Tom Szabo

Crude Oil and Gold: Not Worth Worrying Over

An alternate theory gaining a bit of credibility compared to "first a slight correction, then to da moon!" is that commodities, oil and gold will trade in a wide consolidation pattern during the next few years. There is no fundamental reason why oil couldn't be trading at $50 today just like there is no fundamental reason that it is trading at $80. Similarly, I think the idea that gold cannot trade for an extended period in a price range of perhaps $700-$1100, but instead must inevitably trade much higher in the short run, is a sign of groupthink. I have a large exposure to precious metals in the form of physical holdings and stocks so I would love for gold to explode in price but at the same time I believe it's important not to drink the market's Kool Aid.

Investing in Gold Now

Great advice! Load up on gold just as it hits a record high! If you're reckless enough to buy now, at least spread out the purchases over a few months, huh?

How Does One Value Gold?

The proper way to value gold is based on its monetary qualities, or in other words what it could purchase. Many people use inflation rates such as CPI as a proxy for fair value of gold but this is not very sophisticated for several reasons, the most significant of which include accuracy issues as well as the fact that the aboveground stockpile of gold grows every year. I prefer to use a ratio of gold to the global economy, stock markets, U.S. Treasury debt and/or global asset base.

Global economy is reasonably estimated using global nominal GDP (currently around $55 trillion). There are also available figures for Treasuries and stock markets (an effective if rudimentary approach is simply to use the S&P 500 as it is already market cap weighted).

Global assets are much harder to estimate but this is probably the most relevant ratio because it reflects gold's relative purchasing power. Clearly it wouldn't make sense for all of the world's gold to be worth more than every asset that could be purchased! Indeed, gold could only be realistically worth some fraction of total assets which throws some of the wilder (Jason Hommel, Ted Butler, etc.) gold price predictions right out the window. In any case, you basically add global stock market capitalization, real estate, private equity, debt collateral, fiat money in circulation, etc. but exclude all credit-based money, derivatives and other financial products that are zero sum (offsetting asset and liability). Let's say the current number for the global asset base is $150 trillion (probably a bit high but not that far off).

Now calculate the global market cap of gold: 5 billion ounces times $900 = $4.5 trillion. Thus the gold to global economy ratio is roughly 12 ($55T/$4.5T) whereas the gold to global asset ratio is currently around 33. Similar ratios can be computed for stock markets and U.S. Treasuries.

To determine if these ratios and thus the gold price is fair, too high or too low, you need to come up with similar ratios for various points in time, such as the 1980 high in gold, the 2001 low, under Bretton Woods (pre-1971), etc. as well as an average over time. If you do the math it basically says that gold is currently comparable to where it stood in the mid-1970's after the 1974 high and before the 1980 high. At the 1980 peak, the ratios were anywhere from 3 to 7 times lower. That implies if gold were to reach a similar extreme today, it could rise 3-7 times from current levels assuming the denominator (GDP, stocks markets, etc.) stays the same.

Alternatively, the average gold ratios over the past 40 years or so imply that fair value lies in the range between $500 and $1000. If we strip out most of the 1990's when the novelty of gold mine hedging and central bank leasing were at their peaks, these fair values become $600 to $1200. I believe at least several of the analysts that predict $1200 gold are basing their numbers on a similar model to the one I am describing.

Finally, my own studies indicate that the historical ratio of global asset values to gold may have been approximately 5 under the gold standard. In other words, gold might have typically represented approx. 10-20% of the world's material wealth in the past. Perhaps this could be viewed as the ultimate fair value of gold. If so, assuming a global asset base of $150 trillion would mean gold has a fair value of $3000 to $6000/oz. ($150T/5/5 billion ounces). Such a price assumes the adoption of a worldwide gold standard and no consequent deflation in asset prices, which may not be realistic. Perhaps $75T might be a better number given the already ongoing global asset meltdown in which case the fair value gold price under a gold standard could be $1500 to $3000.

Keep in mind all of the above gold prices are real and therefore don't need to be further adjusted for inflation because the ratios' denominators already account for changes in price over time.

Gold (and Gartman) Haunting Some Investors

Brad, you don't need delta when AT THE MONEY. You receive one dollar of insurance for each dollar move against the underlying position. The cost of that insurance is the time value and it is directly related to volatility. We can ignore the greeks completely as they all disappear at expiration of the option, which is the time period we are seeking to insure. In other words, you wouldn't pay more in time premium than you would expect the underlying could move between now and expiration of the option.

I understand this wasn't the point of your article and I did read Hedging Gold's Volatility. I also understand how one could try to strip out alpha using such a method. But there are problems with the method as presented. I'll pick just three. First, you chose a "convenient" timeframe where DZZ was generating returns, not dragging on them. This made the return and risk-to-reward of the hedged portfolio artificially high compared to real world results. Second, I don't see where you took into account the fact that it took about $20,000 to acquire the hedge. In other words, $20,000 Hecla with a $20,000 DZZ hedge should be compared to $40,000 Hecla. I presume this would make the hedged returns when gold is climbing (which is most of the time in a bull market) even more pathetic. Third, you've created alpha but that doesn't mean it will always be positive. That's because you don't have ANY beta in the hedged portfolio at all. So, when beta is large and positive, you are going to have a large and negative alpha. And that would buy you exactly one calendar quarter as head of a hedge fund.

Gold and the Dollar: Putting the Relative Cart Before the Relative Horse

Otto, $29 billion is chump change in the $1 trillion per day forex market. The Fed alone has swapped (dumped) over $300 billion in Treasuries since the start of the year. The theory that the dollar is gaining its support out of Asia does, however, have merits. If you've watched the currency, commodity and gold markets over the past few weeks, you'd know that a large percentage of the moves in these markets have occurred while only the Asian markets were open. Frankly, the most obvious guess as to why is an unwind trade: funds being pulled out of emerging Asian stock markets, carries, loco metals and energy, etc.. The common denominator with most of these unwinds is that they end up in dollars. Combined with the smallish but persistent selling in the Euro, Pound etc, the demand for dollars to facilitate the unwind has shown up as a very impressive USD rally. So to answer the question about the dollar's rally, it has little to do with economic considerations in the U.S. and almost everything to do with massive capital flows. The dollar will continue to rally while these flows require dollars for conversion between markets. The trick is to figure out which markets these dollars are going into next. Another SA contributor had it right when he mentioned the weakness of BHP, Anglo, etc. in early July as a sign that an unwind was about to take place.

The Bedrock Case for the Return of the Gold Bull

There is no such thing as volume for the forex markets as a whole, that is why there is no volume on the USD chart.

As for gold being used as money, nobody is going to spend gold in a grocery store. Even when money was based on a gold standard, gold itself rarely ever changed hands in everyday transactions. It was used to store and transport wealth and in large transactions. Most of it was used to back gold certificates. And there was silver or other metal coins and also trade bills for everyday trade (but not all of these forms had to be accepted for payment of debt, one could demand gold). So when we say "gold is money" we don't literally mean it will replace the penny, nickel, dime, quarter, one dollar bill, ten dollar bill, etc. Instead we mean that gold serves as the most liquid, immutable and internationally recognized store of wealth and means of exchange. Gold's value soars in relation to other forms of money when wealth seeks absolute safety. Even the IMF, BIS and most central banks recognize these facts, so it is a bit surprising that some of the posters have doubts here.

This Gold Correction Has Further To Run

I'd largely agree that large specs haven't reached a bearish extreme, but it's very possible most of those left are sitting on positions built last Sept-Oct in the $700 range. They may not go for a while, or perhaps not at all during the gold bottom. Thus, I'd say we might actually be closer to a bottom than your COT chart shows. A final spike down to around the $740-750 range with a recovery to around $775-780 during the same session would probably do it.

Gold (and Gartman) Haunting Some Investors

Yes, riskwise they are the same.

No, we don't need to examine the unknowns when buying an at-the-money put against a long position. We know everything we need to know: the premium and the term. We can divide the premum into the price of the underlying and annualize the term, and voila we have the annual cost of the put insurance expressed as a percentage of our position. That pretty much boils everything down to volatility.

Aha, now I get what you were trying to achieve! The fabled, non-existent (positive) alpha in gold stocks as a group! Too bad nobody has seen that in years, and even when it did exist, it always seems to "outperform" on the way down. In other words, gold stock volatility is skewed. Have you checked that for both GDX and DZZ?

If the goal is to seek alpha in gold stocks, you probably want to put together your own porfolio and not use GDX. Ideally, you would pick stocks that have a skew profile that is inverse to DZZ and obviously have good fundamental prospects.

Gold (and Gartman) Haunting Some Investors

Brad, my point was that DZZ neuters the upside, which is a real cost you must consider.

A call option is not the same as a long position combined with a put option. For one, the call option will generate capital gains if you sell for a gain or it expires in the money. Meanwhile, the long position hedged with a put remains tax free as long as you hold it. There are other very fundamental reasons why you cannot equate the two.

Even then, a call option is still better than your long GDX short DZZ strategy. As I already stated, the option will let you keep the entire upside while DZZ neuters it. The cost of capital is also much lower with the put; you fail to consider the time value of money tied up in GDX and DZZ. Worse, one really can't know how good a hedge DZZ is going to be up front, as you reminded us. This causes you to allocate too much to the short leg or else suffer losses related to poor correlation.

With an at-the-money option, you know precisely your loss up front--it is the option premium. In fact, buying a put to hedge a long position should be viewed as a tradeoff -- taking a known loss in exchange for an unknown one. You might know this by another term: insurance.

As for your suggestion we should do some math to figure out why the long GDX short DZZ are not perfectly correlated, that would be a waste of time. Everybody knows gold and gold stocks don't move in perfect unison. It has nothing to do with company management. But even if they were perfectly correlated, you couldn't exactly offset a loss since the correlation is not a flat line along every price point. The easiest way to see this is to realize that the long leg can go to infinity but the short leg can only go to zero. That means if you think GDX is going up 1000% in the next few months but might also go down 50%, then DZZ might be an okay tool (still not as good as a put option) since it could only go to zero which still gives you 900% overall gains. The reason is simple: an option gives you more leverage along the entire price curve. This works in inverse as well but to a much lesser extent. Thus the math is a bit more complicated than you imply: it is not linear math but rather logarithmic math (looking for my high school math textbook as I write this)

Gold (and Gartman) Haunting Some Investors

Hello! Hello? I don't hear anybody discussing PUT OPTIONS here! You know, they have them for both GDX and GLD (just introduced). An attempted offset like DZZ & GDX is not really an investment hedge, it's a waste of time. You want to keep exposure in at least one direction! In April, you could have bought Dec GDX put options at the money for about 5. That's an automatic loss of 10% but you would have no further downside exposure, would get to keep all the upside on GDX, and would still have the money left over from not having to buy DZZ. Of course, there hasn't been any upside so far but next time could be different.

Seven Reasons To Avoid Gold - And Why You Should Ignore Them

Any Eagles or Buffalos will work, there is no reason to be too picky. The key is to pay the smallest premium, generally no more than $2 per silver coin and $50 per gold coin. A guarantee from the dealer to buy a coin back later is meaningless since the dealer might be gone by the time you are ready to sell. Eagles will always be in demand and it is virtually impossible to counterfeit them (due to quality of blanks and special die strikes used by the U.S. Mint) so don't bother having PCGS or other certification, although if you can get the coin for the same price and have the room to store the additional bulk created by the holder, I'd say go for it. The most important thing, do not let the dealer talk you into numismatics. If he even tries, run, don't walk out the door.


On Aug 08 11:25 PM User 30121 wrote:

> Grammy: I'm just north of you in Jacksonville! I would seek out
> the new (beginning in 2006) Buffalos as a preference since they have
> .999 pure gold. They should be housed in the plastic wrap directly
> from the mint or a third party grading service holder....I prefer
> PCGS, period! That way you know they are REAL!!! As far as condition,
> since you are buying bullion, condition is not crucial, however,
> you certainly want them in DELICIOUS condition. Again, if the coins
> you buy are not housed in some tamperproof packaging there is a CHANCE
> they may be counterfeit. I cannot stress this enough. You want to
> be sure! Also, any dealer you buy from should give you...in writing...a
> guarantee that they will buy back any coin they sell you...at the
> market price, at the time should you decide to sell in the future.
> If they don't, RUN don't walk out the door! Hope this helps!

Commodities: On the Downhill Slope?

Some studies suggest an allocation of 1/3rd to stocks, 1/3rd to bonds and 1/3rd to gold will actually increase overall portfolio performance while reducing volatility. This is over the long term, which is what most investors who are looking to invest for retirement would care about. I know gold isn't the same as commodities but the point is that you need more than a mere 5% to make much of a difference in any allocation strategy.

Seven Reasons To Avoid Gold - And Why You Should Ignore Them

Excellent piece Tim! Although you are generalizing in a few places (the gold price in dollars will always change by an equal amount as the price of the dollar changes, although this is often masked by changes in the gold price for other reasons), the comments are pretty much spot on. Perhaps one important point you missed is that unlike the 1970's, the current inflationary environment is much more commodity driven with virtually no labor component due to rapid globalization. In addition, we are actually getting close today to reaching per capita production peaks for many natural resources with the net result being that commodity prices have reversed a centuries long decline and will most likely now start a centuries long advance. This is merely the first upward blip. In the near term, solving the credit mess worldwide will take an order of magnitude upward adjustment in the amount of fiat currencies in circulation. I'm not talking about M3 but rather the kind of money with which one can actually service debt (M2 and below). In effect, it's inflate or die. Gold does well under both options.

Commodities: On the Downhill Slope?

I don't understand why moderate amounts, or only 5%, should be allocated to the commodity theme if you think they continue to be in a secular bull market. Just because they are volatile and can drop 50%? What about financials, home builders, high-tech, retail? What about a strategy of increasing exposure during a pullback and then reducing it during periods when commodities are soaring? What else is currently in a confirmed bull market? If allocating only 5% to commodities, that means 95% is being allocated potentially to sectors in a bear market! Yes, it's very possible there is still some ways to go until commodities reach a bottom--I for one wouldn't be surprised by oil trading under $100--but one could utilize put options to protect against the worst case scenario while still maintaining a reasonable exposure to the sector. But don't bother with a constant 5%, it ain't worth the effort unless you are talking about gold buried in your back yard.

Common Misconceptions About the Fed and Gold

The Fed is only private in the sense that federally chartered banks are required (not permitted, <i>required</... -- no bank would do so otherwise because the 'investment' returns very little in profits) to own a piece of it. Congress can repeal the Federal Reserve Act anytime it wishes (with two-thirds majority if required to override a Presidential veto).

Be that as it may, I think the best way to view gold is as a competing currency. Then we can easily see that gold priced in U.S. dollars IS in a bull market partly because the dollar is in a bear market. Gold priced in euros is also in a bull market, so clearly it's not just about the dollar. In fact, it looks like about 1/3rd of gold's rise is due to dollar weakness and 2/3rds due to relative weakness of all fiat currencies. I think we can expect that most of gold's future gains will be made not against the dollar in particular but fiat in general