Part #1 of 3: Why Gold is in another Secular Bear Market
In this article, and subsequent ones to follow, I will discuss Gold as a unique asset class; the history of Gold prices; what factors cause it to appreciate in value relative to the US dollar, and what makes it sink. Only when investors truly understand why Gold rises, can they appreciate that those same factors can work in reverse, to cause Gold to depreciate versus the US dollar. Because the US dollar is the de facto world reserve currency, and the Seeking Alpha readership is predominantly in the US, it does not make sense to analyze Gold in other currencies, for the purposes of these articles. That said, a key component of the demand for Gold, resides outside of the US. Many investors are now owning/trading Gold through one of the many ETFs, rather than having to take physical possession, or trade in the futures' markets.
In part #1, I will describe why Gold is a unique asset class, and the role it plays in the world financial system.
In part #2, I will discuss the past history of gold prices relative to financial conditions.
In part #3, I will discuss the present situation, and the prospects for future Gold prices.
Gold is a unique hybrid Classification asset
Gold has attributes of a commodity, but also as that of a currency. Therefore, the basic rules that apply to commodities are not strictly applicable, and neither are those that apply to currencies.
Most commodity prices are driven by end demand for the basic needs of society, such as for food, clothing, shelter, and energy. Only a small fraction of annual Gold production is used by industry. In other words, the world does not require very much Gold to function.
Gold is a holdover asset from the last few thousand years of human development. Gold as a currency stems from times when there were no other liquid ways for people, in relatively stable democratic societies to store their wealth.
Most of the annual consumption of gold is still by lower income people living in corrupt and semi backwards societies.
But, Gold is not an actual currency. Gold must be exchanged for actual currency, in almost all normal cases, before it can be used to purchase goods and services. Therefore, in most liquidity crises, Gold is sold to raise actual usable currency. This was most apparent in the financial crisis of late 2008 and early 2009, when Gold plummeted in price. Gold turned out to be a poor store of value for those investors that held it prior to the economic meltdown.
The main reason to own Gold is as a hedge against the debasement of paper currency, which produces inflation. But, unlike other inflation protected assets, such as real estate, or basic businesses that have pricing power to pass on inflated costs, Gold does not produce any cash flow.
Many Sovereign Central Banks Own Gold for Non-Economic Reasons
In my opinion, the only reason that Sovereign Central Banks still own Gold is for show purposes, and not because it the best use of their capital. The real financial strength of a country, and by extension its Central Bank and currency, is based upon the health of its economy. But, sophisticated Central Bankers realize that the average person does not understand that Gold has become a barbaric relic.
Platinum and Iridium are more precious than Gold. Silver and Palladium have many industrial uses, and therefore are a better store of value, in my opinion. Additionally, there are many rare earths that are absolutely essential to many components of 21st century equipment.
"Compound Interest is the Eighth wonder of the world"
"Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it."
The main problem with Gold as an investment, as with all commodities, is that Gold provides no current cash flow.
The advent in the USA of publicly traded Real Estate Investment Trusts (REITS), publicly traded Master Limited Partnerships (NYSEARCA:MLPS), and other publicly traded income pass through investment vehicles, means that investors can gain inflation protection, and have daily liquidity.
In a relatively stable, rule of law, democratic economy, such as the United States of America, investors can have the best of both worlds relative to inflation protection. If there is inflation, the principal value of the publicly traded inflation protected assets vehicles will rise in value, while these investments are producing current income.
If a publicly traded inflation protected vehicle is producing a current yield of say 5%, Gold must appreciate at least that much per year, to produce an equivalent return.
"I think gold is a great thing to sew onto your garments if you're a Jewish family in Vienna in 1939 but I think CIVILIZED people don't buy gold" - Berkshire Hathaway's Vice Chairman, Charlie Munger
Mr. Munger was essentially saying that in relatively stable western societies, there are better liquid investments to protect against inflation than Gold.
That said, today in many corrupt societies, which account for a large part of the world's population, Gold can still make sense to own as a store of wealth for people of lesser means. India and China alone, account for about 1/3 of the world's population, and people in these countries have known for many generations, that Gold is a good store of wealth for the long, long term.
But, in the USA and other western societies, Gold is much more of a cyclical investment vehicle, and generally provides a worse total return than other traditional inflation protected investments, such as real estate.
Gold is a unique asset class that still partially functions as one of the world reserve currencies, but does not provide any current income.
Gold prices are much more volatile against most developed world currencies than is the US Dollar. This is clearly evident as Gold prices declined substantially during the early stages of the world financial crisis of late 2008 to early 2009.
From a strictly financial point of view, a diversified portfolio of high grade US real estate will provide a better l inflation adjusted total return over the long, long term, than Gold.
REITs, and other well run high grade publicly traded Trusts/MLPs, will generally provide investors with a better total return (provided they do not buy the peaks) , while providing the same liquidity as Gold.
I will discuss Gold mining securities as investment vehicles, in a separate article.
Part #2 of this series will focus on Gold prices since it was allowed to trade freely about 40 years ago, along with the associated economic conditions that caused dramatic long term fluctuations, as priced in US Dollars.
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.