Gold rolled over

Gold rolled over

16 Apr 2013

The falling gold price is making the headlines and has reportedly caused a well-known hedge fund manager, John Paulson, to lose $1billion of his clients’ money. Another very smart guy named David Einhorn has also suffered heavy losses on behalf of his investors, according to reports. These men made their names and presumably their fortunes by betting against sub-prime mortgages and the banks that owned them. It is disappointing to see heroic figures such as these getting tripped up like this. I wonder if investors who have a great success begin to believe that they can make something happen through the power of their own genius. Great investing is all about getting the big picture right – but this is very, very difficult and the correct pricing of probability must never be neglected.

Gold bugs often display fanatical tendencies and a fondness for historical destiny (I’m not sure what that is but it looks quite profound so I shoved it in). They seem to incline to the belief that there is a morally correct price for gold (and today’s price always falls short of it) and that not owning gold is an omission that comes close to being a sin. I suppose that the notion of gold as an investment for the righteous derives from its former role as the ultimate reserve currency.

A century ago, nations were supposed to limit their issuance of paper currency to the size of their gold reserves. Notes were theoretically certificates that could be exchanged for gold equal to their face value. This stopped governments from printing money as they wished, which was understandably regarded as irresponsible (sinful, even) but might also have prevented desirable monetary expansion in times of economic hardship.  Keynes wrote in 1924: “In truth, the gold standard is already a barbarous relic.” Yet the world returned to it, frightened by the inflation of the Weimar republic, with the USA running the dollar as the global reserve currency, backed by the contents of Fort Knox.

You may remember that Goldfinger planned to render the contents of Fort Knox radioactive and untouchable for decades, assuming that the United States would be forced to purchase gold on the market (e.g. from Goldfinger) in order to replenish its stocks. This scheme relied on the obligation of the US physically to pay out its gold on demand. It seems to me that the gold could still have been exchanged without actually being shipped (“The third crate on the right is yours. Don’t touch it until it stops glowing”) but, as we know, gold bugs are not always rational. Ron Paul, the Republican V-P candidate last year wants to audit Fort Knox.   “I think it is a possibility,” Paul said when asked if there was truth to rumors that there was actually no gold at Ft. Knox or the New York Fed.(Source: The Hill)

Nixon abandoned the gold standard in 1971 as the costs of the Vietnam war rose and foreign states (take a bow, France)began returning their dollar reserves and asking for the equivalent value in gold. And that was that. The gold standard was over, 32 years ago. Nations that issue their own (fiat) currency have no obvious reason to own gold reserves. Gordon Brown understood that when he flogged the UK’s gold reserves in 1999, even if his execution of the sale was lamentably naïve.

Is it possible to conceive of a return to the gold standard? I have tried and struggled to do so. I suppose that a nuclear war that destroys a significant part of the planet’s resources might generate such international mistrust that some intact nation (Switzerland, for instance, or France, of course) might insist on its own currency or gold in settlement of transactions. But would anyone really want gold in extreme circumstances? Because the absolutely unique quality of gold is that, in comparison to all other commodities, it is practically useless. And normally, practically useless equals practically worthless.

Paper currencies are also intrinsically worthless. Their value rests on their mutual acceptability. The pro-gold argument rests on the assumption that people will accept worthless gold in preference to worthless paper. Good luck with that. When you are living up a mountain surrounded by guns and bars of gold and you need to go and find food, I suggest that you take the gun rather than the gold.

Given that half the world seems to be in shock because the price of gold has fallen below $1400 an ounce, my description of it as “worthless” might seem harsh. It is harsh in as much as you can make jewellery from it, just as you can with silver. Silver trades at less than $24 an ounce (that’s 1.7% of the gold price). So let me go through the ways (if any) in which one might rationally value gold.

In my Investment Rule “Value”, I wrote:

Nothing is cheap per se.  Everything is cheap relative to something else. The simplest “something else” is itself at another time (a comparison naturally much favoured by third rate stock analysts). When the prices of goods are cut, they are cheap compared to how they were before.

So gold is cheaper than it was before. That is a true and truly third rate fact.

You cannot eat gold. You cannot drink it. You cannot live in it. It generates no cash flow. It pays no dividend. Its investment fundamentals are elusive, to say the least. Everyone who owns it needs to sell it to someone else at an equal or higher price. In rude circles that’s known as a bubble or even a Ponzi scheme.

And there’s more. Gold is very resistant to corrosion and degradation. Unlike other commodities, once used it is not gone. Jewellery and even teeth can be recycled. Consequently, the gold mined every year largely adds to the world’s stock of gold. There are now roughly 174,000 tonnes of mined gold in the world. Something like 2,500 tonnes is mined every year and most of this is consumed by the jewellery and dental industries, if the price is not too high. As the price rises, more of it is taken and stored by speculators. Nevertheless, whether it becomes earrings, sovereigns or bars, it continues to add to the world’s stocks.

Sadly, gold mining is a dangerous activity undertaken by poor men in poor countries. As it happens, seventeen men have died in Ghana today, working illegally in a closed gold mine. Perhaps they hadn’t heard about the falling price. In the name of a nearly useless product, one man has lost $1billion and seventeen have lost their lives.

This is an investment blog so I will conclude by saying that the price of gold will have to halve a number of times before it attracts any of my fiat currency.

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