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business newsThree Reasons to Avoid the Gold Bubble
By
Charles Sizemore
May 05, 2011 2:15 pm
Gold today is as risky as tech stocks in 1999 and Miami condos in 2005, and the arguments supporting its rise are every bit as flimsy.
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Investors now have a choice: Should they use the recent weakness as an opportunity to buy more gold or, like Soros, should they take their profits and move on to greener pastures?
The bullish case for gold is straightforward. The government is spending money it doesn’t have, and the Fed is doing everything in its power to weaken the dollar. Standard & Poor’s, in a classic case of closing the barn door after the horse has already bolted, added credence to this argument with its decision to lower its outlook on the United States’ AAA credit rating last month.
Still, investors would be wise to avoid gold, even after the recent pullback. Gold today is as risky as tech stocks in 1999 and Miami condos in 2005, and the arguments supporting its rise are every bit as flimsy.
Let’s take a look at some of these arguments and how they stand up to a brief reality check.
1) Gold is an investment -- FALSE: Let’s start with the very basics. Not to sound evasive like a certain ex-president who asked us what the meaning of “is” is, but it is valid to ask: What exactly is an investment?
I would define an investment as an asset that creates value and income over time. Stocks, bonds, investment real estate, farmland, livestock, productive machinery, and private businesses would all qualify. This is in contrast to a speculation, which is a purchase based purely on the hope of selling at a higher price at some point in the future. Ben Graham, the mentor of Warren Buffett and the father of the investment profession as we know it today, had this to say about speculation:
Another alternative is to do whatever everyone else is doing, even though the price of a stock appears high; this is the so-called greater fool theory. This theory is applied on the basis that “I know I am a fool to pay such a high price for a stock but I know that a greater fool will come along and pay me an even higher price.”
Graham was speaking of common stocks, but the same argument could be made about condos to flip, Dutch tulip bulbs, or even baseball cards and Beanie Babies. And it certainly applies to gold. Gold pays no dividends or interest and produces nothing. It’s an inert metal that you have to pay to store and insure. And yes, your ability to profit from it depends on your being able to sell it to someone else at a higher price than what you paid, plus selling commissions and expenses. Is this a bet you’re comfortable making when it has already risen by a factor of four in a matter of years and the trade is looking increasingly crowded?
Speaking of Mr. Buffett, the Oracle of Omaha has had some choice words for the barbarous relic over the years. One of my favorites is an off the cuff remark he made in a recent interview with Ben Stein:
You could take all the gold that's ever been mined, and it would fill a cube 67 feet in each direction. For what that's worth at current gold prices, you could buy all -- not some -- of the farmland in the United States. Plus, you could buy 10 Exxon Mobils, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?
There is nothing wrong with speculating, of course, if you understand the risk. The problem comes when you confuse it with investment.
2) Gold is a Store of Value -- FALSE: There are plenty of gold bugs willing to concede that gold is not an investment, per se, but argue passionately that its purpose is not speculative. Instead, it is a store of value in a world of paper fiat currencies. Unfortunately, the facts simply do not support this view.
Gold is a great store of value -- except when it’s not. Had you become fed up with the inflation of the Jimmy Carter years and moved your savings to gold in 1980, you would have watched your “store of value” fall by 70% in the two decades that followed. And this would have happened during a period of persistent (though falling) inflation. Meanwhile, the raging bull market in gold since 2000 can hardly be considered “stable.” Sure, no one complains if their purchasing power rises. But if your stated purpose in buying gold is its role as a store of value, even volatility to the upside should be unsettling.
For an asset often touted as a “crisis hedge,” gold also performed remarkably poorly during the 2008 meltdown. Gold went into freefall in September and October 2008 after the Lehman Brothers failure knocked the financial world off its axis. Not a very effective insurance policy, in my opinion.
If you are looking for protection from the ravages of inflation -- which, I might add, seems like a benign threat in an environment of debt deleveraging and continued banking sector shrinkage -- consider buying a piece of productive rental real estate. There are plenty of desperate owners who would be happy to exchange their property for some of that “worthless” green paper that so many investors hold in disdain these days. Do a little homework; there are bargains to be had for those willing to look and willing to haggle.
3) Gold is a Contrarian Trade -- FALSE: This claim is almost laughable, but it wasn’t born in a vacuum. Gold bugs have lived on the fringes of the investment world for so long, they have come to view themselves as the perpetual voices in the wilderness, as rebels set against the Wall Street establishment. But today, gold is every bit as mainstream as stocks and bonds. Like the hippies of the 1960s and 70s who shaved off their beards and became the suited yuppies of the 1980s, gold has sold out. It’s now on the front page of Yahoo Finance, for crying out loud.
Every major city in America is littered with “We Buy Gold” billboards, and similar signs plaster the walls of London’s Underground -- in the heart of the capital of world finance.
American retail and institutional interest in gold has surged via exchange-traded funds like the SPDR Gold Trust (GLD), and now Chinese investors are piling into gold via brand-new gold ETFs trading in mainland China. Gold has even wormed its way into the Islamic banking system. The Financial Times recently reported that several of Turkey’s sharia-compliant banks have begun offering gold deposit accounts, exchange traded funds, and even gold-dispensing ATM machines.
Yes, gold’s popularity transcends nationality, religion, and culture. Its price has also moved in virtual lockstep with stocks and other “risk” assets since the bear market bottom of March 2003. A popular investment that moves the same direction as all other risky assets… does this sound like a contrarian investment to you?A true contrarian would view gold’s universal popularity as a warning sign. They might also be concerned by the deterioration of gold’s primary traditional use -- jewelry. The same Financial Times article that mentioned gold’s popularity in Turkey’s Islamic banks also mentioned that Turkey -- the world’s fourth largest market for gold jewelry -- is now a net exporter of gold, as scrap sales have outpaced jewelry purchases. Gold jewelry sales in India -- the world’s largest market for gold jewelry -- have been in decline since 2005, even while the economy continues to grow.
Worldwide, there was a massive shift in the nature of gold demand from 2000 to 2010. During a decade in which luxury goods enjoyed an unprecedented boom, demand for gold jewelry was nearly cut in half. Meanwhile, gold for “investment” rose by a factor of 65 and is now significantly higher than gold for jewelry. It’s worth mentioning that the last time this happened was 1980 -- the years the last gold bubble burst.
I’ll end this with two anecdotal contrarian signs that the end is nigh. Utah’s state congress recently presented the governor with a bill that would make gold legal tender in the state. It was a political stunt, of course. The drafters of the bill know full and well that using gold bullion to buy a cup of coffee or even a car is impractical, but it resonates well with voters. When any asset class has become this politicized, investors might want to keep their distance.
And finally, half a century after its publication, Ayn Rand’s magnum opus Atlas Shrugged finally made it to the silver screen. I admit, the libertarian in me really does like Rand’s work. Her unapologetic defense of capitalism did a lot to shape my own views in my formative years.
But despite Rand’s cult popularity, her work was never considered marketable. It was too radical and too fixated on the arcane details of issues like the role of gold in monetary policy. It is no coincidence that the debut of Atlas comes at a time when gold is at an all-time high.
Bottom line: Gold’s bull run is based on weak arguments that don’t hold up to scrutiny. Investors might want to follow George Soros’s lead and get out while the getting is good. I might suggest they follow Warren Buffett’s advice and move their attention to attractively priced stocks paying reliable dividends.Editor's Note: Read more from Charles Sizemore by checking out The Sizemore Investment Letter.
No positions in stocks mentioned.
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