Bad day in New Jersey.  Yesterday was the first super-hot day of the late spring, with temperatures approaching 100 degrees Fahrenheit.  Creaking power infrastructure reacted in the way we’re unfortunately becoming accustomed to.  It collapsed.  No power for most of our neighbors, no internet or cable TV for us.  Hence the late post.

Graff

According to Bloomberg, the plug was pulled on the Graff Diamonds offering less than two days before the stock was supposed to debut.

I can’t say I was shocked, for several reasons:

–Hong Kong has been pummelled especially badly by selling emanating out of the EU, where another flight to safety by equity investors is in full flower.  It looks almost like last summer.  (Where did they get all the stock?)

–Chow Tai Fook Jewellery (HK: 1929) came public late last year and is now trading at about 2/3rds of the IPO price.  True, 1929 sells mainly chuk kam pure gold jewelry and knickknacks, not diamonds.  But the market is the same–China.

–TIF, whose main problems appear to me to be in the US, nevertheless also reported a deceleration in its China business last quarter.

–I suspect that retail investors in Hong Kong–always important in that market–were especially badly burned by the Facebook IPO.  IF US retail investors got 5x-10x what they expected, Hong Kongers could have gotten double that size.  Hong Kong is a market of veteran stock market participants, so they’ll shrug off their bad treatment by underwriters quickly.  But if I’m correct, they’re still licking their wounds.

–I haven’t tried to locate a copy of the Graff Diamonds prospectus.  My experience is that in Hong Kong these documents weigh a ton, but don’t contain anything like that amount of information.  Besides, they’re not supposed to be available in the US until after the offering.  Media reports do bring up two potentially worrying issues, however.

Apparently, a mere 20 customers make up 50% of revenues.

A large chunk of the IPO proceeds were said to be earmarked for buying diamond inventory from the company’s founding family.  I’d want to know how this inventory is being valued–and how many months’ (years?) sales this represents.  I’d also want to know how the acquisition of the gigantic gems Graff is famous for will proceed from now on.  Does the Graff family act as exclusive agent for the company?  …is the family paid a commission for acquisition?

a paucity of demand

When the IPO was pulled, the underwriters had orders for only half the shares intended to be offered by the company.  In a healthy offering the books would be, say, 5x covered.  A “hot” offering might have books 10x covered.  In Hong Kong, which operates under different rules than the US, 100x isn’t unknown.

my thoughts

In the current economic environment, Graff Diamonds was always going to be a tough sell, especially with the family wanting 25x earnings for its shares.  I think FB did much more to suck the life out of this offering than most brokers would be willing to admit, however.

I have strong views on gold.  I don’t think it’s money (it used to be, but isn’t anymore in most parts of the world).  It’s no more–and no less–an inflation hedge than any other physical asset like, say, real estate or timberlands or diamonds or oil.

One exception:  in developing countries where people want to hide their wealth or don’t trust the banking system and where barter is an accepted way of doing business.  In these cases, the facts that you can bury gold in the back yard or break off a link in a 99.9% gold chain and give it to a merchant to buy stuff come in handy.  Think:  India or Vietnam.  And, of course, these transactions, like most barter, are by and large off the books.

I began to realize this in the mid-1980s when I saw that my acquaintances in Hong Kong had long since dumped all their physical gold and had forex trading accounts instead.

worldwide gold demand is an emerging economy phenomenon

Worldwide consumer demand for gold by country in 2011, as reported by the World Gold Council, breaks out in tons as follows:

India     933.4

China     769.8  (Greater China = 811.2)

Middle East     199.8

US     194.9

Turkey     144.2

Thailand     108.9

Vietnam     100.3

Everybody else     957.3.

It’s also telling that in the US, where about one in five citizens don’t have a bank account (because it’s too expensive), we’re not set up for people to plunk down a doubloon to buy a used car.

sharply increasing money creation in the developed world

Be that as it may, over the past few months we’ve seen a substantial increase in government money creation in the EU and in Japan.  We’ve also just heard Mr. Bernanke reaffirm that he intends to keep interest rates in the US at the current extraordinary low levels for a long time to come, despite increasing signs that the economy is picking up steam.

All of this spells the increased possibility of a future inflation problem.  Why, then, is the gold price falling rather than going up?

trends in India

I think the largest part of the reason lies in India, which comprises well over a quarter of worldwide consumer demand for gold.  (If we reckon that purchases of 14k or 18k jewelry isn’t investment demand, then India alone could comprise as much as 40% of the global (non-central bank) investment market for gold.)

Two factors:

–as the economy in India has been cooling down over the past half year down and inflation picks up, Indian demand for gold has gone down, not up,

–perhaps more important, in its latest budget, the Indian government is proposing two new gold taxes:  a doubling of the import tax on the yellow metal to 4%, and a new .3% levy on all gold purchases.  In response to the latter, gold shops in India have closed down on strike for almost two weeks.

Speculative stocks of all stripes are often compared with gold mining stocks–not just any gold stocks but young companies with a potentially important strike but no history of profitable production.  Here’s why:

like gold mines

fraud?

In one sense, it’s because gold mining stocks have been fertile areas for fraud, in financial centers from Perth to Denver to Vancouver.  There was even a case in the US many years ago–a major scandal–where a mutual fund took large positions in junior Canadian miners that had fabulous financials indicating deep undervaluation.  When the portfolio manager went to visit the mining operations, however, he discovered they existed only in the imaginations of promoters who were happily churning out fake financial statements.

stock trajectory

Putting such cases to the side, the stocks of legitimate start-up companies often follow the same trajectory as gold miners as they approach the day when their first major development finally comes into production.

–the new strike is announced.  There’s limited exploratory drilling and little other information other than that the find is good enough to be commercially viable.  The stock goes up.

The lack of information itself opens the door to all sorts of speculation.  Analysts, who are always working from imperfect information in any event, may arrive at their preliminary estimates from an average of the productive capability of other mines in the area, or from the past experience of the geologists or the professionals associated with the project.

Even at this stage, analysts begin to jockey for position with each other by offering, in turn, increasingly more optimistic assessments of the find.  The stock goes up some more.

–financing is lined up.  Further drilling has been done to delineate the find and to justify a bank loan that will fund construction of productive facilities.  Getting a loan means a third party has examined, and signaled its validation of, the geological data and production plan.  This sets off another round of more positive speculative assessment of the find.  The stock goes up again.

–the mine and associated processing facilities are constructed.  As analysts can see the scope of the project, even more bullish reports are issued.  The stock goes up once more.

–the mine opens; production commences.  For most stocks this means reality intrudes on–and shatters–the reverie of stock market speculation.  Dream shifts into reality.  Analysts can no longer imagine extraordinarily high ore grade being processed at a world-record rate.  They have to deal with the facts of, say, ordinary grade ore being processed at pedestrian rates.  The stock plummets.

Almost always, the day that the mine opens is also the day that the stock price peaks.  

The highlights:

world demand

Identifiable world demand is actually up by 12% year on year, despite a 28% rise in the US dollar gold price over that time.  Buying of gold, year to date, breaks down into the following categories by tons:

jewelry 1468.3 t, up 8% year on year,  comprising 52% of demand

Industrial/dental 320.5 t, up 13% year on year, 11% of demand

investment 1350.2 t, up 19% year on year, 37% of demand.

Geographically, third quarter consumer demand (i.e., excluding industry and central banks) breaks out as follows:

India     33.2% of demand.   Purchases up 28% year on year, mostly jewelry

Greater China     22.2%     purchases up 16% year on year, mostly investment

Middle East     9.7%     purchases down 10% year on year, mostly lower jewelry

United States     8.9%     purchases up 8% year on year;  jewelry down, investment up

Western Europe     7.6%     purchases down 3% year on year

Turkey     6.8%     purchases up 35% year on year, virtually all investment

Vietnam     3.3%     purchases up 17% year on year; jewelry down, investment up

Thailand     3.2%     purchases up 139% year on year;  jewelry down, investment up

Russia     2.6%     purchases up 17% year on year, on jewelry demand

everybody else     2.5%.

Industrial demand, which is primarily for technology products, has already rebounded to the pre-crisis levels.

Central bank activity has been, from a private investor’s point of view, really odd.  Until 1Q09 and at prices at or below $900 an ounce, central banks were heavy sellers.  Since then, they have turned into big net buyers.  Russia has added 46.2 t to its stockpiles, Thailand 15.6 t, Sri Lanka 6.9 t and the Philippines 4.2t (through late August).

Investment demand breaks out into three categories:

–hoarding of bars, coins, medals–mostly in developing countries, which accounts for 55% of investment and is up by about a third vs. 2009,

–ETFs and similar products, which accounts for 33% of investment and is down by about 40% year on year, and

–”other” identified retail investment–mostly coins bought in the US and Europe, which accounts for 12% of investment and is  also down by more than 40% year over year.

world supply

Happily, supply is much more straightforward than demand.  It comes from:

mine production     62% of supply, up 3% year on year

recycling     41% of supply, down 1% year on year

central bank sales     -3% of supply (since central banks have turned net buyers)

my thoughts

On the supply side first, I don’t think there’s any reason to expect a large increase in the supply of gold from current levels.

Yes, higher prices will make new gold mining projects (which can be developed relatively quickly) economically viable.  At the same time, however, prudent mining practice calls for existing mines to process progressively less gold-rich ore as prices rise.  That way, they maintain profits in boom times, but save higher grade ore for a rainy day.

Again, higher prices should mean more recycling.  But one of the reasons for the sharp increase in recycled gold over the past few years is the recession-induced development of a gold recycling industry in the US.  Output here has presumably reached a steady-state level.  More important, the World Gold Council thinks the rest of the world has pretty much run out of gold lying around to be recycled.

Central bank sales are harder to figure.  Luckily, they’re not that large in the overall scheme of things.  On the IMF still has about 50 t. of gold to sell.  On the other, Russia is carrying out a program to increase central bank holdings of gold.  And some smaller, less stable governments, appear to want to remain net buyers as well.

As to demand, the figures above should make it clear that gold is a developing world phenomenon.  The US and Western Europe make up only 16.5% of consumer demand and 12% of non-ETF investment purchases. (By the way, Japan isn’t mentioned on the consumer list.  That’s because Japanese individuals have been net sellers of gold this year.)

India alone is a third of the overall market for gold.  It and China together make up more than half of global demand.  In India, buyers want pure gold, to serve both as adornment and savings.  The same is true for China, though 18k jewelry has been making inroads.   So demand in both places should be a function of economic growth.  If the two were to intend to buy gold next year at only half the current pace–and I think that’s a very conservative estimate–this would mean almost over a 6% increase in total demand.

Absent an increase in recycling, which the WGC says is unlikely, I don’t see where the extra gold will come from.  Even ignoring demand from fiscally unstable areas like Turkey or Vietnam, or continuing central bank buying, as positive factors, it think this spells higher gold prices in 2011.

gold (my view, anyway)

I’ve come to realize that–contrary to my conscious belief that I don’t care that much one way or the other about gold–that I actually do have deep-seated convictions about gold.  Unlike some of my other beliefs, they’re not simply plucked out of the blue, but derive from my having spent close to ten years analyzing natural resources industries, especially metal miners.  This was at a time when, having virtually bankrupted themselves developing massive deposits of base metals, miners were concentrating on gold. (That’s because gold deposits offer high value in small deposits, making them faster and cheaper to develop.)  At the same time, I was also studying the developing countries that are the main sources of demand for the yellow metal (you can find more under the “gold” tab on my blog).  I have three basic conclusions.

1.  Gold is not some sort of proto-money, Ur-money or the “essence” of money.  It’s a metal that used to act as money, but doesn’t in most places any more.  Its virtues are that a small weight/volume contains a lot of value.  You can wear it.  You can break off little pieces to buy stuff.  And, if you want, you can bury it in the back yard so no one–especially the government–knows you have it.  It’s also great if you don’t trust the banks to give back the money you have on deposit.

If you don’t need these attributes, gold is a waste of effort.  You have to safeguard it.  You have to assay it all the time in significant transactions.  And you have to deal with a potentially large bid-asked spread.

2.  Gold doesn’t give inflation protection.  Yes, it has gone up a lot during the past decade.  But that’s not the same as protecting against inflation.  Since 2000, the price level in the US has risen by about 25%.  Gold is up by 450% during the same period.  Not a great match.

From 1980 to 2000, the domestic price level rose by about 80%.  The gold price fell by over 50% during those two decades.

3.  The more you look, the less historical evidence there is for any of the gold bugs claims.  Maybe this is #2 all over again.  But, for example, during the early days of the nineteenth century, metal coins were used as a common medium of exchange in the US.  But they were silver, not gold.  And Spanish coins were preferred to ones from the US, because of their higher purity.

a “true” gold standard

In its purest and simplest form, this means that the money that circulates is either itself gold or is exchangeable into a specified amount of gold on demand.

I don’t think any serious student of economics or history advocates a gold standard in this sense, despite its two positive points:

1.  Governments can’t just print money, willy nilly, to pay for stuff.  No extra gold means no extra money.

2.  Countries have to watch their foreign exchange positions carefully.  A trade deficit is extremely dangerous.  If a creditor nation were to exchange its holdings of a deficit country’s currency for gold, instead of putting the money into the latter country’s government bonds, it would shrink the money supply of the deficit country–causing a recession.

The negatives of such a system outweigh the positives, however.   First of all, the two positives are themselves two-edged swords.  The first would likely prevent a government from taking counter-cyclical economic measures, subjecting it to periodic very violent economic downturns.  The second potentially turns commerce into a political/military battleground, where it is possible to inflict terrible economic damage on a country by redeeming its currency.

Then, of course, there are issues related to the world’s physical supply of gold.

–It is often pointed out that a static, or very slowly growing supply of gold would mean similar limits on world economic growth.

–One might also look back to the effects of the mid-nineteenth century California gold rush, which made millionaires of many Westerners, including the maker of Levi’s jeans, but unleashed a horrible wave of inflation at the same time that destroyed the real value of the savings of just about everyone else.

–Then, of course, there’s my favorite worry.  It’s that a real-life Goldfinger might steal the gold reserves of a given country (likely a small one), thereby rendering its money worthless and stopping its economy in its tracks.

so, what is Mr. Zoellick after?

He knows all this.   In fact, in any proposal over the years that advocates a return to gold, if you read carefully (or read at all), what’s being said has virtually nothing to do with gold per se.  the “gold” part only provides political cover for countries to agree to a course of action which may imply that they’ve been negligent or imprudent in the past, but doesn’t require that they admit it.  And it allows politicians to deflect blame from themselves if an agreement requires painful measures in the future.  After all, it’s not as if they would be choosing to inflict pain.  Gold is forcing them to.

In this case, the issues are obvious.  Politicians in Washington, and in many capitals in Europe, have been stunningly incompetent in managing economic affairs for a long time.  The Great Recession is only one manifestation of this.  China has reached the point where export-oriented emerging economies have always faced their most difficult challenge–persuading the powerful beneficiaries of the status quo that the country must turn away from exports and toward developing the domestic economy.  All sides realize it is likely political suicide to be seen to be “giving in” to the other.

In this case, popular myths about gold can be made to serve a useful purpose.  Maybe I’ve got to warm up to gold, in this sense at least, after all.

The gold price has risen by almost 20% so far this year.  The advance is an unusual one, however, in two respects:

1.  Historically, the gold price has typically been stable in strong currency terms.  Much of the apparent strength has been related to depreciation of weaker currencies.  In practice, this has meant the dollar price vs. the euro (or its predecessor, the d-mark).  This year, in contrast, the dollar has been relatively strong.  Nevertheless, the dollar price of gold is up sharply.

2.  The advance is being driven not by demand for jewelry, which is usually the case, but by investment demand.  Last year, investment demand worldwide actually exceeded jewelry demand.  It may do so again in 2010.  Government mints are doing a land office business minting gold coins.  The SPDR Gold Trust ETF has over $50 billion in assets. And the Financial Times reports that commercial banks are considering expanding their vault space for storing physical gold for the first time in thirty years.

two big changes in the market

During the almost thirty years I’ve been watching (often from afar) the gold market, it has undergone two significant changes:

1.  The first is a product of the past seven years..  Thanks to the rise of ETFs, gold is much easier to buy today than it once was.  The SPDR Gold Trust ETF alone holds 1300 tons of the yellow metal, or close to half of the world’s gold production in a year.  It is traded not only in New York but also in Hong Kong, Singapore and Tokyo.  Vehicles like this eliminate the need to have a commodities account and solve the problems of physical storage, potentially high bid-asked spreads and the need to assay the gold on sale.

2.  Gold was money thirty years ago, but has been gradually losing that role since.  In developing countries, many citizens would use gold as a substitute for bank deposits.  Some had to little to be able to afford a bank.  Some worried about currency devaluation.  But many also feared either government seizure of their wealth, or attracting unfavorable attention (think:  China) from the authorities as being budding capitalists.

Wealthy individuals around the world have long since replaced gold holdings with financial instruments.  And greater political stability in large markets for gold like China or India has meant less fear-motivated demand for gold.  Jewelry demand (and not simply near-pure gold jewelry) has become the main driver of gold consumption.

why a price surge now?

Not now, though.  What are the main factors in increasing investment demand?

I think the main reason is that gold is the default choice for people who are worried about the current weakness in developed countries’ economies and don’t see what else they can buy.  Cash provides safety but almost no return.  Government bond yields are extremely low–and in the case of the euro have not delivered anticipated safety.  Stocks, after having come close to doubling since the lows in March 2009, are wobbling.  They also do best in times of strong economic growth–so they depend on conviction in economic expansion that investors don’t currently have.

What’s left?  a gold ETF plus …?

the risks

I’ve never been a real fan of gold.  As I’ve argued in other posts on this blog, I think gold price movements are ultimately driven by the ebb and flow of gold mining projects.  When prices are low, mining companies stop exploring.  When prices are high, they reopen shuttered mines and develop new deposits.

I think the case today is different.  I think investor demand is being driven by aversion to other liquid investments.  My worry about gold is what happens as/when sentiment about the course of the economies of the developing world improves.  To a great degree, generation-ago demand from the developing world for gold as money is no longer present.  The fact that gold has been very easy to buy through ETFs also means it is very easy to sell.  Remember, too, that there’s no assurance that the price you get in selling an ETF in times of distress will come close to net asset value.  Like any stock, your price will depend on where buyers are willing to make a bid.

what to buy instead?

From me, the answer should come as no surprise–stocks.

There are four basic ways to buy gold:  physical gold, gold jewelry, gold-related mutual funds or ETFs, and gold mining stocks.

1. Physical gold

By this I mean that you actually take possession of gold bars or coins that have been refined to certain specifications of purity.  There may be a big bid-asked spread, but ultimately the gold is sold by weight.  This is the dominant form of gold buying in Asia.

What would be reasons for holding physical gold?

a. few other alternatives.  Developing countries may not have well-functioning stock or bond markets, so investment choices for most people might be limited to bank deposits or participation in “chit club” loans;

b.  political instability.   In war-torn areas, the need to flee from violence might mean it would be good to have one’s wealth close by and in portable form;

c.  distrust of the financial system.  In some countries, one might have to worry about nationalization of bank deposits.  Or, as in the case of China during the Cultural Revolution, it might not be a good thing to show evidence of having wealth.

d.  unofficial economy.  In a country beset by hyperinflation, tangible goods may be the preferred form of payment over fast-depreciating paper money.

e.  diversification.  A generation ago, standard financial advice in the US would be to hold, say, 5% of one’s assets in precious metals of some type.  Foreign stocks were the preferred diversification for a while.  In today’s world, the recommendation might be to hold base metals stocks, or natural resources funds.

f.  few subjective factors in determining value.   This is unlike the case with other tangibles, like diamonds, colored stones or used cars.  Weight and purity are all that matters.

g.  physical characteristics.  Durability is one.  Gold can also be broken into smaller pieces without loss of value.

g.  it’s super-cool.

The major drawback of physical gold is the need for secure storage.  What constitutes security depends on the circumstances.  I had a friend in London who told me during the stock market collapse in October 1987 that he had foreseen the crash and expected it to lead to economic chaos, including widespread bank failures.  In anticipation he had sold all his possessions and bought gold bars with the proceeds.  He was storing the bars in a bank vault.  I’ve often wondered how he was intending to get into the vault after his bank failed.

2. Gold jewelry

This is more or less the same as buying gold bars, except jewelry can easily be worn.

The important distinction is between 22k or 24k jewelry bought as an investment and 14k or 18k gold jewelry bought in a brand-name Western jewelry store.   The latter two are only 58% and 75% gold, respectively.  Also, as a glance any publicly-listed jeweler’s annual report will show, the markup on a typical jewelry item will be 100% over cost of goods.  So these are fashion accessories, not investments.

3.  Gold-related ETFs and mutual funds

For all practical purposes, for most people this method of holding gold is probably the easiest.  It’s very important, however, to understand exactly what the fund does.  Does it hold physical gold, or gold futures or mining stock–or all of them?  What discretion in changing the proportions of each does the manager have?  In particular, you should understand the characteristics of a leveraged ETF, if that’s what you choose.  (You might take a look at my post on leveraged and inverse ETFs, for example.)

4.  Gold mining stocks

Picking an individual stock takes some security analysis skills.  When you get down to it, however, mining companies are relatively simple operations.  They’re holes in the ground that a special kind of dirt comes out of.

The key factors in determining profits are:  how many ounces of gold can the company extract in a year?  how much will that cost per ounce?  and,  what is the selling price?  The value of the company will be a function of its profitability  and of the reserves of gold that it has mineral rights to.  This will be disclosed in the company’s annual report.

The combination that everyone strives for is low p/e and high sustainable earnings growth.  The latter probably translates in this case into an assessment of the potential for rising mine production at low cost.  It’s also important to keep in mind the possibility of adverse political changes in the country where the production is located.

Three quirks of miners to look out for:

–For most miners, development is much more important than exploration.  In many cases, miners own adjacent property to their mines that they suspect will prove as profitable as their existing operations.  But because they haven’t yet actually drilled on the land, they can’t list the gold that is most likely there as reserves.  This is why good miners always seem to have seven years of mine life left, even though they’ve just sold a year’s worth of production.

–As prices rise, miners typically shift to producing less-rich ore and to doing more extensive land preparation work.  This allows them to shift to richer ore, and still stay profitable, if prices decline.  As a result, operating leverage isn’t as big as you might suspect.  In the mining industry, though, this is a good thing.

–Mining companies sometimes hedge part of their production through gold borrowing arrangements with central banks.  This makes it a little harder to figure what their net revenues are.  It’s a bigger issue when prices are low (as they were in the Eighties and Nineties) than now, but sill something to ask about if a firm’s revenues don’t seem to reconcile with the prevailing gold price.

Predicting the gold price

Who knows?

There are a couple of rules, though, about seeing tops and bottoms.

The gold price will bottom as the highest-cost mines begin to shut down (because the gold price is below their cash costs).

When the gold price peaks, large amounts of inventory (remember, inventories dwarf production) begin to be liquidated.  In 1979-80, for example, when silver prices shot up during the Hunt brothers’ try at cornering the silver market, trucks started appearing in vacant lots in our town, with scales on the back, so you could bring the family’s silver and sell it for cash on the spot (no one asked whether it was your family’s silver or someone else’s).

Last year, there was large-scale liquidation of gold inventories from India.  Right now, gold recyclers are advertising on TV, radio and billboards.   I’ve never seen that before.

It’s hard to know whether this is a signal of a peak or whether it reflects hard economic times.  At the very least, it’s not a strong buy signal.

One final thing.  Over short periods of time, I’d expect the gold price to be stable in the hardest currencies and rise in weaker ones.  This is a decades-long rule of thumb, which the oil market has only recently mimicked.

Three factors have changed the place of gold in investing over the past few decades.  All argue against the inflation hedge thesis:

1.  Gold is no longer money.  So it no longer plays its former role as the lynchpin of a system to protect against excessive money creation;

2.  Other instruments have become available that are better inflation-protectors than gold, such as inflation-linked bonds or futures contracts for “hard” currencies like the euro or the yen;

3.  Increasing world political stability and increased respect for the role of profit-making enterprises–especially in China–have reduced the need for anonymous, portable, durable forms of wealth like gold.

The price history

I would separate the price action of gold during since the last gold standard attempt was ended in 1971 into four different periods:

1971-74.  For the twenty-five years prior to 1971, the world price of gold had been fixed at $35 an ounce by the US pledge to convert dollars held by foreigners into physical gold at that rate.  When President Nixon was forced to end this commitment (we were running out of gold), the price quadrupled over the following four years.

1975-1981.  The US worries about the possibility that inflation will spiral upward out of control (the Fed was trying to set money policy be controlling interest rates, but chronically setting rates too low).  Inflation builds throughout the period, with the price level, measured by the GDP deflator, rising in total by 75% over the seven years.

The prices of most tangible assets rise very sharply.  Some companies even substantially restructure themselves by taking on large amounts of fixed-rate debt and using the money to buy even low-quality hard assets–real estate, mining companies and the like (subsequently ruining themselves during the Volcker era when asset prices collapse and their debt has to be rolled over at much higher rates).  Gold quadruples to $850, before quickly dropping back below $400.

1982-2004.  The price level in the US rises by 82%.  The gold price moves up from $398 to $435, or about 9%.

2005-present.  The price level in the US rises by 11%.  The gold price spikes to $1011, but then recedes to around $870.

Price History Chart

period        price level  Δ      gold price Δ     mine production(ton/yr)

1971-1974              +30%              +366%                            1,360

1975-1981            +76%                +113%                            1,220

1982-2004          +86%                    +9.4%                           2,030

(production rises steadily, peaks at 2,600 tons in 2001)

2005-2008          +7%                    +100%                          2,425

How do I interpret these four periods?

1971-74.  The gold price had been held flat at $35 an ounce for 25 years, before being decontrolled in 1971.  Although the open market price had been drifting up a bit before that, during this period pent-up demand is being satisfied and a market-based equilibrium is being reached.

1975-81.  This was a time of sharp inflationary spiral.  The prices of all tangible assets rose sharply, in an environment where many of today’s inflation-protection instruments were not available.  Remember, too, that although the Bretton Woods agreements had fallen apart, currencies were still subject to considerable government interference and didn’t really float yet.

Still, if you’re a gold bug, you’re right that gold protected you against inflation for this period (unlike any time since).

One other factor present during this time–the famous, unsuccessful attempt by the Bass brothers to corner the silver market in 1980, with the aid of a Middle Eastern partner.

The idea was straightforward, although right out of the nineteenth century.  Silver futures contracts at that time gave the holder the ability to ask for physical delivery of the appropriate amount of silver on the expiration of the contract.  The Hunt consortium bought more silver contracts than there was metal available for delivery to settle the contracts.  They helped their own cause by buying physical silver as well.  Then they announced that they would not accept settlement in cash but intended to take delivery of the silver.  During this time silver shot up from about $5 an ounce to $50+.  Gold rose in sympathy, cresting at about $850 an ounce.

In January 1980, the COMEX, the commodity exchange on which the silver contracts were traded, began to change the rules about how many contracts any one person could hold and increased margin requirements.  The Hunts complained, to no avail, that the COMEX officers were the people on the losing side of their contracts.  Silver–and gold–collapsed.  The Hunts lost over $1 billion.

(Aside:  there was a subsequent attempt to corner the heating oil market.  The same idea–own more futures contracts than there was oil and then demand physical delivery.  In this case, the counterparties were more elegant.  The contracts required the holders to provide barges to put the oil in, and allowed the sellers to designate the delivery port.  The counterparties designated the port only after they had leased all the available barges for the period of contract expiration.  The two sides settled.)

1982-2004.  This is the really telling period.  Prices went up by about 3% a year and gold barely budged.  There’s a supply/demand story here, too.  In the Sixties and Seventies, experts on the economy–industrialists, financiers, economists, government officials–agreed that GDP growth would be manufacturing growth and would require equivalent growth in raw material usage.  Sounds crazy now, but until the early Eighties, that’s what people thought.  ( National Lead was even one of the “Nifty Fifty” stocks of the early Seventies.  These were the “one decision” stocks that you needed only to buy and watch the profits roll in.)

Confident of almost boundless growth in demand for their output, mining companies borrowed heavily and launched huge development programs for all sorts of base metals–copper, aluminum, lead, zinc…  These projects started coming on stream in amounts far in excess of the world’s needs just as global GDP was beginning to stagnate.  Output also began to become available from low-cost state-owned mines in developing countries.  These were run more to provide employment and generate foreign exchange than make money.  So mining company losses began to mount.

What to do?  En masse, the firms turned to gold exploration in the late Seventies.  Why gold?  Relatively high value/weight means smaller, less expensive projects, shorter lead times, the possibility of transporting ore to already-existing processing plants.

The net result–world gold production climbed in a steady progression for 20 years, from 1982 to 2001, keeping a lid on prices.   This is the same thing that would happen with iron ore, or chemicals or any other commodity.

2005-2008.  Two decades of stagnant prices teaches miners not to develop new gold mines, unless they’re low cost.  Consolidation of the mining industry into large conglomerates with financial discipline and a diversified mineral base helps, as well.  No new production in prospect, and a growing world population almost 50% larger than in 1982, equals sharply rising gold prices, even with little inflation.

In summary, we have about 35 years of gold trading freely.  For the first seven of them, gold arguably acted as a safeguard against inflation.  For the remaining 28 it hasn’t.  Instead, it has exhibited the boom/ bust behavior typical in any commodity industry as it swings between overcapacity and shortage.

I’m not a huge fan of gold as an investment.  I can’t relate to what I consider an obsession about the yellow metal by gold bugs.  But I do think it’s a fascinating topic.

When an American thinks about gold, he has images of mystery and intrigue–of pirate treasure, or  James Bond, or  hard-bitten solitary miners making a strike in the hills of the Dakotas or northern California.  In an earlier age, the picture would have been of a guy in a funny hat, wearing an elaborately-decorated bathrobe, trying to “transmute” base metals into gold.

A better image for today might be the situation of a citizen in China or India, Vietnam or Turkey–which are four of the largest consumers of gold (the US and Italy are, too, but the uses are somewhat different). Someone in one of these countries may not be wealthy enough to have a bank account, or may not want an official record of his transactions.  He may also worry that to be seen as wealthy will attract unwelcome government attention, or that a bank account is subject to nationalization in a way that a gold bar buried in the back yard is not.  He may have experienced, or worry about, hyperinflation.  His holding may well technically be jewelry, but more than likely it will be 22 karat or 24 karat  (chuk kam), and bought and sold by weight.

Gold in three posts

I’m finding this topic surprisingly hard to write about.  It’s not so much that I don’t have an opinion–fat chance.  It’s that I think the situation with gold is very complex.

1.  For most of the world it’s an artifact of a past way of life–like spittoons or ashtrays, or writing letters instead of email or chat.  It used to be money but isn’t any more.  It’s a consumer jewelry commodity, like diamonds or colored stones.  Like any capital intensive business, gold mining is potentially subject to periods of boom or bust, depending on productive capacity entering or leaving the market.  But price swings can be dampened by movements of supply in and out of jewelry inventory. Inventories, by the way, are immense relative to mine production.

2.  For some parts of the world, it still acts as money, because it’s the best alternative available.

3.  There’s also a question of old dogs and new tricks.  As the world changes, not everyone adjusts at the same rate.  When ATMs first became available, for example, banks found it almost impossible to convince customers over the age of fifty to use them.  In the case of gold, I personally don’t believe it’s very effective as an inflation hedge.  And there are also much easier instruments available today, like foreign currency futures or even asset-based stocks, to use to guard against home currency depreciation.  But some people will rely on the tried and true, no matter what the advantages of a new development may be.  If so, gold will act to some degree as an inflation hedge because some people act that way.  This is not a great rational for an investment, though.

I’m going to break the topic down into three parts.

The first, which follows below, gives some basic information about gold.

The second will deal with whether gold is an inflation hedge in today’s world.  I’ll argue that it isn’t so great as one, and has some risk if holders become more aware of its true character.

The third will outline what I think are the investment attributes of gold and the various ways to participate in the gold market, from physical gold to gold mining stocks.

The Gold Standard adds to the mystique of gold

From antiquity, gold has been recognized as a store of value and gold coins have been recognized as money.   The gold standard, however, is a relatively modern phenomenon.  In its simplest form it consists in the definition of a country’s currency in terms of gold (for example, $35 = 1 troy oz. of gold), along with a pledge to redeem bills or coins for gold if asked.  The circulating currency, typically made of paper or base metals, derives its value, not from any intrinsic characteristics, but from the conversion pledge.

The most recent instance of the gold standard was initiated in the Bretton Woods agreements at the end of World War II.  The value of world currencies, except for the US dollar, was defined by a fixed conversion rate into dollars.  The dollar was pegged to gold, at the ratio of $35 = 1 troy ounce.  The US promised, for everyone other than US entities, to exchange their dollars for gold at that rate.  The arrangement fell apart in early 1971, as persistent selling of the dollar (notably by France) began to deplete US physical gold reserves.  Put another way, the US printed a lot more dollars than it had physical gold to back.

(An aside:  The pledge to exchange paper money for gold is what made Goldfinger’s plot to rob Fort Knox so fiendish.  If successful, foreigners would have lost faith in US money.  That would have stopped US trade, hence the US economy, in its tracks.  Who knew?)

Gold used to be super-money…

Until less than forty years ago, then, gold was regarded as a special kind of super-money. Adding to its mystique is the fact that from 1933-1974, it was illegal for Americans to hold more than small amounts of gold bullion or gold coins.  Part of an earlier attempt at instituting a gold standard, the government required citizens to turn over their gold to the government in return for $20.67 an oz..  The fact that the gold price shot up by over 4x from 1971 before Americans were allowed to own gold again in 1974 did little to undermine the idea of its special status.

Gold Statistics–gold inventories are huge! (all figures, at December 2007, come from The Gold Council),

One of the most striking facts about gold is how small supply and demand are in relation to inventories.

Supply

mine production                   2,200 tons

recycled metal                           950 tons    = a reduction in inventories

central bank sales                   500 tons    = a reduction in inventories

Demand

jewelry                                      2500 tons      = an addition to inventories

investment                                 700 tons      = an addition to inventories

industry                                      900 tons

In simple terms, then, 2,200 tons of new gold came out of the ground, of which 900 tons was used for computers, other electronic equipment, and medical and dental devices.  The other 1,100 tons went into jewelry, the principal source of demand for gold.

What about inventories?  They are (again from The Gold Council):

jewelry                 82, 700 tons

investment          26,500 tons

central banks     29,000 tons

industry               19,000 tons

Total                   157,200 tons

Let’s subtract all the jewelry from the total (this is clearly not right to do, since 22 karat and 24 karat jewelry have a strong investment motive).  We’re still left with about 75,000 tons of gold sloshing around in the world, or about 34 years of mine production.

More in my next post.