Sunday, May 19, 2013

What is going on with gold?

Warren Buffett once said that all the World’s physical gold fits in a nice cube sitting on a baseball field and you could buy with that gold 400 million acres of U.S. farmland plus 16 Exxon Mobils with an extra trillion dollars for pocket money. A decade or so later, you’d have still a cube of gold but the farmland and 16 Exxon Mobils would have created a lot of profits over that time not to mention what was done with the pocket money. 

The gold bugs don’t agree with this premise and point to gold’s price performance over the last decade or so. And it is true, I owned a couple of gold coins that I bought in the 1990s for around $280 each and sold them in 2011 for close to $1850 each. So are the gold bugs right and is Mr. Buffett wrong? Well, gold was close to $1000 per ounce in 1982 and it was $280 in the early 1990s. Was Mr. Buffett right and were the Gold Bugs way off base? What are we making of the gold price lately, now that it has ‘crashed’ from $1880 down to around $1400? Does that make Rick Rule and Eric Sprott the biggest losers ever? 

People that make all those predictions about gold demand and supply and quote the ever presence of a conspiracy of the world’s central banks do they even have a clue what they’re talking about?  What happened to the thesis that QE1 through 3 and all of its clones will lead to ever higher inflation and that gold is the only form of protection against it? How come that George Soros has lightened his gold holdings… is he losing the Faith? 

These days, I am a fan of Porter Stansberry and his friends. Porter claims that gold is the only true form of money; one of the few things in the world that are a gauge for true value and the only means of exchange that is truly trusted now that people lose faith in fiat money. Although I am a fan, I have my doubts about Porter’s assumption that gold has an absolute value. Yes, we need a means of exchange otherwise we may fall back to barter – can you imagine mortgages and other financial instruments in a barter based economy?  So we need a means of exchange but does that imply that the value of this means of exchange is unassailable?  Do we really need a currency that is backed up by the world economy? 400 million acres of US farmland and 16 Exon Mobils do not represent the value of the overall world economy – probably not even the value of the entire U.S. economy (but here I am sticking my neck out). If the world economy is not the backing of gold, than what is its value? The cost of mining it?
I think Warren is right. We own assets so that those assets may provide us income and so that they may appreciate when we reinvest profits. You may seriously doubt the inflation statistics of various governments, including that of the U.S., but really I don’t invest just to break even on my net worth, in other words ‘to keep up with inflation’. I invest to grow my net worth in real terms. Gold doesn’t grow it is that simple.  Even if at one time gold may have been equivalent to the value of the entire world economy, over time the value of all that gold will make up an ever smaller portion of that economy.
Yes, Porter is right, as long as people believe that gold has an inherent value, just like fiat money, it is a means of economic exchange. But how do you define the value of the Canadian dollar or the U.S. dollar or of gold? It is a matter of people’s confidence. That is why some go to the extreme of ‘bit coins’ – but what is the difference with something that can be created by a random programmer and fiat money and for that matter gold?  There really is none but trust. In spite of all its debt, the U.S. dollar is still one of the most trusted means of economic exchange.  An IOU backed by the U.S. government is still good enough for most people in the world. No matter how hard the Chinese want to change it.  

You see, the world economy is not backed by money, whether it is gold or the U.S. dollar or the Rimbini for that matter. It is the other way around, these currencies are backed by (some) assets of the world economy and the moment we don’t believe that there is sufficient backing then these currencies will lose their usefulness. The gold currency brand is based on our historical trust in its value. It is, just like the bit coin claims, available in limited quantities and to produce more you’d have to spend a lot of money (if you believe the Barricks of the world). If we didn’t have faith in the U.S. economy’s ability to continue to grow and back the dollar then nobody would invest in its treasury bonds and currency.  

Whether it is fiat currency or gold, its function is just a means to transition from one productive asset into another. Thus, we could even use art or rare cars as a means of economic exchange… Oops that is already the case! Really, the world is about owning assets that produce profits. As long as you just see gold/money as a way to exchange assets such as labor into other assets then we’re fine. My objective as an investor is not to hold cash or gold, but rather to hold profitable assets.  Even food is a profitable asset because it provides me enjoyment and quality of life; it also provides the energy to work more. Some assets expire or are used up and it is your choice as to the asset you want to own and how it benefits for you – instant gratification or future asset growth. The first is called consumption the latter is investment.
So, I am holding cash (gold or fiat currency) to either consume or to buy an investment asset that generates more cash and/or appreciation. As an investor it is not my goal to hold cash and as such inflation, i.e. the purchase power of money is secondary. If you think about it, even gold may experience inflation!  For example, let’s look at an egg. How much effort would it have taken to find or produce an egg in terms of human effort 1000 years ago compared to producing an egg in today’s poultry farms? How much gold would you pay for 1 egg 1000 years ago versus today?  Did gold go up in value or did eggs fall in value? What about a pair of shorts? Really we’re not talking about something of absolute value! We cannot even begin to determine what the absolute value of an item is. What represents the value, the gold or the eggs or the shorts?  Gold and other currencies only hold their value for an instant in time – just long enough to make the exchange of assets possible. It is a bit like hydrogen or electricity. They are just means of transferring energy from one spot to another; they are not in itself energy, yet their price fluctuates. This is a very important distinction. 

During the financial crisis, people did not know what means of economic exchange to trust; neither did people trust that their assets (homes or stocks) would ever be profitable again. But they had to choose some place to ‘store’ their net worth and they choose gold. With gold demand increasing, its rising ‘value’ became a self-fulfilling prophecy and the price of gold visa vie other currencies and visa vie assets exploded. Not because of inflation but rather because of perceived trust in the fact that gold did preserve net worth and with a bit of luck it would even make a SPECULATIVE profit just like Dutch Tulips some centuries ago. Gold nor currencies have an inherent value, their momentary pricing are only an expression of people’s confidence in them as a valid means of exchange. 

 Today, now that the stock market and real estate are perceived as great bargains again, guess what… people simply are abandoning gold. ‘Yes it may preserve capital but really we want profits’ the thinking seems to be. Does that mean inflation is dead? Does that mean gold is no good? No not really, it is only that the average investor is becoming more risk tolerant and has converted his/her currency back into profitable assets. With increased confidence in the viability of stocks and real estate we will likely see gold drop in price compared to other currencies and assets. Of course, corporate profitability may decline if the central banks stop supporting low interest rates. This may also happen when we consume more than the economy is capable of supplying (i.e. inflation) and/or when inflation is further fed by increasing government debt and thus by increasing taxes (to pay for ever higher interest rates).  That is the risk recent stock market investors have chosen to take.

Value does not lie in gold but in profit generating assets whose value fluctuates based on profitability, demand, supply, their obsolescence and usefulness. We just don’t know what the instant value of our ‘means of exchange’ (exchange rate) is going to be and when all is said and done, it are the profit producing assets  you own that determine your capacity to generate continuous cash flow to do everything you want to do in life, i.e. net worth.


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