Why Gold Bulls Need To Temper Their Emotions

Aug. 8.12 | About: SPDR Gold (GLD)

LOL! catalysts for a break upwards aren't there? Are you blind? The euro is falling apart. The dollar is doomed because of the USA`s addiction to debt and refusal to reign in spending. The us is warmongering again against Iran. Real inflation closer to 10% not the manipulated figure the government feeds you. The situation in Europe is dire - 25% unemployment in Spain and Greece. Just how long can the USA keep spending money it doesn't have? Digital money not worth the paper its not printed on. WAKE UP to what is REALLY happening with your bankster wrecked economy! Gold should be over $15k by now to take account of all the fake fiat money in existence. I suggest you all watch Mike Maloney - Debt collapse $20,000 gold and wake up to whats coming

- SA Commenter

This comment came in response to a recent article of mine predicting continued weakness for the gold complex over the next month or so; few near-term catalysts, a strong dollar, and overall equity strength being the main reasons. In it, I noted that the gold market has been unwilling to fully price-out QE or LTRO programs from the Fed and ECB, and going short gold ahead of the conferences has been a particularly profitable event-driven trade. I've made it clear in many of my articles regarding gold that I am relatively bullish on gold's long-term prospects for reasons I will re-explain in a bit.

Fair enough right? Wrong.

I've noticed not only in my own, but other contributors' articles that many gold bulls respond very aggressively and frantically to bearish counterpoints.

Full disclosure, I've been a semi-member of the doomsday crowd, as evidenced with an article I wrote in the beginning of 2012. I fully understand the structural issues this country faces; I've simply begun to come to a far different (and I believe rational) conclusion than I used to.

Gold's Utility

As far as gold goes, here's my take on gold's utility as an investment:

  • A hedge for tail-risk (market blowups) - gold has historically acted as a safe-haven in times of war, economic calamity, terrorist attacks etc.
  • A hedge for currency debasement
  • A quality, safe asset that can't be manipulated
  • Diversification purposes

Gold Versus Stocks

Since the dollar-gold relationship ended in 1971, the Dow (NYSEARCA:DIA) has returned about 1,500% (not including dividends), while Gold (NYSEARCA:GLD) has returned about 4,000%.

However, gold's starting value of $35 distorts the percentage. Gold was pegged at $35; its fair value was significantly higher. Only a couple years later in 1973, gold was worth $200/oz. That 4,000% increase just turned into 650%.

On the whole, we can conclude that productive assets like quality equities will massively outperform gold on a long-term basis. This makes perfect sense; gold's long-term value is the reflection of real currency (dollar) declines. The dollar could become significantly weaker, but you can't go below "worthless;" gains are capped by the zero bound.

Productive assets on the other hand have unlimited, perpetually compounding potential. In other words, the return profile for equities is far more attractive than gold.

A Look At Capital Allocation

Moving back to the bull case for gold, I don't believe we are in any sort of a gold bubble. Prices reflect the supply/demand equation, so let's get both sides.

As far as supply goes, we know that annual production adds about 1.5% to the total supply. Unlike many other commodities, gold is rarely destroyed so an investment predicated on scarcity is probably misguided.

In terms of demand, we need to look at the psychology of capital flows:

  • Hedge Fund managers like Seth Klarman use gold as a way to hedge against the aforementioned tail-risk, which feels like a necessity in this environment.
  • Gold is currently stable at these relatively elevated prices due to inflationary risks brought upon unprecedented monetary policy courtesy of the Federal Reserve. While inflation is currently muted and the mass printing in theory should simply partially offset the deflationary forces of deleveraging, we are in uncharted territory in terms of M2 expansion leading to hyperinflation concerns.
  • In the context of heavily indebted developed markets and low interest rates, there are limited quality assets available for trillions in pension funds, insurance float, endowments etc. to be invested in. While these funds have found their way to U.S. treasuries, bunds, and the like, many speculators believe these funds will begin to buy gold for the very same reasons they are.

The Doomsday Case

Outside of the rational aforementioned components of demand (both speculative and insurance), there is a certain crowd that believes gold is headed to $10,000/oz, $15,000/oz and so on.

These price "targets" originate from the belief that a global economic collapse is imminent. The reason being massive, unsustainable deficits on the part of governments who then either print their currency en masse to pay off their debts or default, leading to a collapse of the banking industry and an end to the global economy as we know it.

I used to come to a similar conclusion, but historical research has altered my sentiments. I've found that societies generally manage their ways through crises, especially the ones everybody sees coming. Behind the scenes, America's economy is becoming more flexible courtesy of a major trend toward entrepreneurship. The U.S. financial system and normal consumers have been deleveraging and gradually growing their savings rates, despite efforts by the Fed to keep them spending. This is actually a key reason why we've seen subpar growth. Major investors are taking advantage of extensive liquidity measures courtesy of the ECB to sell their holdings of peripheral debt. Markets are constantly gathering more insights into economic reality, though central bank intervention has in fact slowed the price discovery mechanism, which is why we still see so much volatility.

This sort of investor also believes that inflation is very understated. With the U.S. CPI currently showing inflation of only about 2%, I'm inclined to agree, but to a point. Food and energy costs have skyrocketed since central banks embarked on their easing policies, despite weak demand trends. I do believe that food and energy prices have a significant premium embedded into them as a result of ZIRP and policies that encourage speculation.

That being said, this dynamic isn't particularly relevant to forecasting future gold prices. We may in fact have inflation that is beyond the government CPI, but if so, the gold market has definitely recognized that. Since 2000, the CPI index has risen 31%, while gold has risen over 400%. If gold is supposed to reflect real inflation, it seems to have done its job.

Conclusions

On the capital flows front (which in the end, is the only thing that matters), there is plenty to sustain today's relatively elevated gold prices.

Its utility as a tail-risk hedge, inflationary hedge, and quality asset in a limited-quality environment has resulted in a historical bull market for gold, but these factors are already reflected in today's prices.

Historically, as Ray Dalio points out, gold performs well during periods of economic uncertainty and deleveragings, which sums up our current environment very well. Until the perceived threat of major sovereign default risks is mitigated by legitimate restructurings and real interest rates return to acceptable levels, gold will remain in a slowly uptrending market.

Otherwise, the mega gold bulls need to vastly alter their emotions. There is a legitimate case to be made for gold to be a portion of your long-term investment portfolio, but the doomsday theory is a sloppy investment thesis that won't yield the expected results.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.