Posted by Don Martin on Mon, Apr 15, 2013 @ 04:39 PM
Implications of gold’s crash
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In the last two trading days gold has plummeted down 14% from $1,561 to $1,346. Gold stocks have gone down 15.5% in the past two trading days.
My estimate of gold’s value is a range of roughly $800 to $1,200 so roughly $1,000 is gold’s value. When an asset price takes a significant plunge it can temporarily fall below fair value, so gold could go below $1,000.
Gold went up ironically because deflationary forces scared investors into thinking that the government would respond by creating hyperinflation to cure the recession. However, now that the risk of a recession is much smaller then there is no fear of this happening so people are unwilling to overpay for insurance against inflation by buying gold at inflated prices. And the possibility of serious inflation returning is remote because the EU and Japan have serious intractable problems which they have not addresses. If Japan’s attempt to increase the money supply results in creating inflation in Japan then their currency will drop (this is what Japan wants). A drop in the Yen could actually be deflationary for the rest of the world. If the ultimate outcome of Japan’s economic follies is that they default on their debts that will be deflationary for the rest of the world, especially for the U.S. as capital will flee into the U.S. as a safe haven. In addition as the China boom cools down that will ease pricing pressure on commodities causing American speculators to close out their trading positions, thus making commodities go down. The resulting drop in CPI and PPI will encourage more people to get out of gold. Currently the U.S. is the only major country or region that is doing a good job of getting out of the Great Recession that started in 2007, thus as other countries flounder in a Soft Depression their weakness will be transmitted into the U.S. in terms of helping to suppress inflation. Thus gold and other inflation hedges will continue to go down as people realize they are overpriced and dysfunctional. Any investment can be good if bought at the right price and bad if bought at the wrong price. For gold to reflect inflation it would need to be closer to $1,000, so it is overpriced. Now that it has acquired downward momentum its price may continue down until it reaches fair value of $1,000.
Except for the 1970’s the peacetime rate of inflation in the U.S. has remained close to 2%. The 1970’s inflation was in part due to Keynesian inflation nurturing mechanisms installed in the 1930’s that should have been dismantled when the economy recovered from the Great Depression in 1945, but these systems were not turned off. For the past 30 years many anti-inflationary systems have been installed such as globalization of taxation, globalization of workforce, the runaway shop, automation, discount stores, just-in-time manufacturing, internet based sales and shopping, moving workers to independent contractor free agent status, etc. The post 1980 anti-inflationary changes are more significant and dramatic than the pro-inflationary forces installed during the Great Depression. Thus the theme of precious metals investing as a hedge against inflation is a seriously wrong idea. The prices of natural resources have been going down over the last 200 years, on an inflation adjusted basis, which means that natural resources won’t protect investors from inflation. The one exception was the recent decade, which may be a special case in part due to the debt-fueled Chinese construction boom.
Gold’s crash shows that investing in things that have a stable cash flow as the reason their value are much safer and easier to forecast than something like commodities that have only a balance sheet but no P & L.
I have written an article “Gold to go down when inflation returns”
Investors should seek independent financial advice.
Posted by Don Martin on Wed, Mar 13, 2013 @ 02:04 PM
Will Gold Go Down When the Recession Ends?
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Gold’s price will go down as the economy improves. The economy is improving which lessens the need for governments to engage in massive debt fueled stimulus. This means there will be less perceived risk of inflation even though the stereotype of recovery from a recession implies a higher CPI. During a recessionary crisis some investors worry that governments will engage in reckless deficit spending financed by inflationary Central Bank money printing. This fear factor is so great that investors have overpaid for alleged inflation hedges such as Treasury inflation indexed bonds (TIP’s), gold, base metals, stocks. During the coming economic recovery I expect the CPI to go from the mid 1-2% range to the low to mid 2% range. One could assume this increase in inflation would result in gold’s price going up, however, what is baked into the current price of gold was the mistaken assumption of future hyperinflation which won’t occur. As investors realize this they will move towards revaluing gold near a $1,000 target, down from the current $1,588.
During the inflationary 1970’s stocks failed as inflation hedge. Commodities appeared to have done well but that was in part due to the money market yield nature of futures contracts “yield roll” and was not truly an inflation hedge. This occurs when futures contract buyers save on the cost of interest during a period of high rates, so this savings goes to the contract seller (the short position holder) in the form of higher prices. If interest rates had been zero during the 1970’s then commodity futures contracts would have not gone up as much. In addition commodities went up simply because of unpredictable crop failure and a structural change the political nature of OPEC and not because they were intrinsically a good inflation hedge.
Since 2008 Central Banks have increased their purchases of gold bullion and ETF’s have had massive increases in purchases of bullion. The more people bought it on speculation the higher the price went, creating a feedback loop that fooled investors.
Based on gold’s price stabilizing in the early 1980’s at $400 and then adjusting for CPI gold should be roughly $1,000. If one assumes the massive Federal Reserve money printing of recent years is inflationary then of course gold would need to be valued well over $1,000. However, the increase in the money supply is inside of commercial banks that can’t find qualified borrowers. The banks in turn park their excess funds at the Fed so the extra money has merely made a round turn back to where it came from instead of into the hands of consumers who would spend it and create inflation. The extra borrowing by the Federal government and the extra money printing by the Fed merely acted to prevent a depression/deflation and didn’t create inflation.
China bought a huge amount of commodities in the past decade which made some Western investors think that commodities were going up and that they should be used as a hedge against inflation. If China decides that they have overbuilt real estate then they will sell their surplus hoard of commodities, making the price go down.
As Central Banks throughout the world try to devalue against each other and to sell off gold this will create a demand for the dollar. This foreign devaluation will make foreign stock markets go up only to see that in dollar adjusted terms the share prices didn’t really go up. Expect some risk that high quality foreign currencies could weaken against the dollar, although the truly high quality foreign currencies will probably go up along with dollar against the value of the Euro, Pound, and Yen, which could lead China to keep the price of the Renminbei in line with the major competing currencies.
I have written articles “How low will gold go?” and “Gold going down”.
Investors should seek independent financial advice.
Posted by Don Martin on Wed, Feb 20, 2013 @ 02:09 PM
Is gold a good hedge against inflation?
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In 30 years since the stock market bottomed in mid-1982 the Dow has returned roughly 14.5% annualized total return, a California rental house in a mediocre school district (if owned free of debt) total return about 10.7% and gold 4.6%. (I will keep it simple and ignore Realtor commissions and assay fees to sell houses or gold). This doesn’t include taxes, so the tax on annual dividends and rent would make the returns lower since there would be less to reinvest. Also the reinvestment rate is hypothetical since if you get a $1,000 rent check (net of expenses) you can’t buy a house each month with just $1,000.
The figures show that gold is a very poor inflation hedge. It did an extremely bad job from 1984 to 2004, failing to go up despite CPI inflation of about 2 times. During that 20 year period gold was stuck in the $400 range. Gold mines are an even worse way to own gold because they have lots of expenses, with an inflation rate as high as 25% a year to maintain a gold mine while bearing the risk that gold could go down in price.
When oil went to $60 in 1979 it would cost about $180 in today’s dollars, so on an inflation adjusted basis oil has not kept up with the CPI.
Various non-gold bug experts have estimated that gold maybe worth about $780 or $1,000.
As the economy gradually improves and investors forget about the risk of another 2008 market crash then investors assume the Fed won’t create hyperinflation. Then investors withdraw from gold which pays no dividends and get into dividend paying stocks, junk bonds, MLP’s, EM bonds, REIT’s etc. If there is going to be a “Great Rotation” it will be out of the deadweight asset gold and into something that pays a yield, instead of the overhyped news story that bond investors will sell bonds and buy stocks.
If the fair value of gold is $780 to $1000 and it continues down, then it could overshoot its target, going below fair value. A short sale of gold currently at $1,560 (down nearly 3% today) could result in a 50% profit, however, from my risk adverse viewpoint this is too risky for clients as a Black Swan event can make prices move in unintended ways. If you have a 401k at least you should protect the 401k from a gold crash by getting rid of any mutual funds that hold gold mining shares or even companies that mine other things.
Gold has no friends in Wall Street banks or in the Fed. Unlike Bears Stearns and AIG there will be no Fed bailout of gold. In theory Emerging Markets Central banks may want to buy gold and sell dollars but the two countries (Japan and China, which are not really EM countries) that are the greatest risk of being dollar dumpers also have the greatest desire to make the dollar go up. That way their currencies will go down, which is what they want since it will boost exports. The smaller Emerging Markets countries have bad memories of liquidity crisis and don’t want to be in the position of selling gold at fire sale prices during a crisis, so they will continue to own foreign currency issued by the G-7 nations.
I have written an article “Is gold a hedge against inflation?”
Investors should seek independent financial advice.
Posted by Don Martin on Wed, Oct 17, 2012 @ 09:02 AM
What is the fair value of the U.S. dollar and how will it react to inflation?
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The dollar could retouch its highs of 89 on the DXY index. The Eurozone continues unsuccessfully to seek painless solutions to its problems instead of real reforms. The Euro currency will eventually break apart and the Eurozone members will revert to their old currencies. The Yen is risky because the Japanese government’s debt is huge and growing and it has no solution to fix its financial crisis. By default the U.S. dollar is the cleanest shirt in the dirty clothes hamper. Our growing ability to avoid importing oil, gas and coal means that we will send less funds offshore which will help the balance of payments, thus making the dollar do better than the other major nations that need to import hydrocarbons. The very small sized developed countries with strong finances are too small for the world’s gigantic institutional investors to use as a safe haven currency, so as the financial health of japan and the Eurozone continues to decline investors will have no choice to flee to the dollar. This will push up Treasury bond prices and other investment grade bonds, making yields go lower.
What is money?
I don’t view gold as a currency. You have to pay to store it and to sell it. Its price at times when near $1,900 was probably at least 50% over fair value and during 1999 it was almost 50% under fair value at $250. It briefly was about 100% over fair value during the 1980 gold bubble. At that level a naïve buyer could lose a large amount of his wealth and would be better off investing in a basket of global currencies that pay a high enough yield to offset the risk of devaluation and inflation. Gold often goes down during deflationary times and the dollar goes up, so gold doesn’t pass the test of being money.
I wrote an article “Three items you must know about developed country hard currency” and “Is gold fairly priced?”
Investors should seek independent financial advice. 
Posted by Don Martin on Tue, Oct 16, 2012 @ 10:29 AM
What is the fair value of gold and how will it react to inflation?
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For centuries people have used gold as a store of value. It could be considered a form of money since money is a medium of exchange. If someone is stuck in a country with hyperinflation and no right to convert his currency to a foreign currency then they may find owning gold makes sense. But what if the inflation rate is 2% and some fear it could go up to 10% because of all the Federal Reserve’s money printing?
The best estimate is to look at the traumatic inflation of the 1970’s which was the worst period of inflation in the U.S. and the only significant period of peacetime inflation. For 1965 when the U.S. withdrew all the paper money that had the phrase “silver certificate” on it and withdrew all of the silver coins inflation went up rising to 14% in some years until 1981 when finally extreme tightening by the Federal Reserve brought inflation to normal level. During that time consumer prices increases by several hundred percent. Gold went from $35 to roughly $400 and then settled near $400 for nearly 20 years from the early 1980’s until 1999 when it went down. I think it is fair to say that once gold leveled off at $400 in the 1980’s that it was fairly priced then. So using that as a benchmark and applying a 300% increase in the CPI since the early 1980’s implies gold is worth $1,200.
During a period of panic people will overpay for a well known, high quality asset by 50% to 100% beyond fair value. (For a flaky asset like new dotcom stocks they may overpay by a factor of 10 or even 100). So gold could be the object of panicky investors overpaying by 50% to 100% beyond a fair value of $1,200. Thus it could briefly spike to $1,800 or $2,400 and then come down to $1,200 and go even lower as the pendulum swings too far in the opposite direction. During January, 1980 gold briefly reached $880 and then gradually went to $400 as panicky conditions changed to favorable conditions. So it demonstrated an ability to go to 100% of fair value and then return to settle at fair value for two decades.
My concern is that gold investors and TIP’s investors are trying too hard to protect from the risk of serious double digit inflation and are overpaying for protection, just like in the Cold War the U.S. overpaid for military defense against a crumbling Soviet empire.
Inflation if it comes will come from prosperous businesses and consumers borrowing too much and spending the newly created money. This happened in the 1970’s. But weak consumers can’t qualify for a loan and need to pay down debt. Strong corporations don’t need to borrow and banks only lend to creditworthy business borrowers with a documented, wise business plan showing how the business will use the money. So the banks won’t create inflation. Congress could, in several decades, continue to grow the deficit and then order the Federal Reserve to monetize the Federal debt, but that is unlikely if voters put pressure on Congress to avoid extreme deficits.
I doubt that extreme inflation will occur in the next decade, especially with the problems in the Eurozone, Japan and the high unemployment in the U.S. that we have been stuck with for four years with no end in sight.
A better hedge against inflation might be a basket of short term bond where one could roll them over into new, higher yielding notes when they come due. Assuming a repeat of the 1970’s then by buying a new two year note with a new higher coupon to compensate for inflation one could still get a modest real return; by contrast stocks did not go up enough to compensate for inflation in the 1970’s.
I wrote an article “Is gold fairly priced?”
Investors should seek independent financial advice.
Posted by Don Martin on Thu, Dec 29, 2011 @ 07:06 PM
From 2002 to 2008 Central Banks were net sellers of gold. During that time purchases of gold by ETF’s ranged from zero to 150% of the amount sold by Central Banks. From 2002 to 2008 the average yearly ETF’s purchase of gold was about a third of the amount sold by Central Banks. What is remarkable is the huge increase in purchases by ETF’s in 2009 and 2010 occurred when the gold price increased dramatically. In 2011 net purchases by ETF’s were only about 20% of the amount bought by Central Banks and gold’s price increased by 9.3%. The implication is that the huge price increases in 2009-2010 were due to a huge demand by retail speculators who bought gold ETF’s, which in turn implies that the price of gold is a bubble created by naïve speculators who chased the price way above its fundamental value.
Gold fell below its 200 day moving average on Dec.7, 2011. This was the first significant fall below the 200 day moving average since the Lehman crash period when markets plunged in late 2008-early 2009.
The best estimate for fair value of gold is to use its price in the early 1980’s when it spent a long time in the $400 range and then adjust that for inflation which would imply that it is now worth $1,200. However there are other methods of valuing gold that imply the fair value is a range of $700 to $1,000. I don’t buy the theory that because the money supply expanded due to the Fed’s QEI and QEII monetary easing that therefor inflation will increase in direct proportion to the increase in money supply; if that was correct then gold would be worth $2,400. In order for the increased money supply to cause inflation the banks would need to lend out those funds instead of hoard them. Banks usually lend only to well-qualified borrowers and those people usually don’t need a loan. The banks’ hoarded money is not really money since it merely an accounting entry that is parked at the Federal Reserve.
In the future I expect problems with the Euro will be deflationary which will put downward pressure on gold’s price. Also China’s growth rate may moderate resulting in less world economic growth and thus contributing to a less inflationary world, which would imply lower gold prices.
I wrote an article "Is gold fairly priced?"
Investors should seek independent financial advice.
Posted by Don Martin on Tue, Sep 20, 2011 @ 02:23 PM
For FX or gold one must redefine the word “investment”
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Regarding investing anti-dollar devaluation investments such as foreign currency or gold one must redefine the word “investment”. I saw a lecture online last week by Nasim Taleb at Wharton (he wrote Fooled by Randomness) where he said buying an insurance policy, in the form of a Put option, to protect an investment, is not really a cost, it is simply an investment that one must do to protect one’s investments. He is convinced the markets are full of potential statistical outlier severe crashes, so he is bearish about everything and is frequently talking about buying Puts.
My point is that by analogy to what he said is that investing in foreign currency is like what gold bugs say about gold: that it is an insurance policy to protect their assets rather than a way to get rich. Of course the word “insurance” is simply a metaphor because I am not selling insurance, instead I’m trying to recommend ways to reduce investment risk. There is no guarantee that a purchase of foreign currency will insure against a possible crash in the dollar, etc.
My intent in recommending investing in foreign currency (like the gold bugs slogan about gold investing) is that it is (as a metaphor) an insurance policy against the risk of dollar devaluation rather than a traditional investment where the investor seeks to make a windfall profit. When you buy a property or Life insurance policy you “lose” money paying the annual premium. When you buy gold bullion you lose money on the bid-ask spread, and the fees for assay, storage, insurance fees, etc. This is done because the gold investor views it as insurance against catastrophe rather than a traditional wealth building investment.
Open the door to new ideas
Try to have the viewpoint of a citizen of a tiny neutral country
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Consider the viewpoint of a citizen of a tiny neutral country that has no capital markets. He would be objective about the choice between investing in U.S. dollars versus other currencies. If you told him you refused to diversify out of dollars because you did not have an accounting system to recognize when you assets went down because of a dollar devaluation, he would disagree with you and say that you are missing a key investment idea.
Investors in the U.S. should think as if they were a citizen and resident of a tiny neutral country and then pick investment opportunities objectively between the world’s major regions.
It is a good idea to diversify out of the dollar and it is very hard to time the market for foreign currency, especially in regards to short term fluctuations. One of the basic principles of investing is to diversify, in some cases into things some people don't like; also some academic advisers believe it is impossible to forecast the market so they advocate diversifying and holding on even if an asset goes down. I chose some mutual funds because they have less volatility than other funds in that asset class.
What alternatives are there to the dollar? Gold investing makes me nervous; I would rather be in EM currency than gold bullion. Obviously the Euro is going to go down in value, which is why I have avoided it.
Bernanke lent dollars to the ECB last week so they could prop up their system, so that is a form of dollar devaluation. He has a rare two-day meeting starting today. He likes to devalue the dollar and will keep trying. I like to have an investment that is diversified out of the dollar and which is not in Euros.
Use fundamental valuation to make investment decisions
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EM countries have 52% of the world’s GDP and most of the world’s economic growth and far less of the developed world’s debt then EM countries are the future. Most developed countries lack credibility (except Canada, Australia, New Zealand, Scandinavia, Switzerland, Singapore) because they spent the past 66 years after WWII engaging in massive deficit spending and now the accumulated debt has reached critical mass with little hope of a pleasant outcome. A country with high growth, low debt, good demographics, and a tradition of no welfare state deficits is a country that will have a positive long term inflow of funds which will make its currency go up over the long run. Despite the risk that the world’s capital could flee into the perceived safety of the dollar (and thus make other currencies go down) that risk, if it happened would only be a temporary phenomenon that occurs during a recession. Eventually recessions come to an end and then the world will continue to have problems with developed countries' fiscal imprudence contrasted with Emerging Markets' prudent fiscal behavior. This is in regard to currency values and the quality of debt obligations. However, it is still possible for stock markets in EM countries to have bubbles (caused by overpaying for stock) that result in EM stock crashes.
It is time for investors to respect the EM as an alternative to the major develoepd countries rather then viewing the EM area as a tiny, weak banana republic.
One idea is that the countries best able to do Keynesian deficit stimulus are those with the least debt, which are EM countries, so that might make their economies grow and thus make the flow of funds into them positive, thus pushing up EM currency.
The EM countries are like a borrower who is over-qualified for a bank loan. Remember the cliché that the only way to get a loan is be someone who does not need a loan? By contrast, the developed countries are like a prospective borrower who needs a loan because he can’t qualify for a loan (and thus won’t get a loan).
I don't see how the developed world can do an increased Keynesian deficit spending (needed to get out of the recession) with the current excessive level of government debt.
The macroeconomic questions that economists need to research regarding the preceding paragraph are unprecedented.
I have written “Is gold fairly priced?” and “Two things about devaluation to know”.
Investors should seek independent financial advice.
Posted by Don Martin on Fri, Sep 16, 2011 @ 04:06 PM
Regarding gold, during a deflation, it should go down with other metals, and if one uses a 10 year inflation adjusted Shiller-style average of gold centered around the January, 1980 nominal high of $885, then the one year average would be a $612 nominal price and the ten year average between 1975-1985 would be about $325 nominal, which if adjusted for inflation, would be about $893 to $1,680 current dollars as a fair value for gold.
If we add a post WWII 1942-47 inflation of 70% (to show the effect of inflation after WWII price controls were removed, and to make an analogy between that inflation and the possible future inflation needed to inflate the world out of its troubles) then that would imply gold at its peak would be 1.7 times a fair value range of $893 to $1,680 or about $2,200 which is not far from its current level. However, that may be double counting since the marketplace has already priced in a 70% crisis premium then I doubt yet another 70% premium should be added to the price. Looking the difference between the ten year average of 1975-1985 and the one year average of $612 during the 1980 the price temporarily was at an 88% premium, which is an interesting analogy with WWII inflation.
(My ten year average is a crude figure that is not adjusted for each individual year’s inflation in the 1975-1985 period, thus the difference in real terms between the 1980 one year average and the 1975-1985 ten year average is actually smaller.)
Thus I doubt gold could go higher and I worry it could go down 50% from current levels as it did after the January, 1980 peak.
The problem with investing in inflation sensitive assets is that they tend to get over-bought by panicky speculators who over-pay for them, thus alleged inflation hedges are risky and may be overpriced.
Open the secret to valuation
See the 8-27-2011 Barron’s article about gold or the article in the May 9, 2011 Economist magazine.
I have written “What is the proper value of gold?" and "Evaluating gold".
Investors should seek independent financial advice.
Posted by Don Martin on Tue, Aug 09, 2011 @ 01:41 PM
Various metrics show that gold should be worth between $700 to $1,000. The current run-up is a parabolic panic buying move which is impossible to forecast. It is dangerous to do momentum investing in gold at any time because as it gets higher an investor will become emotionally influenced by the price rally and refuse to sell at the top. Then when the correction occurs, the investor will be so in love with his gold that he won’t sell until the parabolic move has collapsed and he has lost all of his gains. It is not safe to buy in this situation. It is like a high altitude mountain climber who becomes confused by altitude sickness and can’t think clearly.
Gold could go to $2,500 if it matches the (inflation adjusted) January, 1980 movement to $880. But the precedent set in 1980 was a once in a generation panic price and is very unreliable benchmark. I don’t feel comfortable assuming that simply because a high water mark existed 30 years ago that therefor it is somehow guaranteed to repeat on an inflation adjusted basis. An event like the 1980 parabolic move happened only once in history before the current run-up so that precedent is not reliable because it is not something that has happened consistently that can be tested statistically.
Investing in gold is a Keynesian beauty contest where you must vote for the winner based on who you suspect others will vote for rather than voting for the person you believe in. This is a very risky momentum trade.
Gary Shilling said he is agnostic about gold because as a deflationist he feels commodities will go down. My opinion is that during a deflationary crash some investors will need to sell assets to pay their debts or buy investments that are on sale, so they will need to sell gold to raise cash.
The other risks of owning gold
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Gold could be outlawed and Congress could enact a windfall profits tax on it. Owning physical gold buried in one’s backyard is very dangerous as criminals have followed people home from coin stores and beat and robbed them of their life’s savings. Gold mining is a very risky, expensive inefficient business and mining shares do not appreciate as well as bullion.
Gold cost money to store; for example a gold ETF might charge 0.4% a year. By contrast a foreign currency bond actually pays some interest.
Gold storage is risky
A devaluation of the dollar against other currencies is unlikely because other countries would immediately retaliate so that there would be no net devaluation.
I have written “Evaluating gold” and “gold mining stocks risky”.
Investors should seek independent financial advice.
Posted by Don Martin on Tue, May 24, 2011 @ 01:59 PM
Does the U.S. government have too much debt?
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An article recently published in the Atlantic Magazine by Daniel Indiviglio said that US government debt priced in gold has not changed since 1971 when the dollar stopped being convertible into gold. In 1971 and today it takes about 800 million troy pounds (there are 12 troy ounces per a troy pound) of gold to pay off the debt.
Of course gold went up from the official price of $35 in 1971 to approximately $1,500 today, an increase of 42.8 times, or 9.43% annualized.
Read my post "U.S. government debt rating cut to negative".
Important: Get more information in my free Special Report about emerging market currency investing.
Investors should seek independent financial advice.