Friday, December 2, 2005

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The gold bug variations

Despite its romantic allure, gold has historically been a pretty lousy investment. Since the invention of interest-bearing assets portfolio diversification, there is very little financial incentive to hold large amounts of gold. The one exception to this rule, however, is when it seems like high inflation is imminent at the same time that everything else in the global political economy going to hell in a handbasket. The last great gold rush -- when it hit $850 in 1980 -- came at a time of double-digit inflation in the U.S., a stagnant global economy, and geopolitical instability.

Gold appears to have risen in value in recent months and years -- is this a sign of the current global political economy crashing and burning? The Economist's opinion page says I should relax:

Nothing swells the breast so much as the thought that you have been proved right at last. After riding high at the start of the 1980s, gold bugs had a miserable couple of decades. The price declined relentlessly, mocking their credo that the security of the financial system ultimately depends upon the yellow metal. Lately, though, the faithful have enjoyed their reward. In the past five years the price of gold has doubled. This week in Asian trading it briefly surpassed $500 a troy ounceóa level last breached in 1987. You can almost feel the bugs' excitement as the message sinks in: gold is back.

This being gold, the resurgence has brought forth all manner of alarming prophecies. The price is an omen of rampant inflation; bonds are doomed; the dollar is about to fall prey to the United States' reckless deficits; the euro will shortly be revealed as a worthless creation of bureaucrats.

The world is an unpredictable place. But, with the possible exception of a fall in the dollar, not much of the above catalogue of doom looks likely; and none of it has much to do with gold's good run. The dull truth is much less bullish for gold. Investors have put money into a wide range of metals, and precious metals' prices, including gold's, have risen with the base. Meanwhile, gold remains fundamentally unattractive. It yields nothing and central banks are sitting on vaultfuls of the stuff that they want eventually to sell. Gold bugs hope that $500 is the threshold at which mainstream investors will start once again to take an interest in the metal. Caveat emptor.

So do I feel better? Yes and no. While the Economist is correct about gold in particular, I'm more concerned about the fact that "investors have put money into a wide range of metals." This could be because China's growing demand for raw materials has driven up the price of all commodities. But it could also be because risk-averse investors have figured out that they can buy something besides gold as a hedge against high inflation and political instability.

I strongly suspect that Chinese economic growth is the primary driver, because U.S. inflation right now is much lower than it was in 1980. On the other hand, a lot more foreigners hold dollars than they did in 1980, and the difficulty of predicting when the dollar will start to fall has me wondering if something else is going on.


posted by Dan on 12.02.05 at 12:26 AM


One of the big mining company executives was on Australian television last weekend talking about the gold price. He mentioned that during the last downturn, not many companies were investing in production and that the lead time can be as much as 10 years. Also, (from memory) he mentioned that demand in India was up 47 per cent from last year. Of course, he's in the business of talking up gold, but there might be something to it.

posted by: Buzz on 12.02.05 at 12:26 AM [permalink]

I found the transcript to the interview. It was Newmont's president, Pierre Lassonde. Here's the relevant bit:

MOORE: What is driving it, in the short term and the long term?

LASSONDE: Right now what is driving it more than anything else is supply demand fundamentals, just pure supply demand. On the supply side what weíve seen is production falling for the last four years, about two percent per year. In fact last year production world wide fill by five percent. The largest decline in thirty nine years. And it is going to continue for at least another couple of years simply because the industry didnít put money back into their ground when the gold price was very low and it is a long cycle so it takes like seven to ten years to recoup that. And then on the other side demand is just surging everywhere.

MOORE: Inflation driven?

LASSONDE: No not necessarily, mostly just pure economic growth and it is driven mostly by Asia, China and India. India for example, the largest gold market in the world demand year over year to June was up forty seven percent. China was up fourteen percent. You know two weeks ago I was in Beijing, I went to visit a jewellery store which is the size of letís say four regular Starbucks, and in that store the annual sales are a hundred million dollars of gold a year. Just one store in Beijing, a hundred million a year and their sales were going up by fifteen to seventeen percent per year.

posted by: Buzz on 12.02.05 at 12:26 AM [permalink]

"gold has historically been a pretty lousy investment"

"Investing in gold" is a contradiction in terms. One speculates in gold, one invests in a gold mine.

There's a very important difference.

posted by: KipEsquire on 12.02.05 at 12:26 AM [permalink]

I trade stocks, commodities & study charts for a living. I can tell you that everything moves in cycles:

- stocks tank when commodities rise
- commodities in general have been outperforming stocks since 1998
with a run up much more lucrative than
even real estate
- It's not just gold - it's all the
metals, sugar, oil etc...

Inflation is low and if you take away the run up in energy prices you really start flirting with deflation. This is pretty amazing given the credit expansion and monetary expansion of the last few years.

If you believe we're in a secular bear market and what we're having now is a cyclical bull (Japan for the last 20yrs has had several cyclical bulls) then you can pretty much bank on:

1) The Dow crashing at least another 40-50%
2) Gold reaching parity in valuation with the Dow

Secular bear markets last between 10-20yrs.

No way the S&P will get past over 1,800 or the Dow will go back over 13,000 until past 2010.

I know this sounds crazy but there is a lot of history in the charts to support this.

posted by: MikeGWS on 12.02.05 at 12:26 AM [permalink]

I don't know much about gold, but I do know that this is one of your better blog post titles.

posted by: tom brandt on 12.02.05 at 12:26 AM [permalink]

Great explanation for someone who sees the green arrows but is otherwise colorblind to what they mean. thanks.

posted by: Chris on 12.02.05 at 12:26 AM [permalink]

The title is also Richard Powers book and an Alan Parson's project song IIRC ...

posted by: Robert Bell on 12.02.05 at 12:26 AM [permalink]

The Newmont comments are insightful. I do seem to remember that approximately 40-50% of all gold production winds up as jewelry. Hence increased jewelry demand in China and India would be a logical explanation.

Also Russia's central bank just announced that it was buying a very large amount of gold reserves.

Hence the increase in gold prices would seem to be driven by consumption and government spending. Not by speculation or investment or hedging against inflation (unless that's Russia's motivation)

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