Gold: A Wonderful, Terrible Global Investment

Wednesday, June 9, 2010

Gold has its own Midas touch. It can turn depression and despair into excitement and dreams of wealth. War and terrorism? Gold rises. Inflation and currency devaluation? Buy gold. World economy sinking? Gold is the answer. Fantastic. But wait…

Doesn’t a gold stampede, like with any other commodity or investment, mean overvaluation and risk of a dramatic, loss-producing adjustment when the bad times fade away?

It’s very hard to answer that question because gold’s “intrinsic” value isn’t known. Here are common attempts:

  • Inflation-adjusted economic measures, including prices (flaw: other measures are derived from interrelated economic demand/supply conditions  – gold is not)
  • Inflation-adjusted historical gold prices (flaw: assumes past prices are somehow accurate valuations – past price volatility shows that assumption is invalid)
  • Rules of thumb – e.g., an ounce of gold should equal the cost of a high quality man’s suit (flaw: independent demand/supply factors and technological developments can alter any rule-of-thumb price)

Because gold production far exceeds industrial uses, most of the gold ever mined remains in investment form – coins, bars, jewelry and art. Therefore, to put it crudely, gold is just “stuff” that is long lasting and has a slowly growing supply. The question, then, is how much are people willing to pay for the stuff.

My recommendation

View skeptically (i.e., choose to ignore) any recommendation to buy or sell gold.

We’ve all seen them: The recommendation to buy (or sell) gold that uses straightforward, logical and wise sounding analysis, often accompanied by compelling graphs that “clearly” illustrate the rationale.

The problem is the lack of a true intrinsic value. Without it, trying to analyze gold as an investment is exceedingly difficult. My library has many books about gold, currency and inflation that show history is filled with failed attempts to develop a valuation methodology.

To truly understand gold would take a lifetime of study, a global lifestyle with true empathy for all major cultures, information/insight into the politics of gold-owning and gold-producing countries, knowledge of central bank management everywhere along with all countries’ investor sentiment and potential buy/sell flows.

Those graphs? Gold’s history has too many unique events that caused significant, one-time price movements. On the other hand, gold has had too few long-term price cycles to study. Following decades of price-fixing, there have been only three secular moves: the 1970-1980 uptrend, the 1980-2002 downtrend, and then the 2002-2010 uptrend.

I’ll use a graph to show the problem with using graphs. Below is the price of gold in US dollars, both actual and inflation-adjusted. Look at the sizeable moves up and down; and at how long gold can spend at various levels.

Source: Wikipedia Commons

Example of reading too much into gold’s price action

Here is a recent article that is a good example of a sensible sounding analysis that tries to read too much into gold’s price move: “All Currencies Are Weak Relative to Gold” (, by Scott Grannis [Calafia Beach Pundit], June 7)

Note: This is not to pick on Scott Grannis whose articles are well written. I agree with his concern about inflation being the risk we face, rather than deflation. My disagreement is with the use of gold’s rise to mean anything more than people now are willing to pay more for gold.

Scott’s assumption:

“… gold is still the timeless standard against which to measure currencies as it has been for centuries….”

And his conclusion:

“If all major currencies are losing value relative to gold, that is a good sign that the world’s supply of money exceeds the demand for it, and that is a necessary precursor to rising inflation. We should expect to see inflation rising in just about every country….”

Gold’s volatile price combined with long, secular movements belie the assumption that it is a “timeless standard.” Moreover, the conclusion that gold’s price rise in every currency means inflation is coming ignores the key determinant of past run-ups: investor demand built on both fear and greed. It’s a powerful cycle that can crush anyone trying to make a sound investment decision – or derive an analytical insight.

So… Gold is a durable, valuable and beautiful (even mystical) precious metal. However, as an investment, it lacks the intrinsic value needed to make a sound analysis.

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John Tobey on Seeking Alpha

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June 2010