Examining the Appeal of Gold

Gold is a challenging asset to evaluate. When you cut through all the narratives and superstitions around gold, I think its investment potential boils down to two distinct aspects of the metal. First, gold is a commodity that has no tangible value and produces no cash flow or income. Second, gold has served as a store of value or currency over thousands of years. Most people in the investing world seem to view gold through one of these two lenses and that can lead to very different opinions on the metal.

Gold as a store of value or alternative currency

In a world where central banks seem to believe they can print their way out of any economic problem, it’s no surprise that many investors are looking for an alternative to fiat currencies. Given its extremely long history as a currency and store of value many believe that gold is the ideal solution to much more easily manipulated fiat currencies.

In his 1978 work The Golden Constant, Roy Jastram examined centuries of data and found that gold maintained its purchasing power over very long periods of time. Prior to 1971, gold was generally linked to money (if not money itself) and thus it generally lost purchasing power during inflationary periods, thus proving a poor short term inflation hedge before 1971. However, as gold is no longer linked to money it’s possible that it may serve as a better short term inflation hedge in the future.

What makes me nervous about the price of gold today is the move the metal has made in the past decade relative to inflation. The chart below shows the price of gold indexed to US inflation (as calculated by CPI) going back to 1967. In inflation adjusted terms, gold appears to have gotten ahead of itself the past few years, even after its recent decline.

Gold divided by CPI

A similar attempt was made to compare gold to US inflation dating back to 1800 in the chart below, which again depicts a high inflation adjusted price of gold today. long_term_gold_price_CPI_adjusted_1800_2013

However, some people constructive on gold believe that CPI and other official inflation measures understate true inflation. Economist John Williams attempted to create a more accurate picture of inflation in producing his shadowstats inflation measure, which attempts to measure inflation in the same manner it was calculated in 1990. Adjusting gold for this inflation measure presents a very different picture of its current price:chart-gold-1

Unfortunately if you compare that shadowstats inflation measure to other real assets you get some strange results and it loses credibility. For instance, calculating real housing prices utilizing the shadowstats inflation measure makes U.S. housing prices in 2005 look cheaper than at any time from 1980-1995.

If gold is truly an alternative currency then perhaps it should trade as some relative constant of US monetary supply. In terms of monetary supply it would appear gold could trade much higher:monetary_base_M0_vs_gold_price_1940-2012

Again, gold’s a tough thing to analyze. As a store of value gold has outrun inflation in the short run, potentially setting it up to fall in real terms. As an alternative currency gold may be undervalued relative to the expansion in US monetary base. 

Value investors supporting gold

Kyle Bass said last year, “I am perplexed as to why gold is as low as it is. I don’t have a great answer for you other than you should maintain a position.”

Seth Klarman discusses problems with gold as well as its appeal. In 2011 he stated because the greatest risks are of currency debasement and runaway inflation, protection against a currency collapse – such as exposure to gold – and much higher interest rates seem like necessary hedges to maintain. Gold is unique because it has the age-old aspect of being viewed as a store of value. Nevertheless, it’s still a commodity and has no tangible value, and so I would say that gold is a speculation. But because of my fear about the potential debasing of paper money and about paper money not being a store of value, I want some exposure to gold.”

More recently, Klarman has reiterated the need for taking a position: “There will be a day when the world looks very different, so when we rack our brains – how we might protect ourselves – we’re looking for cheap optionality. Rates will be higher at some point. I don’t know where rates would be if not for all this QE and bond buying and expansion of the Fed balance sheet. So what we come up with over and over is gold, the one place you probably want exposure.”

Back in 2012 Jean Marie Eveillard stated “gold is a substitute currency, and I look at the enormous amount of paper that continues to be issued by the Fed and the ECB, and as long as they keep printing enormous amounts of paper, I think gold cannot be overvalued.  There is one individual who, in terms of the backing that would be necessary for the enormous amount of paper that has already been issued, thinks that as of today the amount of gold should be at $15,000 an ounce.”

Value investors not supporting gold

In a 2011 interview with CNN Money Bob Rodriguez stated “When I look at gold, I have a hard time determining its value. There are certain areas of the world that love it for various reasons. It has been a store of value at various points in time. But if you compare gold and oil, which is more productive? That would be oil. Which has a longer life expectancy on this earth? Gold. One commodity does not have a diminishing supply, while the other one does. So I think energy is the better store of value.”

Warren Buffet published one of the more stinging critiques of gold in his 2011 letter to shareholders:

“Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce — gold’s price as I write this — its value would be $9.6 trillion. Call this cube pile A.

“Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?

“A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops — and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.”

Buffett makes one of the strongest arguments against gold from the lens I mentioned earlier: gold is a commodity with no tangible value and produces no cash flow or income. If you inserted ‘US Dollars’ into Buffett’s letter in place of gold his message would remain the same. Echoing this critique of gold, Donald Yacktman has said he’s much more interested in owning strong businesses like Coke rather than gold.

Final Thoughts

I don’t think there’s a clear answer to whether or not the typical investor would find gold an asset worth holding. On the one hand I think it’s self evident that an investor would do much better owning productive assets over any store of value over very long periods of time.

But for investors worried about central banks printing money and the current valuation of most asset classes, gold is one of the only assets with such a long history as a store of value and alternative currency. While easy money programs from central banks around the globe have produced very little inflation to date, it’s possible that the price of gold could react in anticipation of future inflation. So while I worry that gold may have gotten ahead of itself as a store of value, if further easing leads to higher inflation down the road the real price of gold may not be as high as it appears.