Gold Is Speculative But Hardly A Bubble

Includes: AUY, GDX, GDXJ
by: Ken Brier

Gold is speculative but hardly resembles the late stages of a bubble. If history is any guide, bubbles typically exhibit:

  • A parabolic spike in prices to reach new inflation adjusted highs before "bursting"
  • Widespread ownership and a nearly universally consensus bullish view on the asset
  • A series of high profile capitulations that wipe out the prominent bears (e.g., Tiger Management during the dotcom bubble)

None of these conditions are met today. The widespread bearish sentiment alone is ample reason to question the "bubble" theory as bubbles are the product of irrational exuberance and one-sided positioning.

Gold has no shortage of bears. Bears will argue that the supply of gold keeps growing as it is never destroyed. 165,000 tonnes have been mined in human history - enough volume to fill 3.3 Olympic sized swimming pools. This is equivalent to roughly 5.3 billion troy ounces or less than 1 ounce per person on this planet. Every ounce ever pulled out of the ground remains in circulation. Warren Buffett will tell you that a block of gold will underperform an equivalent value of blue chip shares over any long period of time. Both arguments are true but neither is a reason to avoid owning gold. Gold is best viewed as a currency. Like any currency, the supply grows over time to accommodate growth. If money were inelastic, economies would struggle to grow. So while gold supply increases every year, the percentage increase in supply is very small and far lower than paper currencies. At 2,500 tons of production per year, gold supply increases at a paltry rate of 1.5% per annum and far less than growth in nominal global GDP.

As for owning gold versus a multinational blue chip stock, it is true that earnings growth will likely exceed the return on gold over long periods. But that is only a relative statement. It ignores the fact that gold will likely outperform US dollars over the same period. In 1912 an ounce of gold was $18.93; in 1935 it was $34.84 and today it is $1,390. Overnight interest on currency would generally compensate the holder of cash for any loss of purchasing power; but that no longer applies in the zero rate world. Negative real interest rates means holding cash costs the saver the price of inflation each year. Think of this depreciation on currency as the "Bernanke tax" to bail out insolvent borrowers - first and foremost the United States government.

Gold as a Currency

Bears will argue gold does not meet the definition of a currency, so let's consider what that means. Gold is used as collateral with exchanges; gold is used as reserves by central banks, and gold is liquid and exchangeable at a quoted market price. Just because you cannot walk into a restaurant and use gold to pay for the meal does not negate the argument that it serves as a currency. One cannot use US Dollars to buy sushi in Japan just as one cannot use Yen to buy hamburgers in the US. Both are currencies but both require conversion to the local unit of exchange before buying goods. Similarly, gold generally requires exchange to a local currency before buying goods in that country (though there are plenty of noteworthy exceptions.) Unlike other commodities, banks in Hong Kong and Singapore offer gold within the multi-currency accounts - I have yet to see one for copper, iron ore or milk.

The Greater Fool Theory

Gold bears love to invoke the "Greater Fool Theory". Gold has no yield, very little industrial demand relative to outstanding supply, and hence no easy way to value it. It is true that gold is speculative and only worth as much as the next guy will pay you. But the same applies to art, diamonds, collectibles, meteorites and nearly every other zero-yielding asset that derives its value from scarcity. So while Warren Buffett is well justified in saying he would not be a buyer at $800 per ounce, he would likely say the same for a rare painting or for the Hope diamond. He is not opining on what he perceives as fair value but rather his belief in fundamental valuation. If he were to apply a fair value argument, a rare Benjamin Franklin Z-grill 1868 stamp is worth 1 cent (face value) even though some "fool" would pay 3 million dollars for it. Bill Gross of PIMCO is one such "fool" who owns one of only two known to exist.

Negative Real Interest Rates and Gold

Most bulls will argue inflation supports the price of gold. This is not entirely accurate since it is only one side of the equation. In fact, negative real interest rates will support the price of gold. The nominal interest rate less inflation equals your real return on deposit. When real rates are negative, even zero yielding assets tend to outperform cash. Gold has more than doubled in the past 5 years even though inflation remains very tame. With CPI at 2% and Fed Funds at zero, the real rate is negative 2 percent. For this reason, your view on monetary policy and the future path of interest rates should drive your view on gold.

Capitulation or Correction?

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The current correction in gold is more reminiscent of the 44% drop from 1975 to 1976 than the massive and sudden capitulation we saw in 1980. Paul Volker killed the gold bubble when he began hiking interest rates to as high as 20%. Only then did we see gold capitulate. So unless we see a dramatic change in FOMC leadership, don't expect an end to this upward trend. If anything, Janet Yellen - a known dove in favor of expansionary monetary policy - is likely to succeed Ben Bernanke in 2014.

Why "Fools" Love Negative Real Interest Rates

Negative real rates lead to over-investment, excessive leverage and misallocation of resources. Condo development in Asia provides a perfect example. Both Hong Kong and Singapore real estate are near all-time highs having recently exceeded their Asian bubble levels of the 1990s. Real cash rates in both Hong Kong and Singapore are around negative 5%. Both countries import zero rate policy and both countries suffer from bubbles fueled by negative real rates. Some people go so far as to describe their loan as an "asset". Where else can you borrow at a rate well below inflation? Travel around Singapore or China and you will find cranes as far as the eye can see. Many of those sparkling new condo units sit vacant with no one to occupy them. Edvard Munch's "The Scream" set a new record last year selling for 74 million pounds (USD 116mm). General asset inflation is another way of saying money is depreciating. Do not confuse asset inflation with consumer price inflation. CPI remains low as real income growth is sluggish. But for those with money, inflation is rampant.

Fundamental Value in Gold Equities

One does not need to believe in higher gold prices to see value in gold miners. Many of these miners trade below book value with assets that are valued well below their cost of replacement. Gold is increasingly expensive to mine as the easy ore bodies have been exploited. Large cap gold miners would find it far cheaper to increase (or replace) production through acquisitions than to build new mines. At the current level of gold prices, many of these miners can easily afford to pay anywhere from 2 to 5 percent dividends which means you earn "positive" carry for investing in gold. For this reason, owning the miners at distressed valuations offers more upside and better carry than owning physical gold. This is especially true now after several years of miner underperformance relative to physical gold.

Much has been said about the "true cost" of producing gold. Gold miners report their operating cost of production but generally omit the all-in cost of production that reflects capital investment to build and maintain the mine. Just because the "all in" cost is $1,100 per ounce does not mean a gold miner would turn insolvent at prices below that. The all-in cost reflects the capital investment decision but not the operating cash flow. Depreciation is not a cash charge but an attempt to spread out costs to accurately reflect earnings in any given year. Earnings may well be negative at depressed gold prices but cash flow remains strong and positive, especially if management restrains from any future capital expenditure. Poor earnings but strong operating cash flow present enormous opportunity to the savvy investor. It also presents an excellent acquisition target if you can buy the assets cheaply enough. When buying below book (or the cost of replacement), who cares what the initial investment was since you're not paying for it.

Take a simple example. A miner issues USD 10mm in equity to build a mine that will produce 1,000 ounces of gold per year for 10 years. Depreciation alone would cost 1mm per annum which means $1,000 per ounce would go toward this non-cash charge. If the operating cost of production were $500 per ounce and spot price were $1,000, the mine would generate negative 500,000 per year in earnings but positive 500,000 per year in operating cash flow. If we assume the price of gold remains $1,000 per ounce for the next 10 years, the mine will continue to lose money every year until closure. Does that mean the stock is worthless or insolvent? Absolutely not since the mine is fully owned with no debt. A better method of valuation is to discount the expected cash flow over the next 10 years and arrive at a present value. For this reason, the "all-in" cost of production tells us far more about the quality of management and their capital allocation decisions than the fair value of the stock (assuming management does not continue to destroy shareholder value through poor investment decisions).

Ironically, the correction in gold along with the sharp fall in share prices may lead to higher profits in the long run. A few years ago, industry CEOs were investing heavily to build new production at unattractive and unrealistic break-even prices. Today, most CEOs are finding ways to cut cap-ex in favor of generating cash flow. Companies that pursue growth through acquisitions will likely do so at far more reasonable prices today which improves their odds of generating a good return.

I use the term "odds" for projecting a return since no one knows what the price of gold will be in 10 years or the price path it follows between now and then. Even if gold were to become worthless at sometime in the distant future, all that matters is the realized price over the life of the mine. If one were to believe the current price of gold is the best indicator of future prices, then most miners would trade at a discount to reasonable measures of fair value.

The mining industry is plagued with poor management which is why I prefer to own Market Vectors gold mining ETFs (GDX or GDXJ) to diversify away the company specific risk. Alternatively, I prefer to own miners with a long history of capital discipline and cost controls such as Yamana Gold (NYSE:AUY).

Concluding Thoughts

As Grant Williams recently said, "I'm a seller of gold. Just not yet - and certainly not anywhere close to this price."

The day the Federal Reserve takes real fed funds positive is the day I question owning gold. I believe that day is a very long way off.

Additional Disclosure: These views are solely my own and written in my personal capacity.

Disclosure: I am long AUY, GDXJ, NSU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.