Thursday, December 17, 2009

All that glitters... is GOLD - Alpha

Hypothesis: Gold will rise in dollar-terms as its major competitor currencies, the USD and EUR, are devalued when their governments inflate away the burden of debts but printing more fiat currency.
The boom-bust cycle is early in the boom phase for gold.

Analysis: The US government and Euro bloc countries will be forced to run deficits for the next 3-5 years, both to backstop banking losses (which are roughly 40-60% taken in the US and Euro, according to the IMF, not to mention the unsustainable social program spending that is expected soon. Medicare spending starts inching up in 2012, due to the first retiring boomers, and this will double all total outstanding US debt in 15 years (2012-2027). Until 2015, deficits will be about 12% in the US, and 4-12% in the Euro area (Germany is at 5% expected, Greece at 12% and above). See EU projections.

The only way the governments can meet their deficit spending is by:
i) Raising taxes and cutting spending. Some of this will happen on the margin, but spending is sticky and voters by their behavior prefer inflation to tax raises. Greece is the bellwether country for the PIIGS and European stability (testing the "no bailout" clause in the EMU pact).

ii) Borrowing money from the private sector, by crowding out through high interest rates or forced "gunpoint" borrowing. Note that in the US bank reserves have been held in USTs for the last 12 months - a shadow crowding out where private borrowers can't get money.

iii) By creating money through monetization/printing. The US did $300bn of this in October 2009, as the Fed admitted, and bought over $1,000bn in MBS and ABS.
When inflation worries reached their peak in the 1970s, gold reached an all-time, inflation-adjusted dollar high of about $2,200/oz.

Gold shouldn't be treated as an asset like land, stocks, or bonds. Rather, it’s money. Money has 3 uses: a medium of exchange, a measure of value, and a store of value. Gold will never be as good a medium of exchange as USD and EUR currency and checks (I ignore the Yen and pound because they haven't been major reserve currencies in the last 50 years, and also the yuan as it isn't fully convertible). The transactions costs are too high (it's easy to pay with dollar and euro bills or use your Visa/Mastercard to pay in them). Gold probably won't be as good a measure of value, if inflation is relatively low (under 10% annually), as people can still compare goods and services using USD and EUR "markings." Yet as an arbitrary store of value, gold will do quite well, because it's supply is fixed and slightly declining, while the supply of dollars and euros is exploding.

A decent overview of the many writings on gold is here: "Is Gold a Reasonable Investment"

The World Gold Council puts out an interesting quarterly report on gold, available here: (but beware proponent bias).

Supply Analysis:
The amount of actual resources in the world, loosely measured by "wealth stock" and GDP, stays fixed and grows at a stable rate of 2-5% (world GDP growth, a wide band give my lack of economic forecasting ability). The total amount of the world gold stock has actually come down from Q1 2000 (33.4K tons) to Q1 2009 (29.7K tons). See the attached spreadsheet from the World Gold Council. As a "currency", the supply of gold has decreased. I assume it stays flat in the future, but if it keeps decreasing, all the merrier.

Compare this to the monetary base of the USD and EUR. The Fed's adjusted monetary base has grown from $875bn to $1900 bn (2.2x), and the M1 measure in the Eurozone has grown from Eur. 3.8trn to Eur. 4.5trn (1.2x). Gold, meanwhile, averaged between $600 to $700 an ounce from early 2006 to mid 2007. My key assumption is that gold's "fair price" is its average price before the monetary expansion of $650. Gold's price peaked at in December 2009 at ~$1200. Assuming gold tracks the USD monetary base expansion in 2008 and 2009, it's fair price should be, by a back of the envelope calculation: 2.2*650 = $1430 per ounce. Compared to the euro: 1.2*650 = $780 per ounce. That's a wide range. But just look at the direction. Deficits in both the US and Euro area are unsustainable. My simplistic logic is that if the supply of gold is fixed, its price rise must match the increase in the world's fiat currency system of the USD and EUR. If the US monetary base goes up another 50% from current levels, then I believe gold should be "worth" 1430*1.5 = $2145/oz. Simply put, gold is a horrible asset to hold in normal times, when inflation is low and governments are stable. It's a great (speculative, not investment) asset at macroeconomic turning points, like early in the Great Depression and in the 1970s as the US went off the gold standard and inflated away debts.

US: The entire residential and commercial real estate markets (and hence banking system) is being kept alive by two things, thanks to Bernanke. One, zero interest rates for the big banks, who then subsizide housing and governments while penalizing businesses. Two, massive MBS and CMBS purchases by the Fed, to the tune of $1.3trn (not a typo, that's trillion), which must on face end in March, but will realistically continue and likely be monetized in one way or another. Ever wonder why Bernanke looks so haggard? It's not just the Fed losing its independence - my guess is that he knows he'll have to monetize.

But gold as a percentage of the US monetary base is VERY VERY low (bad paper money is crowding out the good, glitterin' metallic kind - Gresham's law at work):

Euro Area: The Greece situation, where the govt. initially forecasted a 3% deficit and then said, "Hey, we were lying!" and then came up with 12%, shows that the Mediterranean PIGS are untrustworthy. Either the richer countries take on more deficits to bail out the PIGS, or they suffer political blowout and monetary collapse together - an unappealing choice. As much as the direct pressure on Bernanke is high, the pressures on the ECB are only getting hotter. Do you really think the ECB can stop accepting shoddy Greek banks' assets as collateral, triggering a run, or will they have to monetize losses away? My main point is, historical evidence shows gold supply is shrinking, but I conservatively estimate it stays flat. Strong historical evidence suggests government debt goes up by 80% and monetization occurs after the end of such a crisis, esp. when the 2 largest economies in the world are involved (the US and the Euro-area).

Demand Analysis:
Note that in 2008, jewelry demand fell by 245 tons, but bar/coin, retail, and ETF demand went up by 498 tons.

China, the world's biggest reserve holder, needs a safer place to put its safe money. Among hard assets, that's either land, natural resources (metals, oil, etc.) or gold. Consider the Chinese discussion:
"Li Lianzhong, who heads the economic department of the party’s policy research office, said that China should use more of its $1.95 trillion in foreign-exchange reserves to buy energy and natural-resource assets. At a foreign exchange and gold forum, Li said buying land in the United States was a better option for China than buying US Treasury securities. “Should we buy gold or US Treasuries?” Li asked. “The US is printing dollars on a massive scale, and in view of that trend, according to the laws of economics, there is no doubt that the dollar will fall. So gold should be a better choice.” (Jakarta Globe,

Guess what, the Chinese bought almost no US Treasuries in October 2009. Where will China's excess reserve buying go, besides Australian and African mines? Buying American land is politically radioactive, so the most fungible and safe currency-like asset is… gold. It's difficult to say how much of China's excess buying will be offset by fewer Indian jewelry purchases (but the Indian central bank, the RBI, has increased its gold purchases lately). Again, consider China's reserve growth from 600 tons to 1054 tons from 2008 to 2009. Do not expect China to blare in the markets about their current buying.

Finally, consider the smart money, the hedgies. Legendary names such as Paul Tudor Jones of Tudor Investment and David Einhorn, founder of Greenlight Capital have also been enthusiastic. Mr Jones, whose company manages more than $11bn in bonds, equities and commodities, told investors recently that it was time to buy the metal. “I have never been a gold bug,” he wrote, but added: “It is just an asset that, like everything else in life, has its time and place. And now is that time.” John Paulson, another well-known hedge fund manager, has adopted a similar view, telling investors he was concerned about the dollar. “So I looked for another currency in which to denominate my assets. I feel that gold is the best currency.”,s01=1.html

Disconfirming Evidence and Arguments:
-Gold has risen from ~$300 in 2001 when central banks were selling to $1200 today when central banks are buying, a four-fold increase. Anytime any asset rises that much, you have to worry about a bubble.

-Gold yields nothing - it's not a productive asset. Hence it's tough to ever assign a fair value to it, through a DCF analysis, like stocks, bonds, and property. This is the best critique of gold. But then again, dollars and euros sitting in a bank don't yield anything either and it's tough to value them (despite the indecipherable moves of Fx market). Gold technically has a negative yield due to storage costs, unlike cash which banks will graciously hold for you today without charge.

-Historically gold has been highly correlated with oil prices, at about 0.70. If oil falls due to weak global growth or a second collapse, so will gold.

-Gold's day-to-day jewelry demand use, in India, seems to top out at $700 to $800/oz (buying dips significantly above those levels, as people substitute silver and other precious metals). I need to talk to more Indians in the jewelry business to see whether they are re-anchoring expectations to a new price, or substituting other metals and avoiding gold. Since jewelry demand is by far the highest portion of the annual gold demand (about 2/3), higher prices could put a natural dampener on this.

-It's unclear what gold's industrial value substitute $-level is, but here are the uses:

-The best critiques of gold come from the inimitable Professors Buiter and Roubini (but they see it as an asset, not as a currency):

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