The arrogance of investing in gold

Don't let the sparkle throw you off your game.

By Motley Fool Pick of the Day Jul 26, 2011 2:23PM

By Alex Pape

 

Gold is a hot topic among investors these days. Some are arguing that the gold run is just getting started. Others argue that we are in a gold bubble that is poised to pop. Still others maintain that gold is a store of value -- a way to protect their wealth. I don't agree with any of these arguments, but I will put forth one of my own: Having a strong conviction about future gold prices is arrogant.

 

What exactly are you analyzing?
However dazzling, gold comes up short when it comes to:

  1. Cash flow analysis (no cash flows).
  2. Any kind of practical fundamental analysis (there are no bottom-up fundamentals).
  3. Any realistic absolute valuation technique.

What we do have is economic data about gold. The data tell us that total 2010 demand for gold amounted to 3,812 tonnes. On the supply side, mines pumped out 2,543 tonnes of gold in 2010. Adding in "recycled" gold (think Aunt Betty trading in her gold trinkets) coming back into circulation, the total supply entering the market last year was about 3,900 tonnes.

 

Demand of 3,812 tonnes, supply of 3,900 tonnes ... sounds like market equilibrium! Not exactly.

 

The real numbers
Those supply and demand numbers are annual figures. Unlike most commodities, very little gold is actually consumed each year (a fact that may preclude gold from being called a commodity). In other words, supply is in a sort of perpetual long run while demand, well, isn't.

 

World total supply of gold is currently about 162,000 tonnes. Mining output adds just 1%-2% to this supply. To put in context how little that is, consider this: If you were to buy all the gold that traded on the London bullion exchange on an average day, you could purchase an entire year's worth of new gold supply in just four days.

 

Pure industrial demand -- demand for gold that will actually be consumed in some value-creating activity -- accounts for just one-quarter of 1% of supply. That's essentially a rounding error, and it means three things: (1) gold can't be analyzed based on demand for it in business operations; (2) demand needs to increase about 1%-2% annually just to maintain gold prices; and, most importantly, (3) gold prices change based on investor sentiment, not the underlying industrial value of gold. This last point is key. If you are going to have an opinion on gold, you had better know who owns and trades it.

 

Where did all the gold go?
If there are 162,000 tonnes of gold out there, and just 420 tonnes or so are consumed each year, the obvious question is, "Who owns all that gold?" Let's divide the owners into three groups.

  1. Central banks. Central banks collectively hold about 30,000 tonnes of gold, accounting for 18% of supply. There seems to be a misconception that central banks have been aggressively acquiring more gold -- in fact, their sales and purchases just about broke even last year.
  2. Exchange-traded funds. Gold ETFs own surprisingly little actual gold. The largest, SPDR Gold Trust (GLD), holds only 1,213 tonnes, or just 0.7% of supply. Other ETFs, such as the iShares Gold Trust (IAU), own even less.
  3. Everybody else. After subtracting gold held by central banks and ETFs, we still have 80%, or about 130,000 tonnes, left to account for. The two remaining groups are institutional investors and retail investors. It's next to impossible to determine the split between these two, but it seems safe to say that a ton (pun somewhat intended) of gold is held by retail investors. This scares me, and it should scare you.

What's so scary?
All investors can be victims of their emotions, but none suffer worse than the average retail investor. Fund flow data from mutual funds show that investors routinely buy high and sell low, riding alternatively waves of emotion-driven greed and fear at precisely the wrong times.

 

Why does this make gold scary? Benjamin Graham, Warren Buffett's mentor, said that the market is a voting machine in the short term, but a weighing machine in the long term. What he means is that, in the short term, stock prices are influenced by emotions and popularity, but in the long term, the market will price stocks based on their fundamental value. Well, what happens when the asset not only has no fundamental value, but is primarily owned by the most emotional of investors?

 

Fear -- of inflation, depreciating currency, political unrest, economic stagnation, or recession -- is a primary driver of retail-level investment in gold. Combine that with the notoriously emotional, fear-and-greed-driven investments these investors make, and one thing is clear: If you are going to reach a conclusion about gold, that conclusion had better be based, at least in part, on your perception of the general investing community's perception of fear-inspiring macroeconomic variables. And if you think you have an edge at reading fuzzy macroeconomic data over millions of worldwide investors, you are undeniably arrogant.

 

Good luck with that.

 

Neither Alex nor The Motley Fool owns shares in any company mentioned. Try any of our Foolish newsletter services free for 30 days. 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.

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27Comments
Jul 26, 2011 4:41PM
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Normally, I like the contrarian view of the Motley Fool. But Motley is the Fool in this post. The Euro zone, the dollar and the yen are racing to the bottom to maintain their trade competitiveness. Gold is the proxy for the only stable currency on earth.

The fundamental fact is that the gold bubble will burst as soon as the governments around the globe start living within their means. Anyone seeing that occurring anytime soon?

Jul 26, 2011 7:03PM
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@cookie,

 

What made gold a store of value? After the barter system became outdated Man needed a new system, after all, not all things can be bartered for equally. Gold was first used as a store of value more than 3000 years ago. Man needed a system where they could trade not only goods but services. They needed something that could not be made (unlike dollars) it has a uniform weight and measure for value (unlike diamonds) it is rare and can not be found everywhere (unlike rocks), it could not corrode, or perish (unlike food). Gold was also easily worked and could be divisible in smaller amounts. Gold was the creation of money. Our consitution expresses that the only thing acceptable for a debt is gold. The US was tied to gold for almost 200 years, "the Gold Standard". After leavinfg this we actually created a dollar bubble. Priced in Gold a median priced house in 1970 is about what it is today. The dollar and all the world currencies are fiat, and "new" compared to that of gold.when you have as much history as gold, as a way to buy and sell, then you have a value recognized the world over. See what trying to buy anything in India with dollars will get you. Even poor merchants in third world countries have stopped accepting US dollars, but gold is universal. Golds value is not rising, it's value is the same as it always was, but the US dollar (and all fiat currencies)  are falling. Until you understand this you will be in a world of hurt when the US economy comes crashing down and you are stuck in Weimar American using you US dollars as fuel for your fires. The question you should be asking yourself is who gave the dollar a store of value, once it was no longer backed by gold, what value does it have? The full faith and credit of The United States? We don't even own our own bills, it is privatized, the Fed owns it! And what faith, has either the government or the FED shown us lately. If you want to hold cash then let me print up some IOU's on my full faith and credit while I buy your gold and silver with useless pieces of paper! 

 

Arrogant Thinker

Jul 26, 2011 6:00PM
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Wow, it looks like this guy is working for the banks who so hardily believe in their own way of destroying the world economy.  The only reason that gold is so high now is that it takes that many more of the defunct dollars and euros to buy an ounce.  I love how the market wants to talk about how the dollar or euro will recover - against what - each other.  How ridiculous this article is when it is really missing the only point - the dollar and euro are on the down hill slide against each other.  In fact if he was truly honest about his reporting he would talk of all the devaluation of gold and silver with all the fake paper that is traded on PMs.  Gold and silver have always been money and always will be - except by  the banksters and all their criminal elite.  Ever give the thought that the bailouts are just there to grab the resources of these countries.  I mean if you want to stretch it a bit - how much paper money is really out there - hidden away in all those nook and crannies-  we really don't know!  What gives it such value - just a belief in it is all!  Just like gold is it not!!  The fact is that gold and silver will always have some sort of value and  they will always be a bet against inflation and a possible exchange for eating and living.  Heck paper money(fiat)  is just made out of thin air - a few bit of resources etc.  Gold and silver still take real capital to get it out of the earth and in reality just as we are finding out about oil - there is a limit to how much can be had.  Gold and silver have an intrinsic value because of that fact - human capital.  The guy that said something of only having so much gold around and 200 trillion of dollars in the world economy - do you really think that the economy is valued that much - it is just a bunch of digital ones and zeros that were made up in bank ledgers  etc.  there is no way there is that much cash out there.  That is why it is called a fractional banking system -  have one dollar of cash against millions of dollars in loans.  Quit listening to these bankers and start listening to the "gold bugs"  they truly know what is going to be coming down the pipe here real soon.   Did you know that the TARP bailout that most of the funds went to the banks and that amount could of amounted to about $450,000 per American tax payer.  I don't know about you but that could of allowed the starting of great businesses or getting free of these toxic house loans.  Go figure. 
Jul 26, 2011 5:31PM
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On the one hand, the author is accursing people (who have some opinion about gold price) arrogant because no one should be able to read "fuzzy macroeconomic data over millions of worldwide investors". On the other hand, he feels that gold price scares him because it is driven by millions of worldwide investors. So, he must be able to read those fuzzy data better and therefore justified in his fear.

 

I am not hardcore gold bug, but so far, I still haven't really heard a convincing deep argument against gold from any of the "experts" or writers. The most important factor for the appreciation of gold price is a fundamental distrust of the government, especially the federal reserve to be the guardian of the value of  paper money. This is simply never fully understood by all these writers. (e.g. look at how this author cites the "Fear - of inflation, depreciating  currency ..." in passing,  without fully understanding the the cause of the fear). And this lack of trust is not going away anytime soon, and more likely to deepen for decades to come, in view of the unsustainable debt and unfunded liability of major nations.

Jul 27, 2011 12:10AM
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Um, in 1973 if i bought my home in gold, 30k at $65.00 and oz, it would have taken 461 oz of gold to buy.

in 2011 if i bought my home in gold , present value 350k , 1650.00 an oz, i would only need 212 oz of gold.

it takes less gold now to buy the same product. that means it has increased over 100%.

or did i loose 50% on my home??? or 200% in dollars, you tell me why gold is bad again?

 

 

Jul 26, 2011 7:00PM
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Ekonoman:

 

I'm referring to the "everybody else" category - the funds not held in ETFs. Basically I mean individuals holding physical gold.

 

Historically, there have been many instances where currency has collapsed, thus rendering the fundamental value to zero. To my knowledge there has never been a circumstance where gold was worth zero. There are many who still believe that we should be on a "gold standard".

Jul 26, 2011 6:31PM
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The author suggests that gold "has no fundamental value."  Let us look at 5000 years of data from the Egyptian empire to the Greek, Roman, Spanish, British, and on and on.  Gold has had significant value and was used as money throughout.  Try to look at the "Big Picture" please.
Jul 26, 2011 6:17PM
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Gold will go down and gold will go up, that for sure. Everyone should have a portion of their portfolio (what % they feel comfortable with) in gold, as gold will always be valuable therefor exchangeable.
Jul 26, 2011 5:33PM
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Bottom line you better just ask yourself a question: do you believe in this economy or not? if you don't then get the hell out of the market and buy gold and silver, and maybe raw land----I would not listen to a stock broker---they were ignorant and lied in 2008 and why should they be different now-----the debt is massive and out of control, and serves the bankers----if you are not a sophisticated investor i say get out, and get your gold and silver----or you can listen to MSN and your stock broker
Jul 27, 2011 9:10AM
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I don't understand why it is so difficult for people to get their minds wrapped around this gold thing.  Gold is a currency. It has been the premier currency for thousands of years because of its natural features...easily recognizable, easily divisible, easily portable, its durable, fake or counterfeit gold is easily detectable, etc. and etc. Conversion rates will fluctuate just like any other currency.  Smart people will take notice when their government is purposely devaluing the national currency and diversify some of their savings into other currencies. But, what if all nations are devaluing their currencies at the same time to try and prop up their exports and economies? Like the present, people turn to gold to protect their purchasing power.

Throughout history, bankers have stolen peoples wealth by issuing paper currency without enough assets to back all the currency issued. This creates "wealth from nothing" that benefits the bankers and their friends who get to "spend" the currency first.  As it flows through the economy, natural law takes over and the more paper money chasing the same or fewer goods causes its value  to fall. Ideally for the bankers, this process is slow enough that the common man will accept  it as normal. History shows us that the banker's lust for wealth and power is insatiable, and eventually  the common man's paper compensation for his labors will not sustain him.   

 In the end, the common man wont accept the paper for his labor and he'll even try to convert his paper into real assets only to find that the bankers who own all the real assets wont accept the paper as payment.

 

Jul 26, 2011 7:13PM
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The real fault in this guys logic is it says absolutely zip about demand for jewelry, which is the biggest use for gold. Jewelry isn't quite the liquid asset that he portrays the majority of gold demand to take the form of.  It carries sentimental value that makes people hold more often than not regardless of what gold prices are doing. Plus, it's one of the few ways gold is taken out of circulation with the many people buried with some jewelry on them... Ignoring that slice of gold demand entirely pretty much makes his entire logic flawed.
Jul 26, 2011 11:36PM
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I find it astonishing that an intelligent man such as Mr. Alex Pape must be, is desperately trying to make the correlation of Benjamin Graham's theory of long term equity valuations analogous to gold prices. Nonsense! Most investors invest in gold because it has NO correlation to equity prices! I could also make a well founded argument that gold DOES have fundamental value, but even this is not necessary for gold's value is derived in the same way other alternative asset classes are valued (such as residential real estate); by what someone is willing to pay for the asset in open-market trading. If an astute investor sees signs that other investors will seek a "flight to safety," than that astute investor will likely look to precious metals such as gold in anticipation of the coming increase in demand. This has nothing to do (and does not need to) with seeking fundamental value. It is simply astute investing. As for your obvious bearishness on gold Mr. Pape.... Good luck with that!
Jul 26, 2011 4:54PM
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two points:

 

1) How can you state that gold has no fundamental value? I disagree. I would argue that gold has more fundamental value than the US dollar right now!

 

2) You must consider that the "emotional investors" (individuals) have no place to quickly dump their gold. In other words, it's somewhat illiquid, thus preventing a "spur of the moment" large scale sale. (a technique that victimizes the same small investor when done by fund managers!)

Jul 27, 2011 11:29AM
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Interesting article. Interesting comments.  Much like current discussion on budget and debt, strong disagreements and name calling between both sides.  Lets just call the gold investors who are obviously conservative, the R's and those who find no value in the purchase and holding of gold, the D's. At $1625 a troy oz.  the R's seem to be correct.  In time, this will undoubtedly reverse, the price decline, and the D's will be correct.  I think the same will apply to the future of the budget and debt
Jul 29, 2011 11:48PM
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Acually Ekonoman,

as mutch value as demand allows.

if all paper went to **** tomorro, then it would skyrocket.

it is and always will be cherished for its rarety. it has some industrial use as conductor material , jewlery,ect. it is the one thing men have been able to agree on for the last 4-6000 years. Not god, not religion, not polotics, not language, not culture,but Gold as a value.

 

you need to stop looking at the $1 as a unit of measure.

i agree with forwills comment as well

Jul 28, 2011 10:08AM
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I agree Ekonoman.  The only path the elites can follow that still leaves them in control is continued currency debasement.  This path is detrimental to the common man though. Another way they're fleecing the commoners is by setting the Fed interest rate near zero for the banks.  The elites are dilusional when they think if they help the banks, they'll help the little guy. My opinion is that their top priority is to retain control at any cost and all their talk about "main street" is lip service.  The only way I see for individuals to exit their scheme is to possess gold bullion. If you own gold bullion, you are exposed to absolutely zero counterparty risk. You can cheaply and quickly convert the bullion to cash currency as needed. I started buying gold and silver in earnest in 2006 and have been handily beating inflation ever since.

Probably the most important indicator of where we're headed is whether or not individuals are taking on more debt or trying to pay down their debt. It appears to be the latter. What this tells me is that the days of easy credit debt accumulation and bogus economic growth are over. The central bank is pushing on a rope.  

As long as interest rates are set below the true rate of inflation and there is no true economic growth(take a look at shadowstats.com) , you can't lose. Gold is a safety net for whatever happens. If there are defaults, you are not exposed. If there is price inflation, the gold price in dollars should rise.  If there is deflation, the price in dollars should fall but the dollars you buy with your gold will buy more.

Jul 26, 2011 5:48PM
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Well said.   Gold like anything else is only worth what somebody else will give you for it.   It is not an investment because it pays no dividend and has no fundamental growth potential.   It's hot right now, fast easy money, but once emotions settle and people realize tomorrow we'll all still be here with the same problems as today it will cool off.  There will be winners and losers following the money moving back into other investments.

In short your only hope as a gold investor is that some other fool will give you back more dollars for it in the future that is greater than inflation PLUS lost compounded dividends / profits that it did not pay when compared to an investment or business.




Jul 26, 2011 5:35PM
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M Kevin Howard,

 

Although it may be cumbersome to trade real gold, there is an incredibly liquid market in the ETF stock GLD.  It takes only a second or two to trade it, and the bid/ask spreads are de minimus.

Jul 26, 2011 5:11PM
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I have a very naive question, but truly, my sincere question is what gives gold it's fundamental value?  It is a consumer driven value?  The value of gold to me strikes a parallel to the 'Beanie Baby' craze - where the consumers inflated the value of a $6.00 toy and bought, sold and traded them.  With gold it seems that there is no value other than that to which we assign it.  We cannot eat it, it's beautiful and is made into awesome items to wear or look at, but it is not essential to life.  Is it a vital part of manufacturing or something I'm not aware of?  Why did they use this as the basis for trade / commerce in the first place? 
Aug 12, 2011 1:53PM
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All investors can be victims of their emotions, but none suffer worse than the average retail investor. Fund flow data from mutual funds show that investors routinely buy high and sell low, riding alternatively waves of emotion-driven greed and fear at precisely the wrong times.
I think that this is the key point that the author makes. Ignoring the debate on whether gold is the right choice, if the average investor always makes the wrong choice then why is the average investor right this time?
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