Tuesday, February 14, 2012

How I Value Gold

Warren Buffett recently expressed again his long held views on gold, that it is an inferior investment since it has no cash flow and one ounce saved in 1500 is still one ounce today.  He continues that its only value is hoping someone else will pay more for it at a later date.  A far more cynical person would say Buffett is attempting to accumulate gold and is hoping his reputation will allow him to buy at a cheaper price.  However I am not that cynical and it is my belief that Buffett in this case is just plain wrong. 

First there are two main ways to speculate on gold.  First is the "physical" market.  This is like buying groceries.  You go to a gold dealer and literally exchange dollars for troy ounces of gold.  Or you can purchase gold contracts at a commodity exchange and holding it through the settlement date, where you will get a physical delivery.  The second way to speculate is the "paper" market.  This is most popularly done through exchange traded funds, which simply mirrors the performance of gold in the futures/spot markets.  Or you can just buy futures contracts like above, but close them out before the settlement date. 

There are also two main types of gold speculators.  The first type has been putting a percentage of his assets in gold ever since he was young.  To him, gold is nothing more than insurance against a period of extreme market volatility where the powers that be lose control of the fiat currency (think 1970s America).  In this instance, Buffett's argument that gold does not do anything is actually a plus.  During times of turmoil where up is down, gold's inertness is a feature, not a bug.  These individuals typically buy their gold in the physical market and perhaps has it accumulated in lock deposit boxes or somewhere around their house.  It should surprise no one that most of these buyers are ultra high net worth individuals who have the most to lose.  For these individuals, Buffett's thoughts do not even apply to them.  They are not buying gold to look for a return on investment (just like you don't buy insurance hoping to cash in later if you get hurt). 

The second type of gold speculator typically believes the dollar is being inflated away into nothing (cue this or this) and has been convinced, especially in the last few years, that gold is a great hedge against ever increasing prices/money supply.  These individuals typically participate in the paper market where much has been written about possible manipulation in the past few years.  The only thing I will say is that perhaps Buffett has a point if he is talking about this group of investors--that there is a more efficient way to make sure inflation does not hurt you.

At end of the day, the beauty of a free market is that it does not matter which mindset is "correct."  If enough people believe it, then it is correct.

This article is technically over.  What follows afterwards is pure conjecture thought up to combat insomnia.

This should prove that an expanding money supply/inflation has little to do with gold.  It did nothing for decades while money supply steadily increased.  What changed in the year 2000?  I would argue that the market is pricing in money printing by central banks.  But here is the rub: the money central banks are printing never touches the private sector; it just sits there(see this), but markets beat to their own drums.  There is a reason great economists/analysts cannot make a dime trading in the markets: it is not about right or wrong; it is about being on the right side of the market and in the right timeframe.  If 90% of market participants believe an increase in central bank balance sheet somehow correlates to higher gold prices, then the market will react that way.  It would be stupid to go the other way and say that the market is wrong.  Yes you will be right, but you will be broke.

Another thing to think about: fiat currency is almost entirely based on perception and trust.  As balance sheet grows, is there a possibility that the powers that be lose their credibility?  I still think the people's productivity is the ultimate decider (no Bush) of a fiat currency's viability.  But I am not entirely confident of the outcome if big chunks of society just stop playing the game.

Sources: St. Louis Fed: Deficits and Inflation (1981)