SocGen On Gold Mania, And Why Gold Is Very, Very Cheap

Tyler Durden's picture

With David Rosenberg discussing gold undervaluation virtually every day in his Gluskin-Sheff missives, it was only a matter of time before the other key currency contrarian, Dylan Grice, chimed in as well. Sure enough, Grice's latest letter will make Mr. Paulson want to launch his gold fund tomorrow if possible, as by January 1 the precious metal may very well have taken off to new stratespheric heights. Bob Janjuah - we are waiting for the trifecta.

Some preliminary observations from Grice:

Central bank hoarding of gold in 1970 ushered in the famous gold bull market. With central banks likely to be net gold purchasers in H2 2009 for the first time since 1988 the same starting gun is ringing out today. The price at which the USD would be fully backed by gold (as it was during the peak of the 70s mania) is $6,300. So there is a case for gold being “cheap.” Moreover, the 70s bull market was facilitated by tight energy markets, overly accommodative central banks and nervousness that policymakers had lost their way. Sound familiar?

In 1965, concerned at the inflationary policies of the US and the attendant threat to their dollar reserves, the French central bank started converting their dollars into gold. This set in motion events which saw the central banks of Belgium, the Netherlands, Germany, and eventually Britain doing the same in 1970. By 1971, the Bretton-Woods system, by which all currencies were pegged to the dollar and the dollar effectively pegged to gold, had broken. The French had fired the starting gun for the great 1970s bull market in gold and silver.

It's worth pointing this out because central banks aren't known for their investment acumen. Some commentators have mockingly suggested that the Reserve Bank of India's recent decision to buy 200m tonnes of IMF gold signals the top of the market in the way that heavy selling by the UK signalled the bottom in 1999.

This is cute. But I think it's wrong. Like today, central banks weren't buying gold in the late 1960s to prop it up, they were abandoning attempts to prop up the dollar. Gold feels frothy today, but the Indian purchase of IMF gold eerily parallels the French purchases of the late 1960s. And ill policy winds are blowing in its favour. With the precious metals consultancy GFMS estimating that central banks will be net buyers of gold for the first time since 1988, have the Indians just sounded the same starting gun the French did in 1965?

Of course, any gold bull, gold "bug" or otherwise, faces some serious competition, in the face of none other than Goldman Sachs' most recent partner in philanthropic, TARP subsidized deeds, Warren Buffett.

“Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”


Warren Buffett

Is Warren right in the long run? How about for those who have a shorter investment horizon (yes Warren, buy and hold is dead, courtesy of REDI and Sigma X, peddled by your very favorite investment bank). As frequent Zero Hedge readers will recall, we posted a "parable" by Jim Grant on the 'value' of gold recently. Dylan takes the same approach but adds a few twists.

The standard reply to Mr. Buffet might be that gold acts as a long-term store of value, the most commonly heard rationale for investing in gold. Indeed, the chart below shows the real UK gold price today to be similar to that prevailing in 1265.

But the same chart also shows how unreliable gold has been as a store of wealth. A 15th century gold bug who'd stored all of his wealth in bullion, bequeathed it to his children and required them to do the same would be more than a little miffed when gazing down from his celestial place of rest to see the real wealth of his lineage decline by nearly 90% over the next 500 years (though he might take comfort from the knowledge that his financial advisor would be burning in hell). More recently, had you bought at the peak of the last bull market in January 1980 for $850, you'd have suffered a nominal decline of 70% by the time it bottomed in 1999. On an annualised basis you'd have lost 6% pa nominal and 9% real.

So gold isn't intrinsically safer than any other asset. There is nothing mystical about it either. Like all other assets, it goes up and down according to its fundamental drivers. But what are these fundamental drivers? How can something with no cashflow or earnings power be valued?

The simple answer is that it can't be. Intrinsically it is pretty much worthless. Indeed, when I tell people I buy gold the most common complaint I hear is that it has no real industrial use. Surely I'd be better at least buying a commodity that industry needs to make stuff with, like silver or platinum?

The more verbose answer is that this "uselessness" is exactly what gives gold its value because it makes it the perfect currency. If you own silver, a recession will cause the price (and therefore its purchasing power) to fall because industrial demand has fallen. The same is true for platinum or palladium. But the price of gold will be unaffected by any decline in industrial demand because there is no industrial demand!

Indeed, when no comps, no DCFs, no fundamentals exist to value an object, one can never say an object is under or overvalued (which begs the question who is buying Amazon at these prices which extrapolate a growth of about 10% into infinity, and alas indicate that the company is the most bloated dot com deja vu behemoth in existence). But back to gold, where Dylan proceeds to demonstrate how one way to "value" gold would indicate that it is roughly 75% undervalued.

To value gold it helps to understand that paper money was traditionally based on the stock of gold (and silver). Depositors of bullion would receive a receipt proving their holdings and it soon became easier to use those receipts for commerce than it did the physical gold. So while the use of paper money had become commonplace by the 18th century, that paper was always redeemable into gold or silver. The money supply was always gold-backed.

Full redeemability was increasingly watered down after WW1 so that by the time the Bretton Woods system was imposed following WW2, only central banks had the right to convert paper for gold. But when that broke in 1971 because dollar holders had become distrustful of US promises to restrain its dollar printing, the link between paper money and gold was severed completely. Since then, paper money has been backed by nothing more than central banks' promises to maintain the money supply at a stable level

So one way to value gold, therefore, is to ask at what gold price the value of outstanding central bank paper would be completely backed by gold. The US owns nearly 263m troy ounces of gold (the world's biggest holder) while the Fed's monetary base is $1.7 trillion. So the price of gold at which the US dollars would be fully gold-backed is currently around $6,300.

The chart above shows the extent to which the USD has been gold backed since the late 1960s. It currently stands at 15%, close to the all-time low 12% reached in 2001 but far from the all-time high of 140% reached in early 1980. Interestingly, during that inflation panic the value of gold rose to such a level that the dollar became over-backed (the red line is higher than 1). The market value of gold held by the Fed was worth more than the paper money it had issued!

Gold has rallied considerably in recent years, but the monetary base has grown even faster. So a better response to Mr. Buffet might be that you should buy gold because it's cheap ...?

At least Dylan has a good self-deprecating, pr-cyclical sense of humor (which for some reason all CNBC talking head guest are allergic to) as the following attests:

If my "valuation" of gold strikes you as a desperate attempt to value something which can't be valued, it's no different from metrics such as the "market cap to clicks" or "ARPU" ratios which were used in the late 1990s during the technology bubble when demand for bullish "valuation analysis" mushroomed. They seem crazy now but speculators bought into them during the tech craze. And there may well be a bubbly parallel ... Charles Kindleberger, drawing heavily on the work of Minsky, outlined the following "anatomy of a bubble".

Stage 1 sees "displacement." Frequently, this comes about through the introduction of a new disruptive technology (e.g. canals, railways, or the internet) although Kindleberger says it doesn't necessarily have to come from such an innovation. It can arise on the back of greater market liquidity through, for example, financial deregulation.

Stage 2 is the "boom." A convincing narrative gains traction (e.g. Asian economies are "miracle" Tiger economies; the Internet will change the world; sub-prime mortgages help financial institutions diversify risk). Price movements which seem to confirm the narrative are stoked by credit creation.

Stage 3 is "euphoria." In the words of Kindleberger, "there is nothing so disturbing to one's well-being and judgement as to see a friend get rich." This greed sucks people who wouldn't normally involve themselves in such practice into the mania. More and more people seek to become rich without understanding the process involved. Rationality becomes stretched and increasingly fanciful notions excuse what would ordinarily be considered irrational behaviour.

Stage 4 sees the "crisis." The insiders originally involved start to sell. Prices level off and begin to fall. Those who bought at the top find themselves pushed out first and their selling eventually cascades down through the remaining believers. Speculators realise prices can no longer rise and the rush to exit is on. To the extent that leverage was used to finance any purchases at irrationally overvalued prices, savage price declines put banks in trouble too.

Stage 5 sees "revulsion" where prices likely overshoot fundamental values on the downside. Scams and frauds are uncovered. Scapegoats are found for the financial distress caused. The object so richly desired as the bubble inflated becomes an object of ridicule and disgust, along with anyone or anything associated with it.

And here is why even if we are in a gold bubble, the actions of various central banks will likely make it impossible to contain the gold euphoria, even if gold is, indeed, as many claim massively overvalued (in some currency of which billions of new bills are appearing each and every day).

With this in mind, consider the parallels between the 1st and 2nd phase of the 1970s gold mania with the situation unfolding today. Then, the "?displacement" was the collapse of the Bretton Woods system, precipitated by central banks, distrustful of inflationary US policies buying of gold. This is very similar to what we are seeing today. Then, the liquidity turning "displacement" to "boom" came from central bank accommodation of the oil shocks. Today, central banks are monetising government deficits to accommodate the recessionary effect of the credit crisis. Then the convincing narrative was that with the Middle East controlling our energy from abroad and aggressive trade unions rampant at home, policymakers were no longer in control. Today, the perception of central bank infallibility has been permanently ruptured by their collective failure to see the 2008 crash coming. Nagging concern at their over-willingness to inflate, at the blurring of monetary and fiscal policy and over long-term government solvency (see chart below) gives traction to a similar narrative today.

On the Kindleberg-Minsky map as I've drawn it, therefore, we've had the "displacement" and are only now entering into the "boom" phase. The "mania phase" lies well ahead. Who knows what unknown unknowns might parallel the two oil shocks of the 1970s? The top of the gold bubble occurred when politicians won a mandate in the late 1970s/early 1980s to take painful decisions, to take on the trade unions, and to raise interest rates to tackle inflation. Only then, during the "crisis phase" did scams such as the Hunt brothers' attempted corner of the silver market come to light. The parallel today would be governments winning a mandate to take the difficult decisions ahead on health care and pension entitlement, or even climate change. And who knows what yet-to-be-conceived frauds await?

But that is a long way off. Governments only won such mandates because by the late 1970s, the "inflation fatigued" electorate was tired of lurching from one crisis to another. We're several crises away from governments winning similar mandates. In the meantime, displacement has happened, liquidity is plentiful, and the compelling narrative is gaining traction. Oh, and gold is "cheap" ...

Short gold, and by implication go long Ben Bernanke, at your own risk.

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CharlesBronson's picture

Whereas the price may rise parabolically, the duration is at end. Articles like this herald the coming collapse. We can expect a major nation to return to a Gold Standard approximately 15 minutes after they finally cut Reagan's face into Mount Rushmore...or your bomb shelters c-rations expire.  

Anonymous's picture

charles charles charles....

what fools ye dumbshits be....

G. Marx's picture


Interesting read. But of late, I think Martin Armstrong has laid out the historical case for when to own gold and what causes its price to rise and fall. His latest missive covered just that topic and I suggest everyone interested should read it, if they haven't already. IMO, its a mistake to ever label gold an investment, its insurance.

Anton LaVey's picture

Reference/URL, please?

(Gold is an insurance - agreed, up to a point, since it can increase its value during times of crisis).

chumbawamba's picture

Indeed, when I tell people I buy gold the most common complaint I hear is that it has no real industrial use.

Short-sighted and dumb.  The only reason gold is not used more in industry is because there are far cheaper alternatives that do an almost as good job as gold in applications where gold is not absolutely required.

These arguments of why to avoid gold are silly and lame.  People are trying to find infinite reasons not to acquire gold, but they forget the most important one in favor of getting it: survival.

Oh well.  As ever, survival goes to the fittest (and smartest).

I am Chumbawamba.

CharlesBronson's picture

In those kind of times, the gold you are describing is wholly mistaken as a precious metal, it is in fact the gold coloration of copper plated FMJ .308s.  

Anonymous's picture

It's not either/or. It's both.

Anonymous's picture

and here boys and girls is the fucktard
and his omnisolution of bullets to all of
life's problems....

i'll take the real gold, thanks.

Anonymous's picture

i really got a giggle outta that comment! thanks

Anonymous's picture

Most people don't understand gold. Even lots of financial talking heads don't appear to understand gold.

The most common response I hear when I mention gold is, "You can't eat it."
They never stop to consider that you don't eat paper dollars either.
The next response I hear is, "Look what gold did after 1980."
No one seems to know that gold spent all of THREE trading days above 800 in 1980. It was a parabolic spike. So extremely few people actually bought gold near the peak. Most people are like me - who bought gold around 300 in 2002.

chumbawamba's picture

Stage 4 sees the crisis.

Yes, ordinarily in a bubble this is how it would play out.  However, in this case we are talking about a hedge against the global fiat reserve currency.  The materialization of "Stage 4" really depends on what the global money meisters come up with as a replacement.  They'll have to work extremely hard to convince me that whatever they come up with to replace the dollar is going to have the same value as my precious metals holdings, enough to make me want to trade my gold for their new paper.

It ain't gonna happen for a long time, brother.

Overall this was a decent analysis.

I am Chumbawamba.

Lionhead's picture

I think folks should look at that "Our governments are insolvent" bar graph and then decide; more paper or more PM. The general public is hardly involved in gold at all. When they awaken, the mania will begin as they begin to realize the US gov't has betrayed them. Be patient all, add on pullbacks & shakeouts.

Oso's picture

so, i actually agree with everything gold related.  The biggest problem i see, however, is that gold is not making new highs in any other currency, which suggests to me the vast portion of the last couple of month's moves has been solely dollar-carry.  and so i cannot advocate getting long it here at all.


but, on a major shakeout, then i reevaluate.

Lionhead's picture

Yes, in a very thin market like gold with a very limited supply available, shakeouts are necessary to rid the "Johnny come latelys" off the bus. There isn't enough metal to go around & more rapid appreciation can occur when the last passengers to enter, exit the bus. Works every time. ;)

As for the relative value in other currencies, I think the current appreciation in USD is just to catch up to everyone else due to the paper gold/silver manipulation. IOW, now we're in the low hangin' fruit days of the advance.

Now the $64 dollar question is which other central bank is going to buy the remaining IMF gold that's for sale?

Good trading, sir!

Anonymous's picture

gold is not a thin market in traditional terms
of thin....its size may not be as
large as fiats but it turns over once every 7 days
or other instrument has that kind
of turn over...

jm's picture


If you think the gold rush will correct in dollar terms, I'm thinking it will do so because treasury yields go up.

So short the long bond.

If you think that the Fed won't let yields rise, then this run up is going parabolic for a while yet.

So go long gold.

Also, just being contrarian here with a healthy respect for Fed power to screw the mind, but perhaps this gold run up is accepted as a way to alter nominal deflation expectations.  If so, then the Fed has no intention of stopping the fun.  Analytics of such a plan:

Anonymous's picture

Yes, excellent point.

guidoamm's picture

Price of gold bullion in all major foreign currencies looks bullish to me. I grant you that technically we cannot yet say if and wheather it'll make a new high but these charts look pretty good so far...[s180955852]&disp=O


Anton LaVey's picture

Gold is not making any new high in any other currency?

Hello, what planet are you from?

  • Gold ounce, priced in Euro, Dec. 1st 2008 = 778 Euros.
  • Gold ounce, priced in Euro, today 2009/11/19 (noon fix) = 1136 Euros.

And that's just in my little corner of the world.

Of course, gold went up, then down, then up again, etc. But the trend is, shall we say, rather obvious, don't you think?


JonNadler's picture

Ah! Anton finally caught it,

"gold is not making new highs in other currencies"


Yes this is an argument i use to scare gold bugs to dumb to check the charts. Of course once in a while i get an astute guy like Anton who sees through this BS and calls me out on it. But by then 10 people swallowed the lie so i don't care

jimmyjames's picture

Whereas the price may rise parabolically, the duration is at end. Articles like this herald the coming collapse.



Thanks for that--tells me we have a long way to go to the top--

That article may well be a temporary topping indicator,but your words,tell me we have much more upside,ahead of us--


Burnbright's picture

How can anyone honestly say that Gold has no intrinsic value. It just blows my mind how retarded they are.

Anonymous's picture

the only item for which the term 'intrinsic value' has any meaning is an option that has gone into the money.
all other value judgments are subjective - there is no such thing as 'intrinsic value', and gold doesn't have any either.

Anonymous's picture

did you learn that in kidergarten today?

Anonymous's picture

Most people simply misunderstand the real nature of money. Gold, et al, has value precisely because of it's scarcity, not it's industrial utility.

If Obama snapped his magic girly-fingers and made all the gold in the universe disapear tomorrow, it would be replaced by some other scarce commodity. In other words, the effect that gold has on economies would not 'go away'. Something else would take up its role as a store of value.

Anonymous's picture

gold's utility as money is based upon much more
than its don't understand money...

TumblingDice's picture

Intrinsic value = utility...value that is there no matter what anyone else thinks.

Examples: shelter/house, food, compass, car, gas, computer, flashlight, kitchen, basically most machines. Factories have intrinsic value but they also derive a lot of their value extrinsically because they rely on the opinion and actions of others, since you have to have others buy the things of intrinsic value that you are making in the factory.

Extrinsic value = faith, efficiency based value. Value that is there because other people attach value to it.

Gold has natural extrinsic value, since there did not exist a law that made people accept it as valuable, people just settled on it as a thing of value used for exchange naturally. Federal Reserve Notes have extrinsic value but it is forced on everyone by law, hence it is a fiat currency. Stocks, and all other forms of fancy paper have extrinsic value because you can exchange it with someone else for other forms of value.

These are very important concepts to understand for anyone who has been exposed to the world of finance for a long time. It is a blurry line, but for some people it is muddier than for others (like the anon who refered to in the money options as having intrinsic value). Gold's value is 99% extrinsic. It is money and money can't solve all problems.

Disclaimer: I hold no position on gold and do not plan to.

Anonymous's picture

Peak oil is here. The biggest bubble. When the tide goes out the scheme of paper will be revealed. Buy PMs

delacroix's picture

the theory that silver as an industrial metal will lose value in a recession, does not take into account, that it is not only an industrial metal but also poor mans gold. coupled with the tiny size of the silver supply to gold or frn's.95% of all the silver ever mined has been used up.theres a reason jpm shorts silver even more vigorously than gold. theres actually gold that could be dumped into the market, to suppress the price. with silver, thats not possible. the metal, in an adequate amount, does not exist. silver is the canary in the coal mine. they will lose control of it first. then its game on, gold will follow .  IMO

jimmyjames's picture

the theory that silver as an industrial metal will lose value in a recession, does not take into account, that it is not only an industrial metal but also poor mans gold"


Exactly--when the poor man looks to buy gold and see's the price as too high,he will instinctivly look to silver--

This is when golds pretty little sister,sheds her veil and starts to strutt her stuff across the world stage--

Blindweb's picture

The biggest bubble of them all is showing signs of popping.  The oil bubble (peak oil).  When the tide goes out the scheme of paper will be revealed.

DaveyJones's picture

that's because oil has no utility at all and is getting cheaper and cheaper to extract

Slewburger's picture

Oil has no utility?

Are you retarded?

Tell me what was your keyboard made from, recycled starfucks cups?

Do you drive to work in a VW powered by sunshine?

DaveyJones's picture

sarcasm. I gave you an itsy bitsy clue with the cheaper to extract bit. Funny thing, once peak oil hits hard, you'll be the first in line for a "vw powered by the sunshine."

Bonesetter Brown's picture

Does Albert apply the same analysis to other currencies in addition to the dollar?  What does it say about the Euro or other currencies?

The EuroZone may hold more gold than the U.S., but very little is with the ECB.  That merits a discount.

Taking the analysis to the logical next steps might affirm that gold is undervalued, but it may also suggest the dollar is undervalued relative to other currencies.

Anonymous's picture

Dollars are a store of value; gold is a store of value; Dollars have no intrinsic value; gold has no intrinsic value. The worth of Dollars is primarily determined by governments; the worth of gold is primarily determined by the markets.

Take your pick.

Anonymous's picture

dollars are not stores of value....they are
merely instruments of exchange. in the
colloquial sense frn have absolutely no
instrinsic value is nothing
but instrinsic value...governments
do not set the value of currency any more than
they set the value of gold - at least not in
the long term....

none of my remarks should be construed to
deny government manipulation of gold price.

equating government with market virtues is
a totalitarian practice i strongly eschew, hitler.

guidoamm's picture

"...the worth of gold is primarily determined by the markets.."


... and by history...


Anonymous's picture

At the most basic level, the only reasonable preservation of wealth you have is in tangible resources - whatever they may be.

That being said, measuring the real price of gold at $6,300 an ounce ignores everything else which trades like currency. We have to include Silver, Oil, and any other resource that can be immediately exchanged for paper on an open market - despite arguments about industrial utility built into the price.

The argument (for a resource-driven strategy) is sound, but the examples do not illustrate the point effectively.

Price is so relative that tangible assets are the only investments that can carry any measure of value or utility beyond a base assumption. (remember, appreciation in value - a flawed concept - is in the eye of the beholder based on a subjective measure at some given interval. I.E. Stocks are up 40% since Jan 1. The measure is subjective at best and completely irrelevant at worst.)

I've heard you can't eat gold - but by the same token you can't make a necklace or a computer out of fried chicken.

Anonymous's picture

oil and resources are not traded like currency....
they are purchased by currency...nor is resources as currency is a completely
moronic notion which the history of economic
man has soundly rejected.....barter is a caveman's
solution to his primitive conditions....

basically you have no idea of what you are talking....

Anonymous's picture

"measuring the real price of gold at $6300 an ounce ignores everything else which trades like currency"

Yes. Gold currently is "valued" at 12% of world GDP. In view of your comment, is this too low or too high or just right? Who TF knows?

Masked Man's picture

Good point here. Gold is not going to replace the dollar as money in the future. Gold (like oil) is merely a store of value that will always have some market value.

kiwidor's picture

mmmMMM!!  Chicken!!

Anonymous's picture

"The US owns nearly 263m troy ounces of gold..."

If you're going to print it, then prove it; otherwise, this figure is absolutely meaningless.

Gordon_Gekko's picture

It is a complete lie.

mdtrader's picture

Of course this assume that the 263 million ounces are actually phsyically there, and and haven't lent to some feckless banker, who sold the gold on the market and replace it with a nice piece of paper. The phsyical stuff may around a woman's neck in China or India for all we know!

Anonymous's picture

Up till now central banks have been sellers of gold, that should all be ending now . If the Indian purchase is any indication we should see more of this for some time. Obviously, central bankers think gold is something more than an industrial metal, which is what matters, perception.

"So the price of gold at which the US dollars would be fully gold-backed is currently around $6,300" !!!!

The Fed still seems worked up about deflation, why else maintain a zero interest rate, that was the reason last time (2003), as our creditors continue lending at these ridiculous rates we should put it on as big as possible and then tank their investment by quickly raising rates. That is when to get outta Dodge on the gold trade, when the Fed start raising (or talking about it) and not until.

Green Sharts's picture

When I read this:


<But the price of gold will be unaffected by any decline in industrial demand because there is no industrial demand!

Indeed, when no comps, no DCFs, no fundamentals exist to value an object, one can never say an object is under or overvalued>

I was reminded of this, from Cramer's infamous "Winners of the New World" speech at the top of the Nasdaq bubble in early 2000:

"Most of these companies don't even have earnings per share, so we won't have to be constrained by that methodology for quarters to come."