Why I Was Completely Wrong About Gold

Is gold headed higher or lower? Higher, most likely, as long as the world continues to fall apart in slow motion. But really, who knows?

What has become clear to me -- a former gold skeptic -- is that railing against gold as a purely sentiment-driven, fundamentals-less asset is a technically correct but ultimately meaningless accusation.

And in the sweeping conundrum that has become our financial and investing landscape, that may be one of the best reasons yet to own the barbarous relic.

Oh, how wrong I was
Let's be clear: I've been terribly wrong on gold's direction.

In fact, in mid-2009, I attempted to beat back the gold bugs and inflation fearmongers with what I viewed as a club o' logic.

Expecting a weak economic recovery, I argued that inflation and money velocity wouldn't reach worrisome levels, despite the Federal Reserve's ballooning balance sheet. Nor did I envision failed U.S. Treasury auctions. All told, I expected that gold-hoarding hyperinflationists would soon be shuffling back to their bunkers, mourning the lackluster performance of their shiny yellow totem.

That was June 3, 2009, when the SPDR Gold Shares (NYSE: GLD  ) ETF, a proxy for physical gold, was changing hands at $94.41. Since then, it's climbed roughly 72%.

Yikes. Why did my forecast so badly miss the mark?

It wasn't my economic expectations. U.S. inflation averaged -0.4% in 2009, 1.6% in 2010, and 2.8% for the first half of this year (tame even when accounting for the dubious nature of government numbers). Meanwhile, money velocity, or the rate at which money moves through the economy, first rallied anemically and then stalled well below precrisis levels. Finally, the yield on 30-year Treasuries has come down from 4.45% to just above 3%, signaling strong U.S. dollar demand and scant inflation fear.

So if these usual macro suspects haven't been driving gold higher, what then?

A logical fear
I don't know how many gold fans gradually understood that the Fed's quantitative easing was only half the inflation equation, the other part being increased bank lending, which clearly wasn't in the cards. What I do believe happened is that fear quite rationally shifted to the longer term. This is where I was caught off guard. It's also the precise location where I can board the gold express without fearing that I'm stepping onto the crazy train.  

The issue here is simple. The U.S.' fiscal house isn't something you'd want in your town, never mind on your block. A combination of stimulus spending, structural changes in the job market, loopholes of all variety, and the largest of all elephants in the room -- entitlements -- makes it difficult to envision a future that doesn't involve money printing. And I don't mean goose-the-market, Ben Bernanke-style QE; I'm talking about a bona fide we're-printing-paper-to-meet-our-debts event.

Staring down the barrel of such a future, gold isn't speculative. Rather, it has all the appeal of common sense.

Meanwhile, Europe offers us a preview of our own coming days. Their debt crisis threatens to rock the global financial markets well beyond the drubbing we've seen in recent months. Yet European officials appear capable of no greater assurance than "we're getting ready to get ready to make a plan."

In this environment, it's not difficult to see how and why gold truly has taken the mantle of an alternative currency, free from political and fiscal mismanagement. Sure, one can question the practicality of gold as a currency in today's world, but exactly how practical is the euro looking these days?

What's that, naysayers?
Headlining the detractor's thesis is the observation that gold is worth no more or less than what people feel it is worth. After all, it generates no cash flow, and that means its intrinsic value is somewhere between nonexistent and your second cousin's best guess.

Hey, I won't argue. But how's that so different from any other asset class?

In the case of stocks, what is the price-to-earnings multiple but a reflection of investor sentiment? Yes, equity investors can avow that they're buying a piece of a business, which throws off profits at regular intervals, but does that business deserve to trade at two times, one-and-a-half times, or equal with earnings growth? Valuation, put simply, is not a science. Instead, it is the sum total of human emotion and historically informed guesswork. It can also be the difference between a 50% gain and a 50% loss -- exactly the sort of extreme outcome that the equities-only champions derisively pin on gold.

Ultimately, calling for gold's demise because its price is based on sentiment is tantamount to indicting the entire financial system as a house of cards. Of course, there may be sage wisdom to that observation. Yet insofar as there is, you probably want to own, well, a nugget or two of gold. Even in the darkest of times, we'll be forced to place belief in some financial instrument, and it's unlikely to be chia seeds or alpacas.

Getting golden
So, yes, as long as U.S. and European policymakers dither and the Dow Jones Industrial Average (INDEX: ^DJI) continues to jump hundreds of points in either direction from day to day, I do recommend that you own at least some gold. Now, will the yellow metal remain volatile? Probably. On a major financial swoon, could it initially sell off with stocks as investors raise cash? Yes. But in the long run, these risks may be small compared to the danger of not holding any gold.

As for gaining exposure, Sprott Physical Gold Trust ETV (NYSE: PHYS  ) and Central Fund of Canada (AMEX: CEF  ) are probably your safest bullion-linked bets. There are also compelling reasons to own the miners. On that note, you might take a shine to Goldcorp (NYSE: GG  ) . Regarding the heavyweights, Barrick Gold (NYSE: ABX  ) offers unhedged leverage to a rising gold price. Same goes for Newmont Mining (NYSE: NEM  ) , with the added plus of a gold-price-linked dividend.

However you proceed, remember, gold is a bet on an increased level of crazy in the political and fiscal world. So how much time do you want to waste?

Fool contributor Mike Pienciak continues to believe in certain stocks, and he is fond of both chia seeds and alpacas. He owns shares of Sprott Physical Gold Trust ETV, but he holds no financial interest in any other company mentioned in this article. 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. Try any of our Foolish newsletter services free for 30 days.


Read/Post Comments (12) | Recommend This Article (25)

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 October 20, 2011, at 1:02 PM, Frankydontfailme wrote:

    Excellent level-headed article.

  • Report this Comment On October 20, 2011, at 4:54 PM, richthegeek wrote:

    Well said, Mike. It's the bigger picture - beyond the day to day analysis - that makes one realize that we are on a the cliff's edge. 14T in debt and interest rates near zero. Printing is about the only thing left to do. Congress could, of course, increase taxes and reduce expendatures, but that would be political suicide. We'd be pulling the bottle away from the belligerent drunk. It's much easier to keep the liquor flowing.

    Speaking of which, I raise my glass to ya'.

    Rich

  • Report this Comment On October 20, 2011, at 6:56 PM, Bkeepr100 wrote:

    Another fact to consider in the larger picture is that there is only 1/3 ounce of gold available per person, if it is split equally over the world's population.

    Silver is even less with 1/14 of a troy ounce per person. The uses of silver is far greater than what is mined from the ground, evey year.

    Still pretty rare stuff even after all of the mining done by man, over the eons. The new big mineral discoveries are slowing down, so worldwide production of gold is down due to lower grade ores.

  • Report this Comment On October 20, 2011, at 6:58 PM, Darwood11 wrote:

    Good article. I think the statement "calling for gold's demise because its price is based on sentiment is tantamount to indicting the entire financial system as a house of cards" pretty well sums it up.

    The question of gold, is "what do the buyers think it is worth" which is fundamental to all sentimental or emotional investing.

    Until the US and the Europeans get their collective act together, I suspect gold will continue to attract buyers and that means, increase in value. Gold today reminds me of the NASDAQ in 1999. It just keeps going up, and it will, until the bubble bursts. But as with all investing, when it bursts in not easily predictable, just as determining when the US and Europe will get their respective financial cards in order.

    Disclaimer: 0.5% of my entire investment portfolio is in GLD. However, I do also own HACMX, and a commodities fund.

  • Report this Comment On October 20, 2011, at 7:48 PM, teflon63 wrote:

    Takes me back to the day that Bill Rickenbacker published " Wooden Nickels" . That tome made hundreds of us goldbugs. It's never too late!

  • Report this Comment On October 20, 2011, at 9:49 PM, xetn wrote:

    " own the barbarous relic." What is barbarous about real money? As a matter of fact, the constitution only recognized gold and silver coin. It is only because of "legal tender" laws that we even still have fiat Without legal tender laws, paper would have disappeared long ago, unless fully convertible to gold/silver.

    But the best part of physical metal is there is no counter-party risk. (No one stands between you and the resource.) This is not the case with efts.

  • Report this Comment On October 21, 2011, at 12:19 AM, georacer wrote:

    Two Things:

    1) I think its hard to describe gold as a 'Investment' in the sense that my definition (an of course our definitions may vary) of an 'investment' is an asset that can produce income for me (in the form of a dividend or a company that is growing) while gold would fit the definition of a 'store of value' if it could be exchanged for a relative good or service, essentially a inflation hedge (which it can be argued it is or it is not.)

    2. Please explain why investing in a Gold ETF is better then owning physical bullion?

  • Report this Comment On October 21, 2011, at 9:13 AM, ShawkNixon wrote:

    " the observation that gold is worth no more or less than what people feel it is worth. After all, it generates no cash flow, and that means its intrinsic value is somewhere between nonexistent and your second cousin's best guess"

    --------

    Like a typical broker are trying to compare gold to equities which makes no sense.

    Gold trades like currency. Because It's money. It may not be used as a transactional medium, but its most certainly a store of wealth as all major

    government central banks hold it as a reserve.

    Money is a commodity. All currencies and gold float in value against each other. The euro, dollar, yen, gold etc. are all valued in a similar way.

    You can technically say all currencies are based on intrinsic value, so its value could be between zero and who knows what. But oddly enough gold's value has never been zero. Many paper currencies have gone to zero.

    Generally speaking, currencies tend to be valued based on their debt levels, strength of economy and actions of their central banks. Gold tends to be the reference point. So in stable times it's value is lower. In more volatile/uncertain times, gold becomes more valuable. As you point out, the future when considering debt, entitlements is not good. So people prefer to own gold.

    Gold is not really isn't an inflation hedge. It's a government hedge.

  • Report this Comment On October 21, 2011, at 3:26 PM, davaidesign wrote:

    I can take this "printing money" argument and turn it right around against gold itself. Gold is constantly being dug up and stashed, so basic supply/demand theory dictates that the price of gold would remain stable as long as the demand keeps growing in pace with the growth of supply.

    Currently the demand for gold is growing faster than the supply and the price of gold is rising, but that can't last forever. This is the same concept as the real estate bubble we are still digging ourselves out of.

    Unlike oil or copper, gold supply can only grow (and growth will accelerate in response to the demand we have now). For gold prices to reverse course, we don't even need demand to reverse course, but simply slow down (ring a bell? hint, hint! real estate prices didn't need to fall in order to cause the house of cards to collapse, but needed simply to slow their growth). Once the demand for gold begins slowing down, that growing pile of stashed gold will need to belong to someone.

    However, the need for housing grows with population growth and existing homes getting older and demolished, so housing demand will keep rising over the very long term. The same can't be said of gold, so whether it happens tomorrow or in five years, gold prices will fall. The scary thing is the longer this crazy demand lasts, the bigger the stashed supply will grow, and the harder the fall will be.

    I'll stick with a geographically diversified portfolio of companies who own cash generating assets that I can get my hands on at a cheap valuation. Valuation may not be a science, but that's where margin of safety plays a role for when you whiff.

  • Report this Comment On October 21, 2011, at 8:31 PM, SilverBully wrote:

    'Gold is constantly being dug up and stashed, so basic supply/demand theory dictates that the price of gold would remain stable as long as the demand keeps growing in pace with the growth of supply.'

    Ah, but you are making the case for the gold bugs. The actual amount of gold you refer to is TINY. More importantly, the RATE that gold is mined cannot be artificially increased. More importantly, it will REMAIN tiny. You must think of gold AS MONEY (store of value), not a mechanism to generate cash flow (interest), like a stock dividend or bond yield. Gold is a store of value that cannot be *easily* devalued by ANY government.

    That means one should think of it as:

    1) a means of exchange. (I give you one shilling for a loaf of bread)

    2) a store of value. (I saved $100,000 for retirement)

    Here are some facts, not conjecture, on what gold will do.

    There is approx. 50 million troy ounces of gold mined every year. That sound like a lot until you realize the world produces a cube of gold that is about 4.3 meters (about 14 feet) on each side every year. That's all.

    http://www.howstuffworks.com/question213.htm

    That means the entire amount of gold produced in the last 200 years would fill a building 1/3rd the size of the Washington Monument. Unless you convert the entire human race into mole people, that amount will not change. Sound like gold is gonna devalue yet?

    Now look at the U.S. dollar as a store of value.

    The buck has lost 97% of its spending power since the Federal Reserve was created in 1913. Back then, the dollar was pegged to 1 troy ounce of gold. $20.67 = 1 troy ounce of gold. In 1913, you could buy a fine suit for $20. In 2011, adjusted for inflation, that would come out to $473.73. You can still buy a fine suit for one ounce of gold, but all you could get with $20 is some shorts and a t-shirt at Walmart.

    Fiat currencies always go back to their intrinsic value when they die. Zero. The worth of gold is that human beings ALWAYS assign value to it. You cannot devalue an ounce of gold. It is an insurance policy against fiat monetary debasement and devaluation.

    Ask former citizens of the Wiemar Republic, the U.S.S.R, Zimbabwe, or any country that devalued their currency to default on their debts. If you, as a citizen, had converted your money to gold, you would have kept your savings. If you didn't, you lost everything, no matter how 'rich' you were. THAT is gold's true worth.

  • Report this Comment On October 26, 2011, at 4:12 PM, rfaramir wrote:

    "2. Please explain why investing in a Gold ETF is better then owning physical bullion?"

    It's not 'better' in an absolute sense, but it is 'easier'. That means it is better in the eyes of some who highly value liquidity and aren't concerned about keeping ownership to it if they were to hold it long-term.

    The risks of long-term ownership are at least these: government confiscation of centrally located gold bullion, bank fractional-reserve lending of gold held for the trust fund creating multiple ownership claims on the same bars, and the fact that a GLD share is a paper claim by a company that you 'own' gold but is not actually gold itself.

  • Report this Comment On October 27, 2011, at 3:23 PM, posidn wrote:

    Thanks to those with truly knowledgable facts, but for most of you, it would be helpful if you tried to expand your understanding of humanity and our world. In the rest of the world, gold is the real currency of all mankind, not the dollar, which was useful that way for a while, especially when it was backed by gold. Since that went away, the dollars value has dramatically slipped, just as it has here. You can't buy as much with it as you used to, yet, with gold, you can buy as much, maybe even more, due to the insecurity of all other fiat paper moneys. Gold, silver and bronze have been the standard of value since at least the bronze age, because of their rarety, and because they make a good consistent and solid item to use in the transfer of value. That has never changed. Despite the centuries, even millenia of corrupt and conniving people trying to devalue "money", alter moetary values unfairly, or defraud their fellow man in other schemes, these metals have consistently remained the standard of real value. It isn't about to change just because a few Americans, Europeans or whoever want to make a fast buck in the markets. I'm afraid most of you missed the point from the beginning, including the author of this article. It isn't ours to figure out what gold should be worth, it is worth what it is. Our problem is to figure out how our paper moneyr will stand up against the standard of gold that is understood across all borders and throughout the whole of the world. You build a house of cards, and a strong wind comes along and blows it down, what did you expect? You build a mighty stone fortress that stands the test of time and uncertainty, winds and storms, violence and deceipt, well that's something of real value, like gold! What is it that you don't understand?

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