Gold - Here's What You Need To Know

by: The Financial Lexicon

Gold, the one asset so many investors love to hate, never suffers from a shortage of people trying to talk it down. As someone who owns gold, I take great interest in reading as much as I can about why I shouldn't own it. Every once in a while, I come across intriguing ideas, although none that has yet to convince me that owning zero gold is the route I should go. Despite occasionally finding what I think are respectable counterarguments to owning gold, much of what I come across is, in my opinion, complete nonsense that is all-too-often filled with attempts to ridicule or mock those who own the precious metal. One of many examples is Charlie Munger's "Civilized people don't buy gold." Another example is Barry Ritholtz's "The Rules of Goldbuggery," which I discuss here.

I can certainly understand why it is so many people disrespect and downright loathe gold. After all, those who enjoy the fruits of a leveraged up financial system and credit-driven economy have an incentive to talk down an asset with no counterparty risk. But despite so many pundits telling you not to own gold, I think it is worthwhile to think through for yourself the merits of purchasing history's ultimate store of value. To help you in that endeavor, I would like to start with the following question:

Why do you own gold?

a. Trade (technicals are favorable/contrarian play)

b. Longer-term investment (money printing/currency debasement hedge)

c. Store of value (carry over wealth from one fiat money regime to the next)

Answer (a)

If you chose a, you likely have a precise reason for believing gold is worth trading at a specific time, and you can ignore all the debate about whether gold is a good long-term investment. For those trading gold, I would like to share four thoughts.

First, don't let a "trade" turn into a "long-term investment." This sometimes occurs when trades go wrong and traders refuse to take losses.

Second, if you are going to trade, you should have a good understanding of options strategies that can help mitigate losses. Chapter 6 of my new book, "Options Strategies Every Investor Should Know," presents what is one of my favorite options strategies for getting out of a losing position.

Third, when trading gold, the type of exposure you choose is extremely important. Buying physical gold and paying markups and commissions is not suitable for traders. ETFs such as GLD and IAU, however, are suitable for trading.

Fourth, if you are looking to leverage your gold trade, in addition to trading on margin or trading futures, there are two other possibilities that come to mind. One is to implement the options strategy I call "leverage without leverage." That strategy is explained in detail (along with a real world example and a review of tax considerations) in Chapter 5 of the aforementioned book. Another way to leverage a gold trade is to purchase silver ETFs such as SLV or SIVR. As demonstrated in the chart below, the prices of gold and silver, and their corresponding ETFs, generally are correlated in terms of price direction.

GLD Chart

GLD data by YCharts

Despite being generally correlated in terms of price direction, when it comes to the magnitude of directional moves, I like to think of silver as gold on steroids. The moves are greater, and the gains or losses will be magnified if you trade silver as a means of gaining leveraged gold price exposure. Of course, you should remember that silver is not gold, and there is no guarantee that the future will bring the same type of correlations as the past.

Answer (b)

If you chose b when answering the question above, you likely have concerns about money printing, currency debasement, and the possibility of strong inflation at some point in the future. You are likely turning to gold as an investment that you think will protect your portfolio from an outcome that is likely to take place in your lifetime, and you are fairly confident that you know what the outcome will be.

I don't like gold as a "longer-term" investment because with long-term investments come expectations about future returns. And I don't think gold is the type of asset that can compete in terms of meeting investors' risk-adjusted expectations for long-term returns. Moreover, in today's financial world, "long-term" investors follow the fiat currency prices of their investments and expect certain returns in fiat currency terms. Given that I think gold should be owned as a store of value, I don't think owners of the precious metal should spend their time worrying about its fiat currency movements. In order to choose answer b, I think you need to be so confident not only about what the future outcome from money printing and currency debasement will be, but also be nearly certain about the time frame in which that outcome will occur.

Answer (c)

Gold is history's ultimate store of value. Its rich history of protecting wealth from one fiat money regime to the next is the reason hundreds of millions of people around the world own it or want to own it. It doesn't matter how many people go on television or write articles to proclaim gold's riskiness and use the fiat currency price movements to justify their remarks. It doesn't matter how volatile gold's fiat currency price movements are over a period of a few years. People who own gold as a store of value are worried about the very long term. Store of value investors take "long-term" investing to the next level. They are concerned about the number of ounces of gold they own. A gold price drop from $1,900 to $1,200 per ounce simply means more ounces can be accumulated for the same number of fiat currency units and that the storage costs will be less (a positive).

Store of value investors care about maintaining wealth from one fiat money regime to the next. These people want to own the physical metal (I am not talking ETFs here). In order to have even the remote chance of convincing store-of-value gold investors to part with their gold, you will have to explain why this time is different. Why are today's fiat currencies going to resist the eventual outcome to which their ancestors succumbed? What will make today's politicians and monetary authorities find a way to avoid the fate of prior nations' monetary experiences? Are today's monetary authorities exhibiting behaviors and making decisions that are all that different from historical failed behaviors and decision making? History is on the side of gold being something worth owning. The future may indeed end up different than all the episodes of the past. But is that a chance you are willing to take?

Should you own gold?

Traders who are long gold will own it for relatively short periods of time. They are not viewing it as a personal store of value or a long-term hedge against currency debasement. Instead, they likely notice favorable short-term price momentum, think they have an edge in understanding recent or expected news flows, or are reacting to changing technicals on gold's chart. Technical analysis has been and I bet will continue to be a huge driver of the price of gold. Don't trade gold unless you have a good grasp of trend lines, moving averages, and support and resistance levels. One final note for traders: Be aware of the random "attacks" that frequently occur on the price of gold, during which the price will suddenly drop 1% to 5% in a matter of minutes on no news. These are extremely common and usually occur during the part of the futures trading session when U.S. institutions are actively trading. They are much less common during overnight sessions when foreign institutions dominate the money flows in gold. Only you can decide if trading gold at any particular moment is right for you. Trading gold is not for everyone, and if you decide to do it, let me reiterate that you should not allow a "trade" to turn into a "long-term investment."

Longer-term investors interested in owning gold need to understand that successfully using gold as an inflation/currency debasement/money printing hedge is completely dependent on timing. It may seem a bit unusual to use the word timing when discussing longer-term investing, but it is not. Timing is extremely important when investing, even if you have a multi-decade time frame. This is especially true when it comes to gold, as gold has experienced long periods of falling fiat money prices even with inflation running in the mid-to-high single digits. If you want to own gold as a longer-term hedge, you should pay close attention to a few things: (1) interest rate movements, (2) the opportunity cost of owning gold versus other assets, and (3) the rate of change in money printing and government deficits.

If we enter a period in which market expectations assume a rising interest rate environment, the opportunity cost of owning the zero-yielding asset gold versus owning other income producing assets will rise. In such an environment, investors should expect the fiat currency price of gold to perform rather poorly. Regarding money printing and government deficits, remember that expectations of changing rates of change will alter market expectations for future gold prices. This means that if the Fed is expected to alter the amount of its QE purchases or if the government is expected to take actions that change the current expectations for future deficits, those actions will have an impact on gold prices. You don't need short-term interest rates to quickly pop to 3% to see a negative effect on gold's price. And you don't need budgets to be balanced overnight for gold prices to react negatively. You simply need traders and investors to believe that deficits will get smaller and that interest rates will head higher for gold prices to react negatively.

If you are interested in being a store of value gold investor, you should keep a couple of things in mind. First, are you intending to/willing to leave a legacy to your heirs? If not, then you are effectively saying that you expect the current monetary system to collapse during your lifetime. If you are willing to leave your gold to your heirs, then you can simply buy gold, store it somewhere, and forget about it. You will have secured exposure to history's ultimate store of value, and, assuming this time is not different, will have protected yourself and/or your heirs from the possibility of complete wealth destruction. Second, you should consider that people living in different parts of the world will have different levels of risk regarding fiat money destruction. You may live in a country in which you think the current fiat money system will last forever. In that case, you don't need to own gold as a store of value. People in other parts of the world may have a different opinion. Where you live matters when it comes to quantifying the near-, medium-, or long-term risk of needing gold as a store of value.

Naturally, it may make some investors a bit uncomfortable to think about the possibility of the current monetary status quo changing in a way that could wipe out their wealth. Changing monetary regimes can bring with them tremendous amounts of pain for enormous numbers of people. It makes sense that most people would prefer to be optimistic (even if that means being hopelessly optimistic) and never think about the possibility of needing stores of value to protect their family's wealth. But owning gold as a store of value doesn't mean you need to go through life miserable and always worrying about whether the current monetary system will fall apart. Instead, you can simply own your store of value as a form of wealth insurance and move on with the rest of your life.

I think the only reason people should own gold is as a store of value. I won't fault traders for wanting to trade it. Although I think the frequent random "attacks" that occur on the price of gold make gold less of an attractive trading vehicle than many of the thousands of other securities available for trading. As a longer-term investment, I think there is too much risk in the current system lasting long enough that the price of gold never realizes the returns in fiat currency that many hope and think it would as a hedge against inflation and money printing. But for store of value investors, especially those willing to pass their gold on to the next generation, it seems to me that owning history's ultimate store of value makes sense. This is especially true given the current environment in which those in power seem intent on reducing the purchasing power of various fiat currencies over time, and future fiscal situations in many influential countries seem too challenging for politicians to address in politically palatable ways.

While there are great research pieces available in the financial press regarding all sorts of securities, much of what you are likely to find regarding gold is simply noise. When it comes to owning a store of value such as gold, the only analysis you need to conduct starts with figuring out why you want to own it, thinking through the likelihood of that scenario becoming a reality (that will require a separate set of research), and then deciding the means through which you want your exposure. Stores of value are owned because people want stores of value. If you need a store of value, worrying about the current fiat money value of that asset is pointless. Simply purchase the store of value whenever you decide you need it, ignore the noise surrounding that store of value, and move on to other assets that require more careful valuation analyses.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Additional disclosure: I am long gold and silver.