I wrote before that gold is a a poor inflation hedge. The myth has its origins in a big run up in the 80s that had as much to do with wild speculators cornering the precious metals markets as with a knee-jerk reaction to two continuous years of double digit inflation rates.
With gold hitting new “all time highs” it is time, again, to revisit how high gold actually is. The following chart shows gold yearly average prices since 1969 in an imaginary currency that adjusts only following yearly official inflation rates. The currency is based on the price of Borodium, and it uses base 1-1969, that is, it measures the prices of gold adjusted for inflation starting in 1969.
As you can see, the 1980 peak was B$ 4377, and the 2007 average was just B$ 2014. That should provide enough fodder for gold bulls to argue that gold is “cheap”. Regardless of the absurdity of valuating any good by the price in the past, that may become a convincing argument to feed an speculative frenzy.
If gold were to reach previous highs, the next yearly high average should be at $2196 in 2007 US dollars. Depending on how long it takes gold to reach that, the price could be much higher. I expect these arguments to start percolating into mainstream media (right now is mostly gold permabulls who make the argument), and stories about fortunes made in gold starting to circulate in cocktail parties.
Since the myth of the relationship between gold and inflation seems to be prevalent and the current and future administration policies will be highly inflationary, it is reasonable to think that a bubble may form around gold. The difference between a normal rise of the price of any good and a mania, is that during manias a number of illusory assumptions reinforce themselves until there is a sense of inevitability to increase of prices of the manic good.
As I said yesterday, gold may lend itself to become the instrument of such mania mainly for these reasons:
- It is relatively easy to become a “gold expert”
- It is massively available
- We all can have the illusion we understand it
- Most of us have some of it
- It has a strong emotional history from where to drive examples to reinforce the mania
- It is easy to trade
- It has prestige
- Buying it and holding it produces instant gratification
- It has some utilitarian value
- Who does not like bling!
Based on that, expect a lot of people starting to talk about $2200 gold and beyond. Again, the arguments will be that
- By “historical measures” gold is cheap (of course they will ignore the fact that they are talking about a 1 year manic high)
- Gold is real money
- Since gold is real money, it is an inflation hedge
The strongest rational argument against such scenario is that if gold were to keep rising to reach those levels (we are talking about more than 200% from today’s prices), the current global economy would collapse in a global depression. To understand this you need to understand that the current global economy runs on slave labor from China and other 3rd World countries.
If the prices of commodities were to keep rising at these levels, the price of labor in those countries should rise accordingly, and added to the increase in the price of goods, it would create an increase in the price of final goods that would stop exporting deflation (as it does today) and it would start exporting inflation to an already overheated inflationary economy. In that scenario, you would not be able to buy at Walt Mart if you are a Walt Mart employee, and the economy will screech to a halt with high levels of unemployment, which would create a over production crisis in the manufacturing countries, which would make it necessary to destroy a large chunk of the means of production. And that would be just the beginning of it. If that were to happen, you would end up with an excess of gold at high prices.
However, if gold does become the object of the next bubble, rational arguments will be laughed at.
Do you want in?
Before even thinking about playing a possible gold bubble remember that the most important aspects of investment are market timing and money management. If you are going to to “all in” most probably you will end all out of money. Think on the real estate speculators who went all in in the past 4 years. They are now licking their wounds or bankrupt.
That said, I am all against buying bullion or gold coins to play a gold bubble. If you doubt me, think that had you bought gold coins in 1980 you would have today a bunch of shiny pieces of metal worth half of what you paid 27 years ago. Bullion and coins carry high commission charges and are less liquid than paper instruments. There are some electronic forms of gold bullion, but that defeats completely the purpose of buying a good.
However there are many relative safe ways the middling classes can participate if gold were to become the object of the next bubble.
The safest of all, is trading streetTRACKS Gold Shares (GLD). According to their description, the investment seeks to strive to reflect the performance of the price of gold bullion, less the Trust’s expenses. It trades at approximately 1 tenth of the price of gold, so you will need 10 shares to invest the equivalent of 1 oz of gold. This is a highly liquid instrument that can be traded in almost every type of account. I prefer this type of instruments over bullion because you can benefit of the short term moves without having to worry about storage costs, high commissions and the risk of having a material good that you need to actually sell in order to realize any profits.
The risk of trading these instruments (besides those inherent to the market fluctuations) are that, were we to suffer some kind of cataclysmic financial collapse, you would end up with a bunch of worthless paper. Since cataclysmic financial collapses are much less common than market price fluctuations, I still think that they represent less risk than buying bullion.
In the more speculative side of things, you can try trading mining stocks. The mining stocks right now are lagging behind the gold move. Bulls will argue that for that reason they are cheap, bears will argue that for some reason companies are not purchasing their own stock and large speculators are not moving the prices higher.
If you decide to dibble into mining stocks, you should know that there are essentially three groups of mining stocks, American, Canadian, and South African. Whenever you buy Canadian or South African mining stocks you are making a double bet: that the company is going to benefit from higher gold prices and that the Canadian Dollar and Rand will rise against the US Dollar. Another problem with mining stocks, is that you need to know how the companies are hedged (if they sold most of their future production at today’s prices, you will not see the stock price following the price of gold). So you will need to bet that gold prices are going up, that the Canadian Dollar and the Rand are going up and research the hedging situation of the company whose stock you are going to buy.
Most of the mining stocks trade options as well (GLD does not have options yet), and more seasoned traders may want to play the gold rush (if it happens!) with options or gold futures. Of course you must know that leveraged instruments present higher risk than non-leveraged instruments.
As usual, do not jump into any important financial decision without researching the risks and if any given instrument is right for you.
Franklin @ January 11, 2008