Gold: Time To Short

Includes: GLD
by: Tim Iordanov

As gold has declined from its 2011 peak of just over $1,900/oz to below $1,400 today, we are witnessing a reinvigorated debate about where the price of gold is headed next, and about the merits of gold as an investment in general. I am strictly of the view that gold is a bubble in the process of popping, and that gold today is by and large a tool of speculation, with its price determined purely by the "greater fool."

In general, the gold market is an excellent exhibit into the human mind's unending battle against reality. What makes gold so different from other commodities and why does it enjoy such widespread appeal?

Gold's role in history is very significant. It was the primary medium of exchange throughout much of human civilization, across geographies and cultures. This was due to its rarity, just rare enough to be valuable in small quantities - but not too rare to the point of impracticality, easily malleable and therefore divisible, and immune to corrosion, and therefore storable. In addition, gold is scattered relatively evenly across earth's geology, which made it the universally agreed upon medium of exchange. This historical significance of gold is what gives rise to the illusion of its intrinsic value. Holding gold provides no flow of benefits of any kind to the holder, and it therefore has no "intrinsic value"; its value is and always has been determined only by the things you can exchange it for. When you could simply exchange physical gold for any good or service available - gold was currency. However, gold's role as a currency came to a final conclusion with the abolition of the gold standard. Nowadays, you will almost always have to convert any gold holdings into fiat money before buying any goods or services. This fact categorically disqualifies gold from being a currency today.

So if gold isn't a currency and has no intrinsic value, why is it considered a significant asset class?

Simply put, gold is a significant asset class only because many people hold it, and the primary reason many people hold it is speculation. This is worth repeating - gold is held almost exclusively for the purposes of speculation, with ornamental and industrial uses far behind on the ladder of reasons for gold demand. When someone mentions "real currency, store of value, safe asset, inflation hedge etc..." they are speculating that the price of gold will either rise, or not fall in sync with other asset classes - and nothing else. This must necessarily be the case, since, as previously mentioned, gold provides no cash flow to its holder, and offers no tangible non-monetary benefits. An owner of a new house in the midst of a volatile housing market can rightly claim they are not speculating, as the swings in the value of their house are likely a secondary consideration to its purpose of serving as living quarters. In this case, the house provides tangible non-monetary benefits.

The price of gold is therefore, just like the price of any speculative asset, subject to the full force of human irrationality. And an asset subject to these forces cannot possibly be referred to as "safe." It's sufficient to glance at the YTD price chart of gold to realize that gold is safe only in the sense that it's safe to say that you're in for a ride. If that is insufficient, examine the crashes and bear markets of 1915 to 1920, 1941, 1947, 1951 to 1966, 1974 to 1976, 1981, 1983 to 1985, and 1987 to 2000.

Recognizing a bubble

A bubble is commonly thought of as a scenario where prices move far enough away from fundamentals, consequently leading to significant mispricing. This is an adequate definition of a bubble, but it doesn't tell you how to spot a bubble. Rather, when prices of certain assets keep moving strongly in one direction, and the explanations and rationalizations of these movements from market participants are consistently off base or illogical, there is a high likelihood of a bubble building. The gold market is a great example of this scenario. The 3 main pro gold arguments of intrinsic value, real currency, and safety don't merit further consideration, so let's take a look at some more nuanced arguments in favor of holding gold at these levels:

Gold is an inflation hedge:

This is true, but so is copper, oil, silver, land, diamonds and practically any other non-perishable asset that tends to rise nominally in price over time, including your collection of comic books and Pokemon cards. This inflation hedge argument isn't specific to gold, and can't therefore be used when the choice is not investing in gold vs. holding fiat currency, but rather investing in gold vs. investing in other, more productive asset classes. Added to this fact is that the inflation boogieman often mentioned by gold bulls seems to be taking its time rearing its head, even with respected economists hoping for moderate inflation to pick up as a sign of a healthy economy. Vocal gold bugs who are usually fierce critics of Fed policy can keep checking for Ben Bernanke under their beds and in their closets before going to sleep, but chances are, he won't be there anytime soon.

Central banks are buying:

They sure are, and so are large hedge funds, retail investors and many others. Prices rise because people buy, and gold's impressive multi-year run is the result of, you guessed it, buying. But I assume everyone knows that, so the argument that central banks are buying gold seems to be deferring to authority - the authority of central bank governors who, curiously, in the opinion of those same gold bugs, can't manage monetary policy if their life depended on it, but are oracles when it comes to asset allocation. How convenient. Let's hope that central bank decision makers don't show the same level of prescience with respect to gold that Gordon Brown showed 13 years ago.

Gold is a safe haven against tail risk:

The reality is that gold will be manhandled in the event of real tail risk. We only have to go back to 2008 to see evidence of this. If real multi-sigma tail risk occurs, the resulting contagion will lead to a run to safety, just as it did in 2008. And safety means the US dollar, Japanese yen, and Swiss franc. Those very same fiat currencies that we all love to hate. Gold only performs well when things are just bad enough, but underperforms when things are good, and gets obliterated when manure starts hitting the fan.

Demand from India and China:

The demand theme was already mentioned, but India and China have turned into magic words when lacking real arguments. Whether you're the CEO of a bloated and poorly run conglomerate, or a portfolio manager trying to explain all of the red in the commodities portfolio; mention India and China, and all is forgotten. Indian and Chinese consumers don't have any special powers with regard to forecasting the price of gold, and the fact that demand in India has spiked recently with the drop in gold is a phenomenon witnessed all too often in financial markets - when the bubble pops, there is an initial buy the dip euphoria, and those that double down eventually get crushed the most.

The concept of gold demand leads me to my last point. An excerpt from this post on Zerohedge will demonstrate, and I quote:

And what about demand? Since gold began its bull run in 2000, scads of new demand sources have come into the picture.

Central banks, which were net sellers of gold in the '80s and '90s, became net buyers.

Exchange-traded funds like GLD and trusts like PHYS didn't even exist before 2004.

Annual sales of gold coins by the U.S. and Canadian Mints have grown fourfold.

Chinese consumption of gold has nearly quadrupled.

Indian consumption (measured by imports) has grown 30% from an already high level.

As mentioned previously, all of these demand sources are speculative, one way or another. What caught my eye is the use of the word "consumption" to describe gold demand in India and China. This is crucial, because unlike other commodities, gold is not used up or consumed (except small amounts in industry). Oil extracted from the ground is eventually burned or turned into polymers. Copper is used to make everything from heatsinks to wires to plumbing. Silver has many applications in industry, and so on. For all of these commodities, previous demand can't be turned into supply. Not so for gold; all of the gold that has been "consumed" via demand during this bull cycle is almost immediately available to turn back into supply. This is ultimately the reason that gold is just a speculative asset, and not much else. New mining supply of gold and the specifics of this new supply is a secondary consideration in light of this fact.

When to short after identifying a bubble?

Betting against bubbles, and its inverse, catching falling knives, are great ways to severely compromise your net worth. A bubble must show real signs of popping before it would be advisable to bet against it. This year, the gold market has shown all signs of bursting. We may be witnessing a perfect storm of events that will continue to precipitate gold's decline in value. Equity markets are outperforming, and rampant inflation is nowhere in sight, even with competitive devaluation and a race to the bottom from the worlds' central banks.

There is no more powerful force in finance than the prospect of losing money, and with gold's recent plunge from $1800 and a sharp increase in volatility, losing money on your gold investments just became a very real possibility, a possibility that the average gold investor did not have to deal with for the past few years. All of a sudden, arguments mentioning gold consumption, India and China, intrinsic value, inflation hedge, money printing etc... will be swiftly thrown out the window and rendered irrelevant in the face of the plunging value of your portfolio. This leads to the conclusion that now is the time to short gold, via GLD (NYSEARCA:GLD) or another instrument of your choice. Volatility is currently skewed to the downside, and I see gold breaching $1000/oz within 2014.

Disclosure: I am short GLD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.