May 2, 2013
Why gold? I do understand why people are bullish on gold, but in the end it’s just a shiny yellow metal. With any other metal, price is dictated by metallurgical value, utility, and the laws of supply and demand. But precious metals such as gold are treated as an alternative currency, driving the price to a level where almost every possible use for it is no longer cost-feasible — it gets priced out of the utility market.
Whenever I ask, ‘Why gold?’ I always get an answer packed with references to ‘thousands of years of history.’ But history in itself does not constitute proof if the premise is false. At one time in history, seashells were used as currency and tulip bulbs cost more than houses. Does that validate their monetary value today?
True, pre- and post-Bretton Woods, the gold standard was used to back national currencies. But that system was still based on the premise that gold is worth something beyond its metallurgical value. Besides, we’ve been off the gold standard for over 40 years and the only reason we went on it was as a means of rebuilding post-World War II.
What a lot of people aren’t aware of is the alternative to the gold standard put forth at Bretton Woods by Ben Graham. Graham is the father of modern financial research, and Warren Buffett’s mentor. Graham suggested useful commodities like steel and wheat, which have real utility, rather than gold, should be used to settle trade imbalances. He went back to the foundation of transactions — the barter system.
People will say this is inconvenient, because you’ve got to send all this wheat and steel halfway across the globe. But is this not what nations do with their surpluses of these commodities? They sell them to other countries — or they just go to waste. Why not trade things with utility?
On this model you can bring in whatever you don’t have, and sell off whatever you have a surplus of. That’s pretty much how trade imbalances are settled these days. If you have too much of something you end up lowering the price and selling it on your national market, which lowers your trade imbalance.
Graham advocated formalizing this structure.
I’m not saying Graham’s approach would have been better than the gold standard, but at least it makes sense from a utility standpoint.
Gold and God
I once heard someone say gold and God are one letter apart and that both require a leap of faith for either to have any value to you.
So why was gold ever valuable? It’s yellow, a rare feature versus other metals, making it sought after for jewelry. And 3,000 years ago it was probably harder to counterfeit coinage made of gold. So are these the reasons we attach so much value to it? I have yet to get someone to provide me with a convincing explanation either way.
Warren Buffett once said something to the effect that gold gets dug out of the ground, melted down, and thrown down another hole. People then get paid to stand around and guard it. On another occasion, Buffett stated the estimated size of the world’s gold reserves was a sixty-seven foot cube valued at over $7-trillion dollars. For $7-trillion dollars you could either have a shiny metal cube or buy 100% of the TSX three times over, all the farmland in the U.S., or eight Exxon Mobils. Which would you choose?
[The gold craze] is a lot like the tech bubble. People were buying companies valued at millions of dollars that hadn’t turned any profit. In the end they had no functional utility. [By the same token,] gold pays neither dividend nor interest, and has little value at the price we inflate it to. All you’re doing is hoping that down the road someone buys the shiny metal for more than you do.
It seems to increase in value in times of inflation, but only in times of inflation. In the last 20 to 30 years it’s gone from $1,000 to $400, and back to $1,000. I don’t recall deflation of 60% in that time. But gold will probably continue to increase. Somehow people think gold is an inflation hedge because it’s pretty and in limited supply.
Som Seif is President & CEO, Claymore Investments, Inc.
Why are you bullish on gold?
With all the uncertainty and risk around the world right now — whether with currencies, government debt, or fiscal and economic policies — gold is an asset the market sees as having a valuable part to play against some of that risk.
That’s why we’re bullish on gold, not because we think gold prices are cheap relative to historical inflated values. What I believe is ultimately driving gold and many of the other stores of value — precious metals like silver, for example — is the fact people are looking for something to store their assets in and to benchmark their values against in the face of uncertainty surrounding the U.S. dollar, the euro and government debts. And demand is outstripping supply dramatically. People who own gold are holding as opposed to selling it, and as a result the new demand that’s coming into the marketplace is driving prices up further.
What do you see as the greatest driver behind higher gold prices?
There’s no single factor driving it — it’s really all the various factors pulled together. The recent announcement by S&P on the U.S. debt is another big one in the overall mix. The market reacted by pushing gold prices higher.
S&P reaffirmed the U.S.’s AAA rating, but they put the U.S. debt on negative watch, since over the last couple of years the U.S. has done nothing to show they’re going to change their fiscal policy and debt stance. Ask anyone whether the U.S. deserves the AAA rating — the reality is that they don’t. They get the AAA rating because their currency is the reserve currency, and they ultimately have the ability to print money and offset their risks.
The euro is another key situation. What’s happening in Europe right now is a major mess that’s going to take a long time to get out of. The European Union will either break up, or you’re going to see more unionization on fiscal and economic policy. Right now they have a common monetary policy, while each country has its own fiscal policy. But you can’t separate fiscal and monetary policies.
When you take on too much debt, you can print money and inflate your way out of it, devaluing your currency. That’s what the U.S. is doing, and that’s what Japan will do. But Europe can’t do that because you’ve got Greece and Spain and other countries that want to do one thing, and other countries that want to do another. The reality is that if Greece and Spain were to solve this they’d have to just print money. But they can’t do that because their currency is the euro, [which is shared by other countries that would stand to lose from such a step].
People normally use currencies as a way to store value. So they buy the U.S. dollar, or the euro or yen — the three major world currencies — as a way of storing their assets when they want to rotate away from risk. Would you put your money in U.S. dollars or the euro right now? The yen is not an attractive asset either, because if Japan ever wants to get out of their current economic mess, they have to devalue their currency to make themselves more competitive on the global scene. So where do you put your money?
You flock to things like gold and silver. It’s a store of value; a real asset that’s priced to effectively be the inverse of what you’re seeing in other areas.
Gold will continue to be attractive for some time. We think it’s going to $2,000 or higher in the next 18 months, and could eventually hit $3,000. It has a long way to go — until that huge mess gets sorted out. As I always say to people, at some point in the future gold will be the biggest short on the marketplace. That won’t happen in the next couple years, but it will at some point.
How should investors approach gold?
You certainly don’t want to do what billionaire Eric Sprott does. He has 80% of his money in gold and silver and [other metals]. If you have $200-million dollars in something else and $800-million in gold, I guess you can take that risk.
But this is the worst thing you could ever do. Investors should put gold at about 5% of the portfolio — nothing more. Unless you’re a speculator, you shouldn’t have much more than that in your exposure. It’s there as a hedge against some of the risks in the marketplace.
People who talk about putting everything in gold will lose all their money. Investors need to be careful with gold — it’s just a piece of the portfolio, just like every other asset class.
Jason Pereira offers another metaphor for the overvaluation of gold.
What’s going on with gold is the concept of social proof, which says if everybody believes it, it must be valid. A perfect example of what’s happening with gold happened in Toronto once during Nuit Blanche, a major arts festival. There was an exhibit on Yonge Street set in a little alcove between two buildings.
It was curtained off, and the title of the exhibit was, “You’ve Got to See This.” There was a massive lineup, and they were only allowing one person behind the curtain every three to five minutes. All that would happen once you got behind the curtain is someone would usher you out the other end. That was it — there was nothing to see.
It was an experiment to see if people would wait around for an hour for absolutely nothing, based on the perception there was something worth seeing. People who went through the curtain and out the other end would come back around to the line and warn everyone the whole thing was a scam. But most of the people in line believed the warnings and complaints were part of the performance, so they kept waiting.
This experiment showed perception wins over reality almost every time. These people were following the lemmings off the cliff. And when it comes to gold, the emperor has no clothes.