The Gold Bull Market

There’s plenty of talk around about the gold bull market being over. Mostly from those who also proclaimed it over at $600 an ounce and $800 and $1000.

 

We actually had an email forwarded on from a reader recently which covered much the same ground as always. We thought it might be useful to share the article along with our counters to points made in it so here it is below. Our counter arguments are in red:

Institutional Investors Are Selling Gold [Perhaps a better (although perhaps a bit too long!) title would be: SOME Institutional Investors are selling gold but others are buying along with Central Banks]

The Dynamic Wealth Report
March 14, 2012

by Corey Williams, Editor

I’ve got bad news for gold bugs… gold is in a bubble.

Before you send me a scathing email about why I’m an idiot, let me explain…

You see, I don’t hate gold. I’m just as happy to make money investing in gold as I am in stocks, bonds, or any other asset for that matter.

My only problem with the shiny yellow metal is that it’s difficult to value. [This is the kind of thinking that gets the likes of Warren Buffett in to trouble too. We’d instead say it’s gold you use to value other assets. Gold’s ongoing rise is actually an indicator of a bubble elsewhere – namely in government treasuries/bonds/paper money.]

Really…

How do you value gold?

Sure, it’s nice to look at. But gold doesn’t have many practical uses. And it doesn’t actually produce anything. Its major use is for investment purposes. [About the only use we can think of is just a couple thousand years use as money! History has show gold to function as a unit of account, a medium of exchange and a store of value. This is because money should also be durable, portable, divisible, consistent, intrinsically valuable and (unlike today paper and digital fiat currency) in limited supply to function effectively. Gold is the only medium to satisfy all these criteria (along with silver). And given Central Banks have proven lately to be very bad at this last criteria of restricting supply of fiat money this is probably a chief reason for the many people exchanging paper fiat currency for gold.]

I’ve seen or heard just about every gold valuation theory there is. And I’m sure you’ve heard them all before too…

For instance, there’s a theory that gold prices should keep up with the pace of inflation. This method says if gold hit a high of $850 per ounce in 1980, then it should be worth about $2,000 today based on inflation alone. [Actually gold doesn’t really correlate that well with inflation but it does correlate well with negative real interest rates – that is interest rates after taking inflation into account. See here Golds critical metric: The one indicator to watch
And currently these still remain negative – very low or negative real interest rates are the best reason to own gold because there is no opportunity cost in carrying it. If you can’t receive a return on savings elsewhere, then there is not much downside in holding gold which pays no interest]

The only problem with the theory is the 1980 high is an arbitrary point. Who’s to say that gold was fairly valued when it reached $850 back then? (It wasn’t…)

Other gold valuation theories try to measure gold relative to the stock market or to the number of US Dollars floating around. But those theories don’t stack up either. [Why not? – why isn’t it of value to compare gold to the amount of dollars that exist? Using this method worked pretty well in the 1970’s. By 1980 the US dollars in existence were actually over 100% backed by gold at that price – that was a good signal to get out of gold. So that would seem like a pretty useful way to evaluate the price of gold. By comparison the US dollar is less than 20% backed by gold at present.]

The reality is the value of gold versus inflation, stocks, and dollars has fluctuated wildly over different time frames. [Yes indeed it has but it has, but as we already mentioned above gold is actually an indicator of what is going on elsewhere. Plus it seems likely that it’s price is “managed” by central banks so a bit of volatility is a good way to deter people from holding any]

In other words, when you get right down to it, gold has very little value. The only reason gold investors are willing to buy it is because they hope to sell it to someone else at a higher price later.[This is just what warren buffet said recently – the greater fool theory. We’d instead comment that many people are holding gold including ourselves, not hoping to sell it to somebody else, but rather to protect our savings from the ongoing devaluation they’ve suffered at the hands of the central banks of the world.]

But here’s the thing… Gold’s still a commodity. [Although interestingly it trades on the currency desks of banks not on the commodity desks – I wonder why that is?] It’s subject to the laws of supply and demand.

Here’s where things start to get scary…

Gold miners are constantly supplying more gold. [And Central banks don’t supply more paper money to the money supply each year?!!!] In 2010, mines produced 2,689 tons of gold. At the current price of gold, that’s about $160 billion of new supply that must be absorbed just to maintain the current price.

Who’s going to buy all that gold?

Needless to say, it’s a combination of investor and central bank buying that has helped boost gold to its recent highs.

Investors of all shapes and sizes have plowed boatloads of money into ETFs like the SPDR Gold Trust (GLD). In fact, ETFs backed by physical gold recently reached a record high of 2,356 tons.

But here’s the thing…

It’s not the smart money buying gold. A laundry list of the biggest gold investors spent the second half of 2011 selling gold. According to Bloomberg, hedge-fund holdings in GLD fell $660 million last quarter.

John Paulson, who manages a $23 billion fund, slashed his GLD holdings by more than 15% in the fourth quarter. All in all, his GLD holdings shrank by more than 45% in the second half of the year. And the list goes on and on… [What list? Who are they? This article actually shows Paulson was adding to his holdings of Gold Mining companies in the fourth Quarter and reports that “The fourth quarter proved that Paulson is in fact still enthusiastic about gold. “By the time inflation becomes evident, gold will probably have moved, which implies that now is the time to build a position in gold,” Paulson said in a letter to investors obtained by Bloomberg.” And this article actually reports that other Institutional Investors like PIMCO and George Soros have increased their gold holdings and that Paulson selling was likely driven by client redemptions. While the article does report some hedge funds selling GLD it points out that some of these have done so in order to own gold bars in allocated accounts instead (a wise move we’d say to avoid the counterparty risk in GLD).]

This is clear evidence the smart money is cashing in as the dumb money jumps on the gold bandwagon. [As above it might rather be a case of the smart money swapping GLD for other forms of gold and in fact other smart money is getting on the wagon too].

Now, gold bulls might point out the smart money sales were offset by an uptick in central bank purchases. In fact, the final figures are expected to show gold purchases by central banks hit 450 tons in 2011.

But according to the World Gold Council, this is the first year in a “generation” that central banks as a whole have added to their gold reserves.

That doesn’t sound good to me…

A one off gold buying binge that happens once every generation isn’t something gold investors should count on repeating this year. [Time will tell – we don’t believe this will be a one off binge but rather an onoing steady accumulation]

In fact, central banks are much more likely to resume selling gold in 2012. [Why? – no reason given. Seems to us they might be continuing to buy because they see a potential return of gold in the global monetary system and they know that whoever holds the gold makes the rules.]

No question about it, the price of gold is on shaky ground. It’s time for prudent investors to jump off the gold bandwagon before the bubble bursts.

The smart money is already cashing in their gold. Don’t get caught holding the bag when the price of gold comes crashing down. [But what do you swap it for? Interest rates aren’t rising yet and as we mention above it is the “real” interest rate that matters. Holding cash for zero or even negative returns seems like a pretty high risk to us. Until that changes we don’t see a better alternative for at least a portion of our wealth and so we’ll continue to accumulate and hold].

Good Investing,

Corey Williams

So we don’t believe gold is in a bubble and is quite some way off it yet.  This old article of ours offers more indicators to keep an eye on for determining golds bubbliciousness.  When will you know it’s time to sell gold?