the value of gold and not the other way around. Just call me chief.

Disclosure: I have no gold or metals positions of any kind