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Jeffrey Dow Jones
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Jeffrey Dow Jones is the managing editor for Alpine Advisor. He has previously worked for PaineWebber/UBS and Ford Motor Credit Company, and he spent the last decade co-managing a group of hedge funds. He holds a degree in Business Economics with a specialization in Computer Programming from The... More
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The Trade of the Decade: A Guide to Investing in the 2010s
  • Why Gold? 0 comments
    Sep 9, 2010 11:09 AM | about stocks: GLD, TIP

    Gold seems poised to make a new all time high in the next week or so.  Yesterday it briefly traded over $1,260/oz.

    I can hear you asking: is it expensive?  Is it cheap?

    To answer that question we're going to play one of our favorite economist games.  You guys like games, right?  This game is called "Let's Price One Thing in Terms of Another."  Don't laugh!  It's actually much more fun than it sounds.  It's fun because it's a game that can make you money.

    See.  You stopped laughing, didn't you?

    This kind of analysis -- to try and clearly discern gold's relative value -- is really important right now.  It's amazing how divergent analyst views are at present.  The gold bugs have been dancing in streets for what seems like forever and the most aggressive of their forecasts call for gold to get above $2,000 or $3,000 per ounce.  On the other hand, it's easy enough to find guys like MKM's Mike Darda who believe gold should be down around $400-500 per ounce.  How is it possible for two groups of people to have such a wildly different set of predictions?

    It's Draconian custom to look at things form a slightly different perspective, but we'll begin with a relatively straightforward view.

    In our first chart we have 110 years of gold prices.  Any time we take this long a perspective of something, it's imperative to adjust for inflation and we've done so here.

    Pretty cool chart, huh?  It's amazing how such a simple graphic can be so eye-opening.

    There was only one time in history when gold was more expensive than it is right now.  It was during the midst of a speculative bubble.  Is it in a bubble today?  Depends which camp you bunk in.

    Before we get too excited about this chart, know that it carries a gigantic disclaimer.  Prior to 1968 the U.S. was on a gold standard.  That is to say, the relationship between gold and the dollar was fixed.  That's why the line looks funny.

    The greenback has a lot of baggage right now, so let's take Dollars totally out of the picture.  What if we priced gold in another currency like the Japanese Yen and then adjusted for inflation?  In this next chart we have the number of Yen it takes to by one ounce of gold, again adjusted for inflation (Japan's inflation).

    It tells a similar story.  If you are Japanese, you're probably evaluating gold in the same way though you might be a little less worried about a bubble.  Gold has traveled quite a ways off its lows but it clearly hasn't been because of an increase in the general price level.  If it were, the real price would be flat.

    We can do similar charts for other currencies but the story will be basically the same in any language that employs a stable monetary policy.  The price of gold has gone up and it's gone up because of some reason other than a drop in value of the currencies it's priced in.

    This is worth mentioning because gold doesn't grow, earn interest, or pay a dividend.  A dollar on deposit in a bank will be worth a dollar 'n change a year from now.  A share of stock in a company naturally becomes more valuable as the company gets bigger or as the company increases the amount of dividends it pays to its shareholders.  Gold doesn't do anything like this.  Its value, like that of any other currency, is based entirely on supply and demand in the capital markets.  Unlike most commodities, the supply of gold is fairly easy to get a handle on and easy to forecast.  Most of the price movement is thus driven by the demand side.

    So why has the demand for gold gone up?

    I'm sure each one of you has an answer.  I have a few of my own but I'd like to submit that demand for gold might be increasing simply because the price is going up and demand is increasing.  That logic might sound circular because it is!  It's a virtuous circle.  If I know one thing about investors it is that they are slavish performance chasers.  With something like gold, more chasing of the asset by definition translates to better performance for the asset.  Virtuous circles are a lot of fun until they snap.

    Again, I'll chicken out and stop short of calling "bubble" right here.  But know that virtuous circles and positive feedback loops play a major role in inflating bubbles.  In both an economic and psychological sense.

    I tell people over and over that the best way to look at gold is as a neutral currency.  And in this framework, the demand for this neutral currency is driven primarily by a dislike of fiat currencies, particularly the US Dollar.

    If you own gold simply because you hate the Dollar or because you're sold on the hyperinflation meme, why not express that view a different way?

    Seriously, think about it.  Unless you have an intrinsic interest in gold, why not use some other asset to express your dislike of fiat currencies and fear about inflation?

    Why not buy Yen or Euros?  Or the Loonie?  Canada's fundamentals are pretty good.  The New Zealand Dollar even pays you a decent rate of interest!   Why not buy a house?  Or farmland?  If it's the US Dollar that you're really concerned about, why not exchange a few for something like energy stocks?  Or TIPS?

    Why gold?

    I suppose that's less of less of a technical question and more of a philosophical one.

    The tip of your tongue

    Back to that central question that I know everybody wants to have answered.  I've dodged it twice so far.

    Is gold in a bubble?

    You tell me.

    That chart plots gold's current ascent against a few other famous bubbles in history.  Something bubbly may indeed be forming, but if gold completely collapses tomorrow, I'm not convinced that we will label it the bursting of a bubble.  On the other hand, if gold does make a run above $2,000 at some point in the next few years, I will absolutely start throwing around the "b word".

    If it's still not clear whether or not gold is being artificially inflated based on speculative demand, let's get back to that question of whether it is expensive or cheap.

    I warned you there would be lots of charts.  Here's one that prices the Dow in ounces of gold.  It measures the number of ounces of gold required to buy one share of the Dow.

    I used the Dow here because it naturally adjusts for dividends, and since it's also denominated in dollars, we can relate it to gold without adjusting for inflation.  The chart covers the years post 1968 as we've been off the gold standard.  It's also log scale, so the rate of change (slope) has meaning.

    Now, we can't just think about this ratio in an absolute sense.  Over the long run and in aggregate, we shouldexpect the Dow to increase at a rate greater than gold because the Dow pays a dividend and participates in growing GDP.  That's why I included a trendline.  That trendline isn't an exact frame of reference, but it will help your brain interpret this chart the way it should be interpreted.  The Dow/Gold ratio oscillates around an ascending trendline, not a flat average.

    You shouldn't use a chart like this to make a buy decision about either asset.  I can't conclude from this if gold or stocks are expensive or cheap on their own.  But I can conclude -- fairly confidently -- that the further that ratio gets below the general trendline, the more stocks I want to own relative to gold.  The further that ratio gets above the trend, the more gold I want to own relative to my stocks.

    It's a rather slow moving chart, but I like to bring it out and dust it off every so often because it does a really good job helping you identify the times when either gold or the stock market is obviously expensive or cheap.  We didn't know it at the time, but 1968 was a great point to own gold and pass on stocks.  By the early 1980's, the smart choice was swapping some of that gold for more stocks.  That was a good strategy for a long time but by 2001 it was time sell those stocks and buy back some gold.  This chart won't time it perfectly, but it's good enough if you have a long horizon.

    If you work in the industry and spend a lot of time thinking about proper asset allocation, this kind of analysis can be particularly helpful.

    Again, it's tough to make the claim that gold is in a bubble right now.  But it's easy to point out that gold is getting expensive here and it's easy to see that another 50-100% increase in the price of gold over the next few years should set off some alarm bells.

    Let me repeat that another way with different emphasis: gold can only be considered cheap at these levels if the market is heading for another bubble or if the U.S. is heading for hyperinflation.  There are clearly safer and possibly more effective ways than gold to hedge the risk of hyperinflation, so ultimately I think the belief that gold keeps going up comes down to a bet on a bubble or at the very least, continued speculative interest.

    My two bits

    As for my personal view, I don't believe that fundamentals are playing much of a role in the day-to-day movement of gold.  In fact, I'm not sure they're playing any role.

    I think most of the action is driven by speculative forces, not unlike what we saw push crude to record highs back in 2008.  I use crude oil circa-2008 as the analogy because in both instances the market was tricking people into believing an incredibly convincing fundamental story.  Back then the majority of the world bought into some variant of the "peak oil hypothesis".  Escalating demand + dwindling global supply painted a pretty clear picture.  It was easy to see and the market tricked itself into thinking that the soaring prices were justified by these fundamentals.

    As for gold, a similar story is being told.  The most popular and convincing argument for owning gold is to protect oneself against future inflation (even if we've shown that it's a rather poor hedge against typical inflation).  Given the current state of the U.S.'s balance sheet, it seems like a no-brainer that inflation will be a problem for our country at some point in the next decade (even if the bond market doesn't hold this view).

    Here's the thing: I think that the crude oil thesis is still good.  I think the long term supply/demand fundamentals point in only one direction for oil prices.  The tough part is that it's going to take longer to play out than we all thought a few years go.  Loading up on crude oil back then was a disastrous investment strategy even if the basic thesis may ultimately prove correct.  And it's the same deal with gold.  Looking ahead into the next few decades it seems hard to avoid a serious bout against inflation.  Isn't that what Reinhart & Rogoff taught us?  That these stories of debt gone awry end in one of two ways:

    1. Default
    2. Inflation (a sneaky way of defaulting)

    For 800 years it has unfolded in the same way.  Heck, even the ancient Romans figured that one out and slowly debased the denarius by minting them with less and less silver.

    Anyway, the thesis for gold appears sound.  But like crude oil a lot can happen between now and then and if I can make one guarantee, I'll guarantee that the story won't play out in the exact sequence that most are expecting.  Always remember: investing doesn't work like a wormhole.  Do not fall victim to The Wormhole Fallacy.  Don't do it!

    If you load up on gold at these levels, strap in for a bumpy ride.  I wouldn't be surprised at all if gold went to $800-900 before going to $2,000.  And if you think that gold can't get back down under $1,000/oz, you haven't studied enough history of the gold market.  The gold market is certifiably insane.  I know Reinhart & Rogoff don't have 800 years of data about gold traders, but I'm pretty sure all of those guys end up the same way:

    1. Going crazy
    Thanks, but...

    We've taken a twisty trail through a foggy forest today.  Where exactly are we now?  What conclusions should we take home with us?

    For one, do not try and short gold at these levels.  The trends in gold are immensely powerful right now and I'm not one to step in front of freight trains.  If you want to ride the trend, go for it.  Just understand what can happen if the Gold Train derails.

    If you've owned gold, good for you.  *HIGHFIVE*  If more than 10% of your investment portfolio is gold, now is a good time to think about bringing that back in line with a more appropriate weighting.  But my guess is that if more than 10% of your portfolio is in gold you're either a gold bug, John Paulson, or someone who really knows what they're doing.  In the event that you are actually John Paulson, please contact me at Feedback@TheDraconian.com so I can tell you about our awesome investment products!

    If less than 5% of your portfolio is in gold, you're probably better served just hanging out for a pullback.  Don't worry, gold always pulls back.  I think that 5-10% is a good weighting for the average investor to have in gold.  Bullion is best.  Coins are cool.  And the GLD ETF is fine.

    I think everybody needs to own gold at all times but not because I expect it to always perform well.  I like gold for one reason and one reason only: it's different.

    I like things that are different and things that are different can be incredibly powerful tools when it comes to constructing a robust investment portfolio.  Over the long-run, gold has exhibited little correlation with any other asset class.  That is immensely desirable for professional asset managers like us.

    My lovely wife, Mrs. Draconian, swears that gold has other "utility" but this is a debate that is still unfolding in our household.  Her birthday is approaching.  Currently, she has the upper hand in the argument.  Perhaps some of you other men out there understand what a troublesome confluence of events this represents.

    Yet again, the conclusion seems inevitable.

    The Box

    I feel like I've fallen a little short this week.  Informative, perhaps.  But this week I think I missed the mark on usefulness by raising more questions than I answered.  So I'll close with a personal story that I was reminded of as I wrote all this business about gold.  If I can't be useful then I'll at least try to be entertaining.

    I'll never forget my first experience with gold.

    You see, I am the son of a gold bug.  Before founding an investment firm and launching his own fund, my dad was a local coin dealer.  I'm sure that was a great business in the late 70's when gold was going up, but now I see why he gave it up in the early 80's and pursued a different line of work.  I doubt people were buying much gold as the bubble was deflating.

    Despite that, he was a guy with an undying love of precious metals.  He wrote a newsletter about gold .  He kept bags of silver in a vault downtown.  He was a man that buried bags of pure-copper pennies in the backyard.  I was told repeatedly as a youth to some day dig them up when the price of copper was higher than that of the penny.  Are pennies even still made of copper?  We had an honest-to-God treasure map for their location.

    One day he came home and set a small box -- maybe half the size of a shoe box -- down on the kitchen counter.  I picked it up.  It was very heavy.  Inside was a dozen or so plastic cylinders.  They were sealed tightly and he would not permit me to open any of them.  He did uncork one tube, however, and emptied out a single, radiant coin.

    "Daddy," I said.  "What's that?"

    "It's your college education."

    There were probably two or three hundred one-ounce Canadian Gold Maple Leafs in the box.

    It might have been $100,000 of gold sitting right there on the kitchen counter, where later that night I would eat my mac 'n cheese.  I wonder how much of his entire net worth was sitting there in front of us.  My little mind couldn't fathom that, of course.  But the enormity of it left an impression nonetheless.

    Who knows why we recall the specific experiences that we do from childhood.  Whatever the reason, this one would impact me me in several profound ways through the rest of my life.

    As a boy I remember being utterly transfixed by those coins, if not on the surface then subconsciously so.  I wonder if there's something deeper that attracts us to gold, something woven into our genetic code, something baked into the marrow of our bones.  I think this might be why the history of the gold market is one of madness; it's a corollary to our own history as humans.  That knowledge and that feeling follows me everywhere.

    By the time I went to college, those coins were worth half of what he paid.  He always hoped I'd go to Stanford but I wound up at UCLA.  Tuition was probably cheaper than what he originally budgeted, but I doubt that box of gold coins would have paid for all four years.  When I graduated, I thought of those coins.

    After graduation my first job was as a commodities broker.  (Remind me to tell you that story sometime, the story of my first day at work -- it was September 10th, 2001.)  Gold was trading in the mid-$200's.  It had gone down for almost twenty straight years and was sitting at a generational low.  Every single person I talked to about gold hated it.  Everyone.  No rational individual considered it a worthwhile investment.  Even most of the old skool gold bugs had given up that ghost.  I'm astonished at how dramatically sentiment has changed in just the last ten years.  Don't be surprised at how dramatically sentiment can change from here.

    Today as I reflect on that box, I realize what he really was doing was making an investment in me.  Even if that box wasn't literally for my college education.  There was something large and weighty sitting on the counter, and that put the hopes and expectations for me into perspective.  Today that much gold might be worth close to half a million dollars.  That's a lot of money that was invested in me.

    There's not a day that goes by that I don't wonder if that investment was worth it.

    I can only speculate.



    Disclosure: Long GLD, Long TIP
    Themes: Gold, Commodities, Inflation Stocks: GLD, TIP
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