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Five Reasons to Avoid the Gold Rush

Vitaliy Katsenelson's picture





 

 This is the third in a series of what some may consider as “gold bashing” articles. I am not short gold in any shape or form. I have no axe to grind against gold bugs. I am simply presenting the other side of the argument in response to what I deem to be dishonest, gold-pimping commercials (e.g., “If gold prices went up to $5,000 this pile of gold would be worth $300,000”) that we are subjected to all day long on TV. I may be wrong, but I am honest.

Five Reasons to Avoid the Gold Rush 

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

The reasons why one should sell the cat, pawn the mother-in-law, and use the proceeds to buy gold are well known: the Fed is printing money faster than you can read this, which will result in inflation; the government is borrowing like a drunken monkey, so the dollar will be devalued; this will debase all currencies, so the only thing that will save you is the shiny metal.

However, here are some arguments why one should think twice before jumping in bed with gold bugs, or at least remain sober while determining gold’s weight in the portfolio . 

1. For investors (not speculators) it is very hard to own gold, because you cannot attach a logical value to it. Unlike stocks or bonds, gold has no cash flow and has a negative cost of carry  it costs you money to hold it.  It is only worth what people perceive it to be worth right now.  The argument I commonly hear is, “What about all those Enrons, Lehmans, Citigroups, etc. that either went bankrupt or got near it?  What was the value of those?”  If the lesson learned is not to own stocks but to own gold, it is the wrong lesson.  The lesson should be: own companies you can analyze (the aforementioned companies were unanalyzable) and diversify – don’t put your all net worth into one stock. 

2. The gold ETF SPDR Gold Shares (GLD) is the seventh largest holder of physical gold in the world.  If its holders decide to sell (or are forced to sell; think of hedge-fund liquidations), who will they sell it to?  This is extremely important, as the presence of GLD changes the dynamics of the gold price, both to the upside and downside.  If gold keeps climbing, the ease of buying will drive gold prices higher than in GLD’s absence.  In the event of a significant sell-off, there are not enough natural buyers of physical gold. It is a bit like a roach motel – easy to get in, hard to get out.

3.   In the past, gold had a monopoly on the inflation and fear trade. Not anymore.  Now you have competition from Treasury Inflation-Protected Securities (TIPS), currency ETFs, short US Treasury ETFs, government guaranteed/insured FDIC checking accounts, etc.  TIPS suffer from the flaw of the CPI being measured and reported by the US government, which has an inherent bias to understate inflation; returns of commodity ETFs are skewed by price differentials between financial derivatives and spot prices of underlying commodities; returns of leveraged ETFs diverge significantly over the intermediate and long run from the underlying index; FDIC reserves are being depleted with the every-Friday-night bank bailout (but believe you me, the US government will not let FDIC go bankrupt, even if it means it has to raise taxes and impose draconian fees on the banking sector).   

The bottom line here is this: none of these investment vehicles are perfect, in fact many have significant flaws; but despite their flaws they attract money away from gold, thus undermining gold’s monopoly on the fear/inflation/currency debasement trade.  (I’ve discussed it in greater detail in my book).

4.  If, because of points 2 or 3 above, gold fails to perform as expected, the perception  of what gold is worth may change dramatically.  

5. Over the last 200 years, gold was really not a good investment. It may have a day in the sun, but it may not.  And the cost of being wrong is fairly high.  

Though gold bugs make it sound as such, gold is not the only and not the best alternative if the worst fears come to pass.  The best way to deal with the risks of dollar devaluation and high inflation – with a much lower cost to being wrong – is, instead, to own stocks of companies that have pricing power of their product. When inflation hits, they will be able to raise prices and thus maintain their profitability.  Also, companies that generate a large portion of their sales from outside the US will benefit from the declining dollar. 

Gold bugs look at gold as a currency, but it is not one and unlikely to be one in our lifetime. Here is why: there is not enough of it around, so even if world government were to adopt a fractional system (currency in circulation as a multiple of gold reserves), they will never go for it, because central banks and governments will never give up their monetary tools – inflation is a very addictive tool to fight growing monetary obligations.  

There is a wild card in the price of gold, though: China (John Burbank made that argument at the Value Investor Congress in Pasadena). If it decides to switch partially from owning US Treasuries to owning gold, the price of gold will skyrocket.

Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo.  He is the author of "Active Value Investing: Making Money in Range-Bound Markets" (Wiley 2007).  To receive Vitaliy's future articles my email, click here.

 


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Sun, 09/13/2009 - 05:03 | Link to Comment Anonymous
Sat, 09/12/2009 - 23:39 | Link to Comment Anonymous
Sat, 09/12/2009 - 23:19 | Link to Comment Anonymous
Sat, 09/12/2009 - 22:10 | Link to Comment Anonymous
Sat, 09/12/2009 - 15:06 | Link to Comment Anonymous
Sat, 09/12/2009 - 07:15 | Link to Comment Anonymous
Fri, 09/11/2009 - 16:07 | Link to Comment Anonymous
Fri, 09/11/2009 - 13:24 | Link to Comment Anonymous
Fri, 09/11/2009 - 03:41 | Link to Comment dark pools of soros
dark pools of soros's picture

just make lots of daughters - they are always worth something

Wed, 09/09/2009 - 15:41 | Link to Comment What_Me_Worry
What_Me_Worry's picture

I'm not a gold bug, but your argument actually makes me think I should add gold to my portfolio.

What other true hedge is there against every major currency in the world "creating" money 24/7?  Other commodities are dependant on demand much more than gold.

It's hard to buy something that has already had its day in the sun (not to say it couldn't go higher still).

Wed, 09/09/2009 - 12:37 | Link to Comment azgoldhound
azgoldhound's picture

debtor revolt video on marketticker must watch http://market-ticker.denninger.net/

Wed, 09/09/2009 - 11:48 | Link to Comment FreddyInBangkok
FreddyInBangkok's picture

"inflation is a very addictive tool to fight growing monetary obligations".

sure is. nothing much beats o'd-ing on credit. whatcha going to do it?

 

the kicker to all this is simple demographics boat-scuttling  - which is why they're unscrewing the hangar.

 

Wed, 09/09/2009 - 11:27 | Link to Comment FreddyInBangkok
FreddyInBangkok's picture

P1 “For investors (not speculators) it is very hard to own gold, because you cannot attach a logical value to it”.

 

Can one attach logical value to a portfolio mgr talking bollocks?

 

P2 “It is a bit like a roach motel – easy to get in, hard to get out”.

 

Some truth in this. GLD & SLV were designed by serial career traitor Akerlof whose wife is a senior FED official. how conveniently coincidental.

 

P3 “In the past, gold had a monopoly on the inflation and fear trade. Not anymore.  Now you have competition from Treasury Inflation-Protected Securities (TIPS), currency ETFs, short US Treasury ETFs, government guaranteed/insured FDIC checking accounts, etc”. 

 

TIPS are unbacked IOU debt instrument made of paper for convenience like FRNs with COUNTERPARY RISK, all currencies are sinking together against gold no exceptions,,, none,,, the more guvs bail bankrupts the more diluted the currency, the higher the nominal price of gold. FED has managed sentiment well to date, running out of credibility at a faster pace. Awareness of guv Ponzi con tricks, schemes, lies, plots now entering mainstreams

 

P4.  “If, because of points 2 or 3 above, gold fails to perform as expected, the perception  of what gold is worth may change dramatically”.  

 

Gold doesn’t perform, it never has. Gold doesn’t move. Paper dilution raises it nominal price & vice versa. Gold’s real price as defined by gold divided by commodities increases in the post-bubble crash scenario by way of natural compensation for the gross mismanagement of & corruption in financial matters. wherein even if the price of gold stays at $1000 for the next 3 years mine profits will rise as commodity prices fall - again, real price of gold, a point you conveniently failed to address.

 

P5. “Over the last 200 years, gold was really not a good investment. It may have a day in the sun, but it may not.  And the cost of being wrong is fairly high”.  

 

Gold is not supposed to be an investment, it’s a medium to store wealth when corrupt governments start unscrewing the hangar & sell their country out. The growth of portfolio managers has a linear correlation to fiat printings. Portfolio managers die on the vine when fiat shrinks as you see. Firings of unnecessary, undesirable parasites in the hostile environment of their own making.  

 

 

Yes, Chinese citizens are encouraged to buy PMs – unlike the advice you give your clients which will cost them dearly.

 

Wed, 09/09/2009 - 08:02 | Link to Comment Anonymous
Wed, 09/09/2009 - 07:55 | Link to Comment Daedal
Daedal's picture

Vitaliy - you are Russian, and yet that makes me even more perplexed about how you come to these absurd conclusions? Of all people making these posts, you should be even more aware of how Gold is money. Look at how people in Russia scrap the Ruble and hoard gold jewelry. I guess you are truly Americanized. Talk to you parents, maybe they can explain to you the importance of Gold.

Wed, 09/09/2009 - 06:11 | Link to Comment Anonymous
Wed, 09/09/2009 - 19:54 | Link to Comment Mediocritas
Mediocritas's picture

He may end up being right, but it won't necessarily be for the reasons he states. Precious metals have many complex factors underlying pricing. Different people see them different ways and so trade in different ways. At the end of the day I stick by one simple fact: physical gold and silver can't go bankrupt. There's a paper war going on out there right now and an awful lot of funny money going around. I want less risk so I like PMs.

A big factor to bear in mind is the natural price suppression of PMs that arises as a consequence of the PM carry trade. If that breaks then PMs are going to the damn moon, especially silver.

Wed, 09/09/2009 - 04:51 | Link to Comment Mediocritas
Mediocritas's picture

Ah yes, Buffett. I remember this quote of his, it came from 1998.

http://quotes.nobosh.com/gold-gets-dug-out-of-the-ground-in-africa-or-so...

But here's the thing: in 1998 Buffett bought 130 million ounces of silver causing the price to double. His stash was 20% of annual silver production at the time and over the next few years it would rise to be 37%. Until 2006 Buffett routinely held more silver than the COMEX.

I prefer to judge a man by his actions rather than his words. Buffett's words inferred he didn't like PMs, his actions were the exact opposite. I call that a head-fake.

In 2006 Buffett sold out of his position (at exactly the same time SLV suddenly acquired 170 million ounces without the expected move in silver prices). He later went on to say:

“We had a lot of silver once, but we don’t have it now—and we didn’t make much on our prior holdings...I bought [silver] early and sold early. Silver was my fault. [Speculation] is wildest at the end.”

- Warren Buffett, 2006

http://www.silvermonthly.com/162/analyzing-warren-buffetts-investment-in...

Wed, 09/09/2009 - 11:33 | Link to Comment FreddyInBangkok
FreddyInBangkok's picture

the sooner the asshole kicks the bucket the better

Wed, 09/09/2009 - 03:52 | Link to Comment Grand Supercycle
Grand Supercycle's picture

USD Index daily chart is neutral.

Weekly chart remains bearish.

Monthly chart is BULLISH.

more here:

http://www.zerohedge.com/forum/market-outlook

Wed, 09/09/2009 - 00:47 | Link to Comment Anonymous
Wed, 09/09/2009 - 08:21 | Link to Comment Gunther
Gunther's picture

Look out a bit farther, the world is bigger then the US.

Wed, 09/09/2009 - 08:01 | Link to Comment Daedal
Daedal's picture

"So unless your view is that the government will stop accepting it's own currency, and start putting faith back in gold, I don't see how gold can be a store of monetary value."

 

Anon #63196: With all due respect: you, sir, are an idiot.

Wed, 09/09/2009 - 00:11 | Link to Comment Anonymous
Wed, 09/09/2009 - 08:36 | Link to Comment Mr. Mandelbrot
Mr. Mandelbrot's picture

Correction - - Britain sold approximately half of their publicly stated gold stores at the bottom.

Wed, 09/09/2009 - 00:05 | Link to Comment Anonymous
Tue, 09/08/2009 - 23:47 | Link to Comment Gordon_Gekko
Gordon_Gekko's picture

Warren Buffet forgot what his dad taught him, and he has paid for it dearly - to the tune of $25 billion last year. And no, if you are a "genius" as Buffet has been projected so far, last year's crash is no excuse. Anybody who was not branwashed and did not believe his own good press could see it coming. In fact, those who really knew what was happening (unlike Buffet) MADE MONEY. Remember John Paulson?

It says a lot about the rotten state of our education system when a CFA, of all people, does not know that Gold is money. Vitaliy, if you had kept your mouth shut about Gold we would have probably given you the benefit of doubt and kept on reading your articles, but now you have exposed yourself as a complete moron.

Wed, 09/09/2009 - 04:34 | Link to Comment Mediocritas
Mediocritas's picture

Warren sold his megastash of silver in 2006 (it is rumoured: straight into the SLV ETF. The more conspiratorial folk believe he didn't sell it at all, but leased it to the ETFs).

He sold at $7.50.

I wonder how he feels about that now?

(HK spot right now at $16.50)

Tue, 09/08/2009 - 23:13 | Link to Comment Gunther
Gunther's picture

Vitaliy, if those are your arguments, please prove the arguments in favour of gold wrong. I try my best to prove your arguments wrong.

It has no utility.

You can not argue with the tape. - Jesse Livermore

So , when I can sell for more then I bought I did something right. Whether that is a stock or gold matters only for the risk.

To 1:

For CFA’s it might be hard to own gold, why for investors? Currently the S&P 500 trades around 130 times earnings. A fair value is around 14, so the stocks are overvalued. If you take projected earnings, the number goes to around 20, but that does not change the fact that stocks are overvalued. Future earnings are by definition as unknown as the real value of gold. Some stocks are actually in worse shape then a P/E or similar measure shows. Take Reggie Middletons analysis of JPM for an example.

http://boombustblog.com/Reggie-Middleton/1132-Why-Doesnt-the-Media-Take-...

In short, JPM runs an insane risk.

This analyzed stock does not look promising either.

To 2:

In a bear market for stocks it is hard to sell a big holding. This argument applies to stocks and gold alike. Tyler posted a while ago that a company was obliged to issue stock to pay interest and did not issue stock in clear breach of contract. There were no buyers either. In contrast, the Chinese would like to exchange their green paper for other assets and are kept back by fear of rising the price of gold too much. The commercial shorts might be willing buyers of gold.

To 3:

In most of the past gold was money. In bad times gold bought less stuff then in good times, overall the value was relatively constant. In contrast, since 1971 gold is not used as medium of exchange anymore. Considering both periods together does not make sense and after having that pointed out keeping the argument borders to intellectual dishonesty. Since 1971 gold is up some 28 times in dollars. Why do you ignore this fact?

To 4:

Applies to other investments as well, in case of gold the perception has increased the value some four times since the last big bottom, nicknamed the Brown bottom according to the genius British finance minister who sold exactly at the bottom.

To 5:

The cost of being wrong in any investment can be high; ask owners of pets.com (recommended by Wall Street analysts) for details. What companies will have pricing power during inflation when real wages do not go up? Oil comes to mind, but then you need to make up your mind whether peak oil is real and if so, when it happens or has happened. That discussion is way out of scope of this reply. Depending on where the company operates, there is geopolitical risk involved too. Should the FED be powerless and we run into deflation, this group of stocks will not do well; there is no pricing power. In a worst-case scenario stocks and government debt might become worthless; there are a variety of scenarios with different investment implications but stocks and bonds are NOT the alternative. Not enough gold? That is a matter of valuation; moreover, there could be currencies for domestic use and gold for international transactions. No government will willingly give up the keys to the printing press – agreed. Will after another bad experience of inflation or default any lender show up? You are saying that governments are stronger then market forces. I go with the market. Beside traditional buyers in India and Turkey there are two more wildcards: Russia and the Arabs. Putin stopped leasing of the central bank’s gold and the Arabs are traditionally in favour of gold.

Vitaliy, I challenge you to provide three to vive investments of your choice and I will provide a precious-metal-related investment with timing calls. Let us see who ends up better in a year.

Tue, 09/08/2009 - 23:14 | Link to Comment bbbilly1326
bbbilly1326's picture
 

IMHO, China is talking up the price of gold, in retaliation for Ben's QE policy devaluing their dollar holdings.

They have already publicly disclosed they've been stocking their reserves with gold for several years now, and recently have disclosed they are urging their citizens to buy gold and silver.

Ben has said that in the 70s stagflation "we let the price of gold get out of control".

Since then, its price has been suppressed by Western CBs.

China is making that suppression harder, but talking up the gold price. Money flowing into gold is flowing out of treasuries, driving yields higher, making QE even more catastrophic for the costs of servicing our debt.

We think we won the Cold War......but not all the players have stopped fighting yet.

Wed, 09/09/2009 - 04:55 | Link to Comment Mediocritas
Mediocritas's picture

Haha, I read Cold War as Gold War.

Tue, 09/08/2009 - 23:11 | Link to Comment Anonymous
Tue, 09/08/2009 - 23:11 | Link to Comment Mr. Mandelbrot
Mr. Mandelbrot's picture

"The best way to deal with the risks of dollar devaluation and high inflation – with a much lower cost to being wrong – is, instead, to own stocks of companies that have pricing power of their product."

The experience of the last major inflationary episode in America, the '70's, taught me for one that the "best way to deal with the risks of dollar devaluation and high inflation" is to buy gold (and silver).  Detroit could teach us a lot about what starts to happen to pricing power when the unemployment rate gets into double digits!

Tue, 09/08/2009 - 23:05 | Link to Comment Anonymous
Tue, 09/08/2009 - 23:00 | Link to Comment Anonymous
Tue, 09/08/2009 - 22:59 | Link to Comment Anonymous
Tue, 09/08/2009 - 22:58 | Link to Comment Anonymous
Tue, 09/08/2009 - 22:57 | Link to Comment Anonymous
Wed, 09/09/2009 - 21:18 | Link to Comment Mr. Mandelbrot
Mr. Mandelbrot's picture

What about all those Enrons, Lehmans, Citigroups, etc. that either went bankrupt or got near it?  What was the value of those?”  If the lesson learned is not to own stocks but to own gold, it is the wrong lesson.  The lesson should be: own companies you can analyze. . .

To quote John Bogle (founder of the Vanguard Mutual Funds) in his latest book "Enough,"

"Loose accounting standards have made it possible to create, out of thin air, what passes for earnings . . . [b]ut the breakdown in our accounting standards goes far beyond that: cavalierly classifying large items as immaterial, hyping the assumed future returns of pension plans, counting as sales those made to customers who borrowed the money from the seller to make the purchases, making special deals to force extra sales at quarter's end, and so on. . .What we loosely describe as creative accounting is only a small step removed from dishonest accounting." (p. 108-9)

Where are these companies the lay man, or even the best financial gurus on the planet for that matter, can accurately analyze?  I for one apply Occam's razor to investing as well.

Tue, 09/08/2009 - 22:51 | Link to Comment Anonymous
Tue, 09/08/2009 - 22:48 | Link to Comment Anonymous
Wed, 09/09/2009 - 03:33 | Link to Comment Mediocritas
Mediocritas's picture

Exactly. Build a time machine, jump back 200 years, make an investment in gold and an equal one in any form of paper, jump forward 200 years, check out how those investments performed. 99.9% probability the paper is worth nothing. 0.1% probability the gold is worth nothing. When paper is collapsing, precious metals are a good place to be.

Tue, 09/08/2009 - 22:42 | Link to Comment Lionhead
Lionhead's picture

This is the third installment of rubbish. If you were my money manager after reading this, I would fire you. Moreover, if this is how a typical CFA is educated, or indoctrinated, then you're schilling for others to entice novice investors into their products. Furthermore, you have the gall to write a book with your non credentials. Shame on you sir. Go away lest you attract a following of folks with pitchforks.

Tue, 09/08/2009 - 22:40 | Link to Comment Anonymous
Tue, 09/08/2009 - 22:37 | Link to Comment Anonymous
Tue, 09/08/2009 - 22:23 | Link to Comment Anonymous
Tue, 09/08/2009 - 22:21 | Link to Comment TheDreadPirateR...
TheDreadPirateRoberts's picture

Several of your contra-arguments are flawed. In particular, if you would simply do the work, you can indeed compute a quantitative value for gold, in terms of USD, depending on what assumptions you would like to make. Perception is important, particularly at any specific point in time. That's what makes a market, in stocks, gold and anything else that's traded. Gold, stocks, bonds, real estate, fiat currencies. All can be good investments at various times. One merely needs to be correct!

The argument that gold is not money (I assume this is what you mean by currency) is also incorrect. Gold meets the benchmark requirements for money. Again, you need to do some research before jumping to conclusions. Additionally, if you study some monetary history you will see that it's not a particular fraction of gold that matters, nor usually the physical possession of it. it's the fact you can't print gold, it's relatively rare, the supply grows slowly, and the faith that this fraction will exhibit any stability over time. 1 oz or 1/1000th of an ounce doesn't matter. But if people don't believe that fraction is stable, they'll rather own the metal itself than any paper claim on it. History tells a tale. There is nothing new under the sun. 

Finally, these arguments that gold is dangerous because this or that entity might sell a bunch is not particularly unique to gold. If you buy a stock just before top shareholders liquidate suddenly, is there some special protection you'll get from mark-to-market losses? it's a risk.

Gold may be a great investment, or it may suck. Just like lots of other choices. 

 

 

 

 

 

Tue, 09/08/2009 - 22:38 | Link to Comment michigan independant
michigan independant's picture

Lets not shoot the message. His law of marginal utility he awakes with in the morning is his own. Up, down or whatever is it the harbinger of inflation there and our deflation black angel. Metal for thousands of years posits it own value not a opinion I feel.  Answer me this tho author: If gold metal was a commodity, what is it doing on the balance sheets of a central governments as we read since athens? It can remove uneasiness since it has been the safety valve for countless centurys. Denizens here predict $1200. I have no clue how high or low in the next dacade but will get some later for utility purposes only then. Current gold bubble coming, why not every thing being hard to price. Government could answer if they wake up from drunken ways but I do not see that going to happen with these debt locust's in power. Prudent people will buy some over time as always.

"US government will not let FDIC go bankrupt, even if it means it has to raise taxes and impose draconian fees on the banking sector." Where tapped out uncle Sam next question. The hum of the press persists...... 

Tue, 09/08/2009 - 22:19 | Link to Comment Anonymous
Tue, 09/08/2009 - 22:07 | Link to Comment Anonymous
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