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BookmarkJim Rogers had been right when he had stated that gold would only rise after its most ardent followers had sold out of their positions. After all, the best time to buy is when an asset class is the most hated.
Gold is up again, at last, but I would be hesitant to call for a recovery. It would seem that the powers that be will decide when that happens. On the other hand, knowledge of the bubble in stocks appears to be spreading. I can take comfort in that.
This article is devoted to examining the case for gold in detail; I intend to be exhaustive but apologize if I inadvertently miss some significant detail.
Why gold?
Gold is indisputably the oldest currency that is still in use. It is also an extremely complex commodity, for it is affected by a multitude of factors to a multitude of extents that vary almost randomly across the spectrum of time. Nonetheless, there are only three basic reasons for holding gold:inflationary hedging, hedging against instability and of course its use to manufacture jewelry.
These reasons stem from gold’s primary attributes: it is rare and non-printable (unlike currencies) allowing it to ward off inflation. It does not diminish nor deteriorate over time (unlike most, if not all other commodities) allowing it to preserve wealth and serve as a hedge against instability as a reserve commodity. Finally, it is highly desirable, creating real demand for the commodity as a useful (or useless, purely aesthetic) product in the form of jewelry; unlike fiat or paper currency. It is desired even when a fiat currency is not. During WW2 for example, Germany eventually had to finance much of its war effort with gold rather than the over-inflated Reichsmark.
Indeed, most arguments for and against gold involve the above three reasons; included in the arguments made below.
Common arguments against gold:
Argument 1: QE in the US has not led to rapid inflation
What is QE?
Unlike plain money printing, which it is often confused for, QE is the purchase of US treasuries or debt. Debt creates money that can be used now (inflationary) which must be repaid (deflationary) with interest (very deflationary). In essence, the US has pledged to repay every dollar it has created to combat the financial crisis. This would work out quite well if we assume that they are really able to repay the debt at the end. A low velocity of money however implies that much of it is not being loaned out to regular consumers and thus not much of it will actually be used to ‘improve’ the economy, and thus a low likelihood of the debt being successfully paid off.
Has QE been effective? Is it even inflationary?
The stimulus is simply not achieving its stated objective. The reasons for this might range from banks being unwilling to lend to people with poor credit, to people being unwilling to take loans that they cannot afford, to banks not passing on the entire low-interest benefits, to new regulations. This is not to say that money should be lent out indiscriminately, but that the entire premise of stimulus is flawed; as we shall see, malinvestments of other varieties rise to absorb the excess money.
A Fed insider has even come forward, apologizing and explaining how QE had only helped large banks earn more cash via speculation. Further, the remainder of available funds that are not being lent to ordinary people or small businesses are either being loaned out to ‘safer’ hedge funds and large corporations, further fuelling speculation, or accruing interest paid out by the Fed itself. Apparently a 0.25% rate of interest is sufficient to deter banks from lending out most (81.5%) of the QE money, highlighting how risky they feel the real US economy is. This is in contrast to their very public belief in a recovery. This is probably also why rapid inflation in the real economy has not occurred, although one must wonder what QE was supposed to achieve other than benefit the banks and what would happen when this cash starts flowing out. Regardless, speculation and helping banks seems to be the raison d’être of QE.
On a side-note, had QE been lent out in full it could have helped people by reducing the pain of a recession. On the other hand it also (by encouraging the behaviour that had led to the previous crisis) will lead to at least one of the following: over-investment, over-consumption and over-speculation.
Now, as ‘useless’ as over-investment in an over-hyped area is, over-consumption is worse because it does not guarantee investment; at least you gain say an extra road or power-generator you could use later (maybe). As useless as over-consumption is, it is far better than over-speculation because at least you end up with a car/fridge etc. Not to say the original buyers would end up keeping these assets, but at least they are there.
What does over-speculation do, however? Although you side-step the hazard of inflating capital/consumer products, you will end up inflating speculative products, the only asset-class that people are more likely to buy the more expensive it becomes. Further, at the end of it, it is not immediately clear if anything tangible is ultimately created, or indeed if the suffering of the people had even been briefly impacted. This however is only the second worst outcome. The very worst outcome however is when money is left sitting in banks accruing interest, money created by debt to do… nothing. Money that the government had spent and must repay with interest from tax dollars one day, left in a bank accruing interest for the bankers.
In essence, when money created by QE and is only used for speculative purposes rather than for consumption or investment in the real economy, we observe spectacular inflation in stocks or housing but very little inflation in real goods or in capital goods (the symptoms currently observed in the US). The reason for this increased speculation in the stock market is further augmented by QE’s additional demand for treasuries, which suppresses treasury yields and interest rates, causing people who seek to preserve or create wealth to seek out profitable investments in shares as well. As share prices rise, more people enter because of its apparent profitability.
Inflation is occurring, but mostly confined to certain specific speculative goods which are profitable to only a few initial investors. Further, the full rate of inflation is still being held back by the Fed. Should QE end, much of this liquidity would exit speculative products, causing inflation elsewhere in the economy.
Tapering vs. the end of QE
The key word is ‘end’ rather than ‘taper’; tapering QE has not created the doom that some have been calling for mostly because the taper was miniscule and likely reversible. 75 billion USD is still going to be pumped into the economy. I could be wrong on this count, and perhaps sentiment and pure optimism will push the US economy into recovery, for that is what you have to believe if you are bullish stocks.
An end of QE would herald the deflationary aspect of QE debt (the most inflated assets stand to be hit hardest), which may be warded off only as long as QE creates debt faster than the debt that must be currently repaid, the US enters a real recovery where wealth creation pays off the debt completely or literal money printing takes place.
The reason why I believe this increase in share and housing prices is not supported by a recovery, the US is not in a real recovery and indeed why deflation is a best-case scenario shall be explained in the next section; there exist other reasons beyond simple inflation and tapering to be aware of when investing in US shares.
Argument 2: The US is in recovery; hence there is no need for a hedge against instability
(click to enlarge)
The graph above is taken directly from the Federal Reserve Economic Data department. Observe that the Employment to Population ratio had declined sharply in the last recession, that at 58% it is the lowest since the 1980s and that despite all of the jobs ‘creation’ reports we have received this year, employment has not increased in proportion to population in a significant manner. This is unlike most previous recessions, where a rebound is observed soon after a recession. This graph is far more telling than a simple ‘unemployment’ number because it also factors in people who had simply given up looking for work. A 5% drop in participation that happens to coincide with the recent crisis would also put to rest any belief that this is only driven by baby boomers retiring in droves (the most common explanation). Also, it should be noted that this does not even count underemployment, and most of the jobs created were part-time and in low-wage industries.
(click to enlarge)
Despite all this talk of a housing recovery, US home-ownership rate is at its lowest since 1997. (click to enlarge)
We observe that median income in the US has reached its lowest ebb since 1996; A housing price boom with far fewer owners actually able to afford housing and indeed lower ownership rates would indicate a bubble. Obviously fewer owners implies that rental demand is also higher, though with a lower median wage we have to wonder how much rent the average Joe can afford to pay. This does not explain why the US stock-market is currently reaching record highs however; for that we have a segment below.
Argument 3: US stocks are at record highs, there is less reason to hold a metal that has no returns
Netflix (NFLX) is up 667% in 14 months, Amazon (AMZN) is up 751% in 5 years and TESLA (TSLA) is up 485% this year alone. Yes, the US stock market is at record highs. However, there is one other similarity between the above shares: none of them are turning a justifiable profit! Amazon’s Price to earnings is 1419; it will take 1419 YEARS at current profitability to pay for the cost of a share! No matter how optimistic one is, surely that goes beyond the pale of acceptable rationality. Record highs in the stock market occur as a result of a recovering economy, but one must be cautious in accepting the converse proposition that a record high stock market indicates a recovering economy; much of it may only be optimism, especially with QE pushing speculation in that direction.
Argument 4: Indian demand for gold is down due to new regulations
It is true that demand from India has been reduced significantly, in a mistaken bid to encourage investments in the financial sector, by the new regulations banning gold imports. Being the former largest consumer of gold in the world, this has led to a reduced demand for gold. When taken together with the mistaken bearish sentiment, gold has been sent on a downward spiral that it has only just begun to beat back.
Common arguments for gold:
Argument 1: China
China has more than made up for this reduced demand by becoming the world’s largest consumer of gold. China has purchased record quantities of gold, and it is safe to say that much of this has to do with its intentions of replacing the USD as a world reserve currency.
Thanks to the instability QE/tapering has lent to the markets, China has come out openly calling for a USD alternative, it has reduced its US treasury holdings, it has taken large steps to internationalize the RMB and it is the second most traded currency world-wide, recently surpassing even the Euro. Gold, as it happens, would provide a country with the legitimacy to back its currency should it decide to pursue such a course of action.
China has performed better than expected in terms of exports and GDP growth; as long as this continues, it will continue accumulating gold both to accumulate wealth and to lend support to the RMB.
China does not only support gold by buying it, rather by creating an alternative to the USD (perhaps by creating a currency that does not rely on the world as a crutch, one that maintains value and has unsuppressed treasury yields), it might also be able to persuade other countries to reduce their holdings of USD. With up to 60% of USD held overseas in reserves, this could be a truly devastating outcome.
Argument 2: 1200USD per Ounce is the average cost to mine gold
Just recently we observe that gold had dipped below 1200USD per ounce; this price is certainly unsustainable as miners will begin to shut should the price stay below the cost to produce for too long. As mined supply dwindles down sharply past this point, I believe that it would be difficult for any dip to last very long.
Argument 3: Do as we Say and Not as We Do
Investment banks such as Goldman Sachs have come out calling for 1000USD gold, reducing their forecasts every single time. However it remains one of the largest holders of the SPDR Gold Trust ETF (GLD) together with several other investment banks that are also claiming a US economic recovery.
Argument 4: Interest Is Interesting
Now, all those points I had made regarding the riskiness of US debt comes to a crescendo. Even though QE remains at 85 Billion USD and shall remain at 75 billion for an unknown period of time before reverting, it would seem that the Fed is having trouble keeping treasury yields down; the more treasuries you have on issue, the less effective the subsequent treasury purchase will be. An effect that can be visualized by comparing the impact of spitting into the ocean, as compared to say spitting into your wife’s eye.
Similarly, the impact that additional debt has on the economy can be qualified in the same way; the law of diminishing returns cannot be evaded, so sayeth a wise man: “Compound interest is the eighth wonder of the world. He who understands it, earns it, he who doesn’t, pays it.”
Interest has reached its highest since 2011, passing 3%, and unless more debt is purchased, it is set to rise further. Higher interest when so much downward pressure is being exerted only hints at the kind of country risk buyers are beginning to price into the security.
At Last, The Conclusion. This Article Is Getting Out of Hand
It is easy to lose sight of the above arguments for gold when the market fluctuates wildly. Emotions are tough to restrain, and critics are harder still. If it becomes too difficult, you could always take up a gold bear’s point of view. It’s rather simple in fact, just close your eyes and repeat the following mantra: “gold is just a shiny yellow metal. My only god is QE”.
I continue to be bullish miners (GDX) and juniors (GDXJ) long-term and had added during the spot crash. I would encourage those who are interested to buy reputable companies which are not too heavily leveraged.
