brewtul

Gold: The Only Remaining Bubble?

To take your points in order; firstly, to demonstrate a bubble you need to demonstrate a complete detachment from fundamentals. The degree of margin used in buying an asset is not in and of itself sufficient to identify bubbles. Robert Shiller's excellent book Irrational Exuberance defines bubbles as a psychological phenomenon in which rising prices and belief in a new paradigm, rather than underlying fundamentals, sustain a price advance. While those conditionas may or may not exist in the gold market I think you have fallen well short of proving that they do.

Secondly, historically gold has risen in times of inflation as well as deflation. The reason gold rises during deflation is that it is the only asset without a corresponding liability. Put simply, gold cannot default. During periods of deflation default of financial instruments accelerates and is the greatest fea. It is this fear, not the fear of infation eroding wealth, that is the current driver of the gold market.

Thirdly, I will not argue with your interpretation of the technicals, but will say that over the last twenty years as the markets have become ever more enamored with technical analysis the chance that they will have any utility greatly diminishes. Whatever edge, if any, they ever provided simply cannot be much anymore as everyone is using the technique. The true contrarian play then would be to completely ignore technicals.

Ignore the Hype - Gold as Currency is Dead

I agree that gold/Dow ratios of the past do not predict the future performance of either, the same criticism could be leveled at just about any system of investment. They work because they have worked in the past, until they don't anymore. Then a new paradigm must be created. VIX over 40 was supposed to be a sign of an overly pessimistic market. Many people got wiped out betting against volatility When VIX was 50, then 60, then 0, then over 80.

The inflation adjusted performance of gold shows that historically it has underperformed equities and bonds. But that's as it should be. Holders of those instruments get paid a risk premium for their investment. Which simply highlights the fact that gold is MONEY. Not an investment or a speculation.

And what is money? A universally accepted medium of exchange. What is more universally accepted than gold? Don't fool yourself, dollar bills, or any fiat currency for that matter, are mearly claims on money. Much like bonds or bank notes. The problem is that sometimes the issuers of these instruments default and the owners of those claims never get their money. Fiat currencies are inherently unstable and therefore make a poor medium of exchange. In fact, every firm that does international business has to hire accountants and currency traders to manage their exchange rate risk.

Finally, your decrying gold because you can't use leverage to invest in it shows that you have not been chastened by recent market fluctuations. The world is learning a painful lesson that leverage is a double edged sword that destroys as easily as it creates it. Gold is money and money is impossible to "leverage". Leverage is just a fancy name for debt, a claim on money. You can leverage claims on money as much as you want - make believe there is more money in the world than there really is - but money is a finite structure built from human capital. Not printed at will.

What's It Going to Be: Inflation or Deflation?

We will have deflation THEN inflation. While falling commodity prices have cheered the mainstream financial press they have scared the bejeebus out of Bernanke et al. They prefer not to have prices falling when monetary policy is already HIGHLY accomodative (i.e. negative real rates). SO... entere the non-traditional means of putting money into the economy. If banks won't lend and borrowers won't borrow the Fed (and it's wall street owners) can simply juice asset prices directly. Buy real estate, stocks, long term bonds, anything you want. The exchange stabilization fund and treasury are authorized to do it and even if they weren't they'd simply change the rules. Only those with eyes to see what happens to purchasing power when ALL currencies decline in tandme will be able to protect their wealth. That's the problem. Asset inflation does not create wealth - just the illusion of wealth as your nominal accounts inflate. That is why the authorities are trying to crush gold - it is the only alarm left in the system.

Is Gold A Sucker's Bet?

I did not say that gold would completely repeal the business cycle, only that it acts as a sort of shock absorber. Even with a gold standard humans will not suddenly become completely emotionless calculating machines, free from swings of emotion. The Austrian School, with which I generally agree, says not that markets don't have cycles, only that central control of the money supply without constraint makes matters worse. It makes it too easy for the central planners to believe their own BS. They and everyone else get caught up in the utopian idea that progress can move in a straight line - that there will never be a correction, that all cycles have been repealed.

Is Gold A Sucker's Bet?

People are muddying up a very simple concept. The power to print money given to a privileged few will always result in debasement of that currency. Study the fall of the Roman Empire - it began in debasing their gold coinage with lead and using the inflated currency to support their military. It worked for a while until the currency was so debased that it was no longer an accepted store of value. The fall from grace of their currency that ensued mirrored their fall from power.

All currencies are initially backed by something but when the power to create money is unhinged from that collateral abuse is inevitable. Unbridled greed leads to printing money which is nothing but debt, also called leverage. Great - makes a mint on the way up, as long as assets keep inflating. The masses see assets rising and buy assuming that "trees grow to the sky". But that leverage desrtoys even faster on the way down (fear is a more powerful emotion than greed or euphoria)

The reason gold is the ultimate store of value is because it can't be printed or destroyed. Yes, it's inflexible. That's the point. It constrains the natural tendency for humans to exhibit herd behaviour at the extremes of greed and panic. You see what happens when human emotion is left unchecked. Trillions of dollars of wealth evaporated in a few months, millions of baby boomers facing retirment severely underfunded if not destitute. Is that what proponents of fiat currency think is desireable? How about Weimar Germany? How about Zimbabwe? If printing money was the way to prosperity Zimbabwe would be the wealthiest nation on earth. Damping, not amplification, of human impulses is what is needed.

Is Gold A Sucker's Bet?

Alan, you wrote "I am curious how you address the notion that this is not just a U.S. issue but rather a global issue - the entire G-7 and beyond. Classical economic theory assumes that it is just one nation." The answer is that gold will rise in terms of all currencies, just more in some than others. Those countries that have largest reserves will see the least devaluation of their currencies. In a sense those reserves act as collateral for their currency. Those countries with the greatest debt (anyone come to mind?) will see the greatest devaluation of their currency as they have no collateral.

I agree with the poster Facts who suggests that our current monetary system, what some have called Bretton Woods II, is not writ in stone. It wil collapse and something new will rise from its ashes. A new gold standard or some other way of reigning in currency inflation will have to be established before faith in the system will be restored. Credit bubbles only occur when credit expands without a commensurate expansion of tangible collateral. Whatever the new system is it will have to make printing money much harder.

Is Gold A Sucker's Bet?

You may be right in the short run, but in the longer term you are incorrect. The logic is much simpler than most make it out to be. In the later stage of credit bubbles all assets inflate massively. That includes stocks, bonds, real estate, and finally commodities. Gold rides up this inflationary wave. Then the credit bubble pops and all assets begin to deflate. Initially panicked investors seeking to perserve wealth flee into cash and short term treasuries. That causes the reserve currency of the world to rise. That is where we are now in the credit/debt cycle. Gold gets sold like everything else as there is a "dash for cash". The next phase is when the central banks respond by trying to reinflate by putting the printing presses in overdrive. That strategy doesn't work. In no credit bubble in history has that strategy worked, yet it doesn't stop the bankers from trying. At that point the value of the currency is destroyed and the last paper assets, cash and short term treasuries lost their ability to store value. Then the flight into gold ensues. That is how it has happened in every asset bubble in history. Make no mistake - when the flight into treasuries ends the dollar will crater and lose its status as the reserve currency of the world.

Gold as an Investment? Think Again

One more comment about the value of the Dow versus gold, inflation adjusted or otherwise. The Dow is not a group of 30 stocks, it is a managed fund. That means there is a huge survivorship bias built in. Stocks that do poorly simply drop out of the Dow when it is rebalanced periodically. If you had "bought the Dow" in 1900 you would have seen most of the 30 companies you bought eventually go bankrupt. So let's say that you really do not "buy and hold the Dow" but rather buy and sell every year as necessary to have your holdings mirror the Dow. Then transaction fees start to add up materially affecting your returns.

Another problem with the methodology has to do the way average percentage yields are calculated. To walk through an example. Let's say that at the start of 2000 the Dow is trading at 10,000. In 2001 it closes unchanged at 10,000. Let's then say in 2002 it falls badly to 8,000, a 20% loss. Let's say finally that in 2003 it rebounds strongly to 12,000. Now think about the investor who bought in 2000. After 2 years he is looking at a loss of 2000 points, from 10,000 to 8,000. He is down 20% over 2 years. The average annual percentage loss is then simply the square root of -20% or about -9.5% per year. Now let's look at his more fortunate counterpart who bought the Dow not in 2000 but at 10,000 in 2001. Two years late in 2003 the dow is trading at 12,000 and he is up 20%. Annualized this is 9.5% per year gain. See where this is headed? Although we have all heard the Ibbotson study that says stocks return ON AVERAGE 7.2%/year only a few have pointed out the flawed methodology. IT makes a huge difference what year you start counting in. The way to fix this problem is create several model portfolios each starting in a different year and then continuing for say 50 years and then AVERAGING the returns. It so happens that Ibbotson started his study in 1900 the start of a long bull market. Had he started his study in 1929 that 7.2/year return would have dropped dramatically (I think the number may have been closer to 4%).

Gold as an Investment? Think Again

The argument is an old one. Keynes called gold "a barbarous relic" in 1923. The implication is that modern finance has created a more efficient, higher yielding, paper system that has made gold based economies obsolete. The problem is despite whatever financial innovations paper economies engender those economies all eventually end in ruin. Men are intrinsicaly selfish and greedy and giving a small group of them power over the creation of currency always leads to debasement and final collapse. Such events are historical in time frame and 30 year windows chosen selectively to make the counter argument do not prove otherwise.

The author is correct that gold is not an investment, but rather a sort of insurance policy. Insurance against what, though? Insurance against debasement is the answer and since the bursting of the tech bubble we have seen debasement accelerate at an alarming rate. This is why people are buying gold - not because of visions of armageddon. And so far they have been right. Were it not for generously massaged financial stastics coming from the government there would probably be a lot more flight to gold as people would realize that inflation is probalby running close to 10%.

Think of it this way; Say you are a retired little old lady with $1,000,000 in the bank earning 5% a year, netting you $50,000 (pretax, of course) to live on. If inflation is running at 5% a year that is the equivalent of 100% tax on your earnings. If inflation is running at 10% a year that is 100% tax plus another 100% in penalties for having the audicity to save rather than consume.

Don't be fooled by nominal stock market returns. If you bought the Dow on Jan 1 2000 it would have to be 14,184.39 today just for you to have broken even in real terms. And that is using the "official" government CPI with all of its "adjustments". If inflation was calculated using the pre 1980 methodology that number would be closer to 20,000. Still think the stock market is a great deal? How long do you think it will be before the REAL returns on the Dow get you back to the levels of 2000?

The Coming Commodity Correction: Hedge Your Downside Risk

While the dollar may bounce and commodities fall, the reasons given in this article are simplistic and flawed. First, interest rates are not the sole determinant of currency exchange rates. Economic growth, national debt, faith in leadership, trade relations are all causative. Second, even the interest rate only crowd looks at rate differentials, not just absolute rates. Third, there is no reason to expect robust growth in the second half of 2008. The bulk of ARM resets is just happening now and corporate profit expectations, as usual, are overly optimistic and price in basically no stock market contraction (based on expected P/E). Fourth, the interpretaiton of the VIX leads something to be desired. Markets are generally not considered overly pessimistic until the VIX trades above 40. This has not happened in this correction and indeed market sentiment by several other measures has quickly turned mildly bullish. Finally, trading commodity related stocks is risky, high volatility business because of the inherent leverage to commodity prices. Trying to time short term swings is a very difficult game.