Gold Isn't the Big Trend

In a December 2009 interview, with gold around $1,150 per ounce, the Bank of Korea's Lee Eung Baek said to Bloomberg:

There's an illusion in gold. We follow the big trend. Gold isn't the trend. Out of more than 200 nations, how many countries have bought bullion? ... [Gold] offers little value.

Since then, the metal has appreciated over 40% against the dollar, and Mr. Lee is no longer responsible for reserve management at the Bank of Korea (in fairness, I don't have any evidence the two are tied). Meanwhile, the central bank's new head of reserve management is singing a different tune, as the bank announced yesterday its first gold purchase since the Asian crisis of 1997 and 1998.

A powerful and long-lasting trend
At 25 tonnes (rough worth: $1.3 billion), the purchase isn't huge for a central bank -- hedge fund Paulson & Co.'s position in the SPDR Gold Shares ETF (NYSE: GLD  ) at the end of March was over three times that size. However, it's indicative of a phenomenon that I highlighted 13 months ago, when I wrote that, "we may be witnessing an important shift in the way central bankers perceive gold, which could become a powerful and long-lasting trend."

In 2009, the "official sector" (banks, sovereign wealth funds, and other government investment vehicles) became a net buyer of gold in for the first time in two decades. Among the buyers that year were Russia, India, and China (the largest manager of foreign exchange reserves in the world). In 2010, European central banks all but halted gold sales, while their counterparts in the emerging markets continued buying the yellow metal.

Goodbye dollar, hello gold!
This year, with Mexico, Russia, and Thailand among gold buyers in the first half, official sector purchases are on target to achieve the largest annual total since 1971, the year in which gold was allowed to float against the dollar.

Is gold attractive here?
With increasing demand from emerging economies that are managing growing pools of reserves, is gold an attractive purchase at these levels? Certainly not, if you're looking for an investment. As I wrote last week, based on a careful analysis of monthly gold prices going back to 1971:

Jeremy Grantham, the chief investment strategist for asset manager GMO and an experienced bubble watcher, defines a bubble as asset prices two standard deviations above the long-term trend (for a normal distribution, that represents roughly the top 2% of values). On that basis, gold is in a bubble in terms of American and Canadian dollars and the South African rand, and is getting close in terms of the Australian dollar.

Even against the Swiss franc -- long considered a safe haven currency -- gold is overpriced by almost 60%.

Anytime you hold an asset that is overpriced, you run the risk of suffering a permanent loss of capital.

For the speculator
Speculating is an entirely different matter. I believe that gold is a bubble, but I also think the bubble hasn't run its course yet. The yellow metal's rise has been pretty orderly to date; there has been no euphoric, frenzied buying that creates a sharp acceleration in prices. During the last gold bubble, the metal rose by two thirds during the first three weeks of January 1980, peaking at an inflation-adjusted price of $2,467.

Spike or stagnation?
I don't know that the current bubble will end with a massive spike in prices followed by a collapse; instead, it could deflate slowly through stagnating prices as inflation catches up. However, given the exceptionally uncertain landscape investors must now navigate and the trend of central bank buying, betting on robust gold price increases looks like a pretty good speculation.

However, let me be clear about my assessment of the risk inherent in buying gold today: I'll define a speculation as an operation in which the adverse outcome could produce a permanent capital loss of at least 50% and stretching until total loss. Gold is a speculation (but if it's any comfort, it'll never produce a total loss). Incidentally, this is also true of silver; shareholders of the iShares Silver Trust (NYSE: SLV  ) are likewise warned.

Better, low-risk options
For investors, I think there are much better options than gold to try to preserve and grow your purchasing power at low risk. Credit Suisse's Global Equity Strategy group took an original approach to the matter and looked for companies with bonds that are cheaper to insure than those of the average G-7 government (measured by credit default swap spreads) and shares with a dividend yield higher than that on government bonds.

Those parameters turn up seven companies in Europe and six in the U.S., including Philip Morris International (NYSE: PM  ) , Pfizer (NYSE: PFE  ) , American Electric Power (NYSE: AEP  ) , Conoco Philips (NYSE: COP  ) , and Merck (NYSE: MRK  ) . Large-cap, high-quality stocks are not as cheap as they have been at various times over the past 18 months, but they should provide an adequate long-term return from these levels.

With gold prices at historic highs, one little-known company is minting a fortune -- find out which is "The Tiny Gold Stock Digging Up Massive Profits."

Fool contributor Alex Dumortier holds no position in any company mentioned. Click here to see his holdings and a short bio. You can follow him on Twitter. The Motley Fool owns shares of Philip Morris International. Motley Fool newsletter services have recommended buying shares of Philip Morris International and Pfizer. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (13) | Recommend This Article (13)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 03, 2011, at 1:45 PM, SN3165 wrote:

    Why do you keep putting up non-sense like this every time gold has a rally?

  • Report this Comment On August 03, 2011, at 2:54 PM, StoneyTerp12 wrote:

    Alex,

    I've read a few of your pieces and tend to agree. The one piece of information, or theory if you will, that I can't quite put together is a catalyst for gold to decrease. It seems like the demand keeps growing. I was hoping you could share some thoughts on the topic. (If you've done so before, I apologize for missing it.)

    Probably the best reason that I can think of that would decrease the price of gold is an increase in the interest rates. However, I don't see that happening in the near term, though I obviously could be wrong.

    Thanks in advance for your thoughts.

  • Report this Comment On August 03, 2011, at 4:06 PM, silverminer wrote:

    Alex,

    Name a stock, and I'll offer up a scenario whereby an "adverse outcome could produce a permanent capital loss of at least 50% and stretching until total loss". By that definition, every equity investment is inherently speculative, since no equity can be deemed completely immune to such an adverse outcome.

    To be sure, you've mentioned some quality defensive large cap stocks that are unlikely to suffer massive permanent losses, but still the line between investment and speculation is inherently an exercise in subjectivity. I personally perceive zero risk of gold losing 50% of its dollar-denominated value anytime over the next several years, while I would not ascribe the same absence of risk to certain select equities in select sectors that are universally viewed as investments rather than speculations.

  • Report this Comment On August 03, 2011, at 4:15 PM, silverminer wrote:

    Also:

    [With gold prices at historic highs, one little-known gold miner is minting a fortune -- find out which is "The Tiny Gold Stock Digging Up Massive Profits."]

    The company in question is not a gold miner, has never produced a single ounce of gold, and therefore has never earned a profit. It's a great investment, to be sure, but it's not a gold miner.

  • Report this Comment On August 03, 2011, at 5:02 PM, TMFAleph1 wrote:

    I agree. As far as I can see, interest rate increases are the most obvious catalyst,

    In this article dated April 29 (http://www.fool.com/investing/general/2011/04/29/gold-is-now..., I wrote that I thought the Fed would raise rates during the second half of 2012. However, the news concerning the U.S. economy has not gotten better since then -- quite the contrary -- and that target keeps running away from us. I think we'd be doing quite well if we witness a rate hike in the first half of 2013.

    The lack of identifiable catalyst is one of the reasons I expect this bubble to continue inflating. As such, if I wanted to speculate on the bursting of the bubble, I wouldn't even look at GLD puts, as the furthest maturity is January 2013.

    NYMEX gold futures, on the other hand, go out to June 2017 (note that the Jun 2017 futures settled at 1874.78 yesterday.) Options on the futures are also available. That gives a speculator nearly six years for a bearish thesis on gold to play out.

    NB: This is not a recommendation, not in any way, shape or form. Simply thinking about some of these scenarios and how to implement a bearish view is an interesting exercise in itself.

    Best,

    Alex Dumortier

  • Report this Comment On August 03, 2011, at 5:11 PM, TMFAleph1 wrote:

    Chris,

    I disagree; if one focuses on predictable, high-quality businesses bought with a margin of safety, the risk of a 50% PERMANENT loss of capital is virtually zero.

    You certainly bear price risk (i.e. volatility) when you own equities, but I don't equate the two. Those who believe in the omniscience of the market may not see a difference.

    Alex Dumortier

  • Report this Comment On August 03, 2011, at 6:30 PM, xetn wrote:

    I realize that TMF is a company that makes it money selling stock investment information. It could hardly be expected that you would want to recommend anything that was not "stock oriented".

    You keep telling us that gold is over priced by this amount or that percent. I am not sure how you come up with these numbers, only to have the "dollar or name your fiat" take a dive against gold. For that is really what the "price" of gold is, at least in part.

    But your friends in Washington DC and other major capitals around the world that can effect huge deficits, while monetizing their debt with monetary digits created with the click of a mouse are the best indicator of the future direction of gold.

    Even the great inflationist in China have been stockpiling gold and even recommend their citizens purchase gold and silver as a hedge against inflation. And lets not leave out the Indians who have held onto to their gold (are actually net importers of gold) for centuries.

    As long as all those governments keep creating new money worth the paper its not printed on, while passing ever more regulations on every aspect of your business and private lives, gold has nothing to fear from gravity.

  • Report this Comment On August 04, 2011, at 8:40 AM, XMFSinchiruna wrote:

    Alex,

    [if one focuses on predictable, high-quality businesses bought with a margin of safety, the risk of a 50% PERMANENT loss of capital is virtually zero.]

    One may have determined RIMM to be a high quality business when the Blackberry was king of the smart-phone world, and others may have reasonably figured they were acquiring a margin of safety by buying RIMM under $50 after its big post-iPhone fall. Will those investors ever retrieve their lost 50%+ of their capital? I don't know. Tech in general is a great example of where the unknowable can come in and change a game in ways no one could have predicted. Apple sure looks like an amazing company today, but hypothetically, what if some genius in a secret R&D lab somewhere were currently putting the final touches on the next generation of superdevice that becomes the proprietary platform for generations to follow? I know it doesn't seem likely at the moment ... purely a hypothetical to point out that -- using your definition -- an investor seldom knows the difference between investment and speculation except in retrospect. One can only decide for oneself which assets or vehicles present the lowest forms of risk of capital loss.

    I have a far better example. Bear Stearns of Lehman Brothers prior to the crisis. No one on Wall Street would for a moment have questioned the suitability of those equities -- or any major financial stocks for that matter -- for low risk investment prior to the crisis. And when does permanent become permanent? I tried to warn some of the people close to me about their equity stakes in Bank of America when the stock traded for $40. Some of those individuals are getting up there in years ... I think those BAC shares represent a permanent loss to them. So you see how an equity that looks like an investment can quickly be flipped around to meet your criteria for speculation once a given scenario plays out?

    And whether capital losses become permanent depends in large part about investment behaviour. One can hardly fault Fools for making some decisions to sell stock during the big panic... decisions that only in retrospect come into view as damaging. I suspect many investors suffered multiple permanent 50% losses on multiple stocks during the panic ... does that mean those investments were speculations for them because they lacked the resolve to wait out the worst selloff of our generation?

    I think your definition of a line between investment and speculation could use some work. As presented above, I find it highly subjective and conditional.

  • Report this Comment On August 04, 2011, at 10:25 AM, wfu01 wrote:

    Gold rally is likely to continue as long as investors keeps looking for safe havens and world Inflation keeps rising and economies slowing.

    Once the major Economies starts stabilizing/growing, I believe Gold and Silver will head south. I think another 2 quarters Gold can maintain the upward march.

    Rest, one never knows about the wave tides in market! But whatever, its gonna be dangerous!

    Stay safe ...

  • Report this Comment On August 04, 2011, at 11:51 AM, TMFAleph1 wrote:

    I didn't define the distinction between speculation and investment, but Ben Graham did in 'The Intelligent Investor.' If you haven't read it before, I highly recommend it.

    Alex Dumortier

  • Report this Comment On August 04, 2011, at 12:12 PM, AvianFlu wrote:

    You said: "the metal has appreciated over 40% against the dollar"

    While technically a true statement, I prefer "the dollar has depreciated 40% against gold"

    Gold isn't changing. The dollar is changing. In general.

  • Report this Comment On August 04, 2011, at 1:17 PM, TMFAleph1 wrote:

    "Gold isn't changing. The dollar is changing. In general."

    Gold is most definitely "changing". All you have to do is look at the real prices series to confirm it.

    Alex Dumortier

  • Report this Comment On August 07, 2011, at 8:21 AM, hank2800 wrote:

    "if I wanted to speculate on the bursting of the bubble",

    Alex, You already did in your April Article,..... 4th quarter, 2012 , significant price drop, eventually calling for $475 or something like that if I remember correctly. I'm not saying put everything into gold, I'll state once again though that a well diversified portfolio has a % of gold or metals like other investments. Why are you and Tim Hanson pushing stocks when your articles are talking about metals. ?? I appreciate your replies on your articles though. Thanks ,You are at least determined.

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