Gold, Revisited: Is $1500 Near?

Gold bars. Source: http://www.australianminesatlas.gov.au/education/rock_files/gold.jspUnless you’ve been hiding under a rock (or a gold nugget?), you’ve probably heard about the skyrocketing gold prices. As of this writing, gold is at $1425 USD! Only a few months ago, I don’t think most people other than a few gold bugs would have imagined prices shooting up so high, and so fast. Now it looks like $1500 is quite possible.

So, is gold in a bubble? What would make gold rise so fast, and is it time for the greedy to start becoming a little fearful? I’m going to revisit gold in this post, and look at some of the fundamentals and trends behind the recent moves in the price of gold.

What is gold?

Gold crystals. Source: http://en.wikipedia.org/wiki/File:Gold-crystals.jpgBefore we can analyze gold’s recent price moves, we must first understand what gold is, and how this relates to the supply and demand dynamics. Gold is a pure stable element which naturally occurs in nature, and can be found all over the world. It has been mined since ancient times both for its beauty and for its suitability as a form of money.

Over 165,000 tonnes have been mined in human history; an amount which is still largely in circulation and storage. If this amount was melted together, it would fill a giant cube a little bit more than 20 meters on a side. Gold’s flow, however, is much smaller: Only about 2,500 tonnes are mined per year. This is a supply increase of less than 2% per year.

If high prices remain, then more mines will be profitable, which will increase production down the road. On the other hand, environmental regulations and other restrictions will dampen this expansion, limiting the overall production increase.

What does this mean? Gold is a mineral with a very large stock, but a very small flow. This is only one of the many qualities that has made gold such an attractive form of money in the past, and is contributing to its demand today. A high demand for TVs can be compensated for by producing more TVs. A high demand for gold can only go into the price.

What are some of the reasons behind the recent price increases?

The U.S. Dollar is falling.

Image of a balance scale balancing the CDN$ and the USD$Gold has been in a bull market since the early 2000s, and this can be traced in large part to easy money policies.  The recent launch of the second quantitative easing program is contributing to this rise in the price of gold through a devaluation of the U.S. dollar. Through quantitative easing, the Federal Reserve has committed to effectively monetizing an additional $75 billion of U.S. deficit spending per month.

As of this writing, the U.S. dollar index, which compares the U.S. dollar to a basket of foreign currencies, was at 76.8. This is down from a high of 88 back in June. By this measure alone, the U.S. dollar has lost about 13% of its value against other currencies. The U.S. dollar index, however, does not notice when all currencies depreciate, as it is only a relative measurement, and many currencies are not included in the comparison basket.

It cannot be predicted exactly how the effects of this spending will reverberate through the economy, but nothing comes for free. Someone, somewhere, will pay the price; it might be the taxpayer, it might be everyone through higher prices for goods and services, and it might be foreign bondholders who will have to take a haircut on the value of their bonds.

For every loser, there will be a winner as well. It may be the banks and Wall Street executives who continue to receive large bonuses, it may be the public-sector that benefits from increased spending, and it may be large debtors who see the value of their debts reduced in real terms.

When we look at U.S. policy, we can see a clear trend toward a devaluing of the U.S. dollar. Although the link between gold and inflation is not so clearcut, gold nonetheless provides a form of money that cannot be debased nor politically manipulated as easily as paper money can. If all of the paper money systems collapsed, gold would still be there. That is where gold’s true value lies.

Sentiment toward gold is changing

Survivalist. Source: http://www.theplacewithnoname.com/blogs/klessons/p/0025.htmlUntil recently, gold has been considered as something fitting for jewelry, but something strange if considered as an “investment” or as money. In Western culture at least, the image of the gun-toting, food can stock-piling gold bug living in a cabin in the woods has not been an easy one to shake. The very term “gold bug” is derogatory, and these so-called “gold bugs” used to be the joke of the investment world as they saw the value of their gold holdings plummet toward the earth in the 80s and 90s, losing more than 4% of real value per year.

Things are no longer quite the same today. We can see all of the ads on TV talking about turning in your gold for cash, and some financial planners are even starting to recommend some exposure to gold in your portfolio. For us Canadians, Canadian Capitalist has made the point that if you are invested in a Canadian equity index, you already have about 20% exposure to gold equities.

Gold is no longer just for the Asians (who have always placed cultural value in gold, unlike Westerners who looked upon it as a “barbarous relic”) and the weirdos: Even the World Bank President is now talking about the value of gold in the international monetary system. This is a viewpoint that would have been unheard of only a couple of years ago.

Investors are moving down the pyramid of assets
Liquidity Pyramid. Source: http://www.runtogold.com/

Liquidity Pyramid. Source: http://www.runtogold.com/

Trace from Run to Gold has created this chart, which shows the flow down the pyramid as credit collapses. So long as overall credit is shrinking rather than expanding, this pyramid can also play a part in the overall movements of the gold price.

How has gold performed over time?

Now, gold is not an investment in the traditional sense: It does not spin off dividends, and it does not do any traditional work. In this respect, I agree with Warren Buffett that it would be kind of silly to sit on top of a pile of gold and to consider yourself rich, although you don’t have a bite of food to eat. Gold is actually wealth in the form of money, and therefore it has value because others also value it as money, and you can therefore trade it for real goods.

Nonetheless, it would be interesting to see how your money would have done had you placed it in gold versus the Wilshire 5000. Here are the results of annual investments in gold; see my post “Gold as an Investment: Performance over Time” for more details on the analysis:

Chart of gold versus the Wilshire 5000, nominal value, annual investments from 1975 to 2010.

As we can see, with equal investments in the Wilshire 5000 and in gold, our Wilshire 5000 investment would be worth about double. Gold was around $1100 and the Wilshire 5000 was around 41 when this chart was created, so at the current values of $1425 and 49, gold would be a little bit closer to the Wilshire 5000. Gold would have to double in value against the Wilshire 5000 in order to match its returns.

Chart of gold versus the Wilshire 5000, nominal value, annual investments from 1996 to 2010.

The story looks different for someone who started investing more recently. If we had started investing in 1996, then equal investments in gold would have far outperformed the Wilshire 5000, and at the current values of both, gold would be a little bit further above the Wilshire 5000.

So, where are these prices going to go?

Although gold looks parabolic within the last decade or so, this is precisely why you should exercise more caution in regards to gold. The time to buy gold for cheap was a decade ago when you could have bought it for around $300 an ounce or even less, not today. Any asset is vulnerable to over-bought situations, and gold is no exception. Whenever any asset starts to rise stratospherically, all kinds of people will be attracted out of the woodwork, including those looking to make a quick profit by flipping their investment on to someone else. Since gold is mainly price-driven, it is especially vulnerable to large swings in value.

That said, so long as the fundamentals do not change and easy money continues to be the order of the day, I do recommend that one keep some allocation to precious metals in both physical form and as other forms, such as pool accounts, allocated storage, or precious metal mining companies. Even the gold bear Jon Nadler recommends 10% of one’s portfolio in precious metals, and I think that 5% could be a decent place to start. Canadians: remember, you already have some exposure through the Canadian equity markets. It is up to you if you want to hold some physical as well.

Always remember Warren Buffett’s adage:

Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation…, they should try to be fearful when others are greedy and greedy when others are fearful.

Further Reading

So, reader, are you currently invested in precious metals? How do you feel about quantitative easing, and what do you think its overall effects will be on the economy?

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Comments

  1. Dd says

    I liked gold as an investment but never bought in when the price was right. As things are now–I think if the economy really tanks, gold will go much higher… but i think in such a situation I would trade all of my gold for food. Right now I am just staying away from it as I believe the price of gold could go either way.

    • says

      I believe that chances of a total collapse of the economy are very, very, slim, and not likely to come about unless as a result of total war or something like that. The U.S. dollar crashing won’t be enough, as disruptive as that event would be.

      I think it is possible for gold to go much higher if the US keeps abusing their reserve currency position. If they get their act together, it’s possible for most commodities to crash. This is really a story about the U.S. dollar and about the global currency system.

  2. says

    What an informative post. It’s interesting how quickly the discussion has shifted from “Those crazy gold bugs predict $1500 by 2015″ to “Do you think we’ll see $1500 by Friday?”

    I hope your gold position has you a little closer to the finish line in the rat race! :)

  3. Mike says

    Thanks for the mention Kevin,

    Great article and charts/graphs by the way. We’ll see gold back in the monetary system officially before too long. It’s already been decided and is now being leaked in order to prepare people slowly. However, gold is literally a tiny investment as the pyramid shows, which explains its parabolic rise as of late.

    The U.S. is the Saudi Arabia of gold (Largest holder by far, next to the EU) and US will eventually use that gold to “stabilize” the monetary system. That’s the wildcard they’ve had and what has just recently surprised most (eg announcement by World Bank President. That comment didn’t just happen by surprise; it was floated)

    If one observes the inverse relationship in gold vs. dollar (especially the last 10 years) there’s clear evidence the market never abandoned gold.

    Anyway, I have to admit I am somewhat biased to say “Buy Gold” today as I’ve been long for years. I understand the negative sentiment which has always been a bullish signal.

    • says

      I really don’t know about gold being used internationally. So long as laws prevent people from freely contracting in any currency they prefer instead of whatever is legal tender, this removes power from the people. It also turns gold into an easy scapegoat for erroneous central banking policies.

      Still, I think it’s a good move that at least gold is being seen as something that can be useful beyond jewelry and something for the gun-toting survivalists to bury in their backyard. 😉

      It’s interesting how all of this, including the U.S. dollar collapse, could actually play right into the hands of the U.S. However, I’m concerned that the benefits would mainly go to the top rather than distributed amongst the populace. Whenever there is hyperinflation, it is not the rich and elites that suffer the most, it is the middle class and the poor.

  4. Mike says

    I should also mention that anyone getting ready to enter these markets (gold and silver) should be prepared for extreme volatility. It WILL correct. The corrections will be violent. So, it’s not a cake walk…Just think that needs to be said.

    • says

      Agreed! I haven’t surpassed 10% so I’m not yet selling into strength, but I would like to see a BIG pullback before I buy in.

  5. says

    Really thorough post, Kevin. Good work.

    I have to agree on the notion of keeping a percentage of one’s net worth in gold. Now, I don’t necessarily do that today, at least in terms of direct investment. However, I see it’s place in one’s overall asset allocation, even if at a relatively small percentage.

    The thing is, I don’t like now as the time to obtain more exposure to gold. The prices have gone up quite high, and I have seen enough investment bubbles to recognize some of the signs that it might be overbought.

    • says

      Agreed. The peak is usually not the best time to buy anything. The thing about gold is because there are so few fundamentals to analyze, it’s really a story about the devaluation of other currencies and a change in sentiment toward gold. That is difficult to analyze. What if the peak is really just a bump on the side of a long parabolic curve? There isn’t really any way to know this unless you can read the minds of all the central bankers out there. 😉

      I still think we’ll see plenty of volatility, and using DCA + buying in at relatively low prices may be a cheaper way to build up to a desired position.

  6. says

    Wow! What a post, your graphics are off the chain.

    Wish I would have bought gold when I wanted to get in around 1000, but I was scared then of it. Thought the bottom would fall, then when it went to 1100, then 1200 I thought the ceiling had to be near, but it just kept on going. Until today we are above 1400 and I really don’t want to get in now.

    But what is worst is I am missing the silver rush as well. Man, it doesn’t pay to be on the sidelines!

    • says

      I guess you could stick it out and reevaluate on a price drop? Worst thing would be to say “oh, fine, I don’t want to miss the last train!” and then that’s when it crashes. 😛

  7. says

    It’s a shame the train has left the station, or has it?
    In any case, I am not a gold bug and would not touch it at these levels unless I really find a good company that is worth investing in.

    I have some exposure to silver, but I am starting to get itchy into locking profits, nothing goes up forever!

    • says

      The same dynamics that are affecting the gold price are also playing out in oil to a certain extent, and since that’s what you love and understand that may work out better for you!

  8. says

    Great article Kevin, a lot of information, well written, and easy to read.
    I wish we have some gold to sell. My wife is not into jewelry much though so nada…
    Maybe the next time gold drop, we’ll pick up some bullion.

  9. says

    Good post, Kevin.
    I quite like precious metals as savings vehicles. The Gulf States, the Russians and the Chinese have talked for some about an alternative currency backed by some form of hard assets, like gold or silver or other metals.
    A different perspective on gold would be to not consider it as an investment, merely as another store of value. As you said, other cultures in Africa, Middle East and Asia consider physical gold itself, whether in bar, bullion or jewelry, to be a form of savings and wealth. Same could be said for silver, although because of its industrial uses, there is much less physical silver in the world. I like physical gold and silver, precious metal resource stocks, gold mutual funds, and gold ETFs (not GLD or SLV).
    The higher gold goes though, the harder it will be to do a “double”. I’ve bought in at $250 and $900, so it’s been a good ride so far, but I’m not buying anymore for now.

    • says

      Hi 101 Centavos,

      Were we to see a rise of importance in precious metals, many developing nations would see themselves jump many places ahead in line. In some countries like Vietnam, Malaysia, etc…. gold has always played an important part in the psyche of the populace. In China, the government is actively encouraging private ownership of gold, after having confiscated it during the horrible years of the worst times of communism. It is only in North America and maybe Europe where gold has become something only for the “cooky and weirdos” to invest in.

      Given how international monetary politics has suppressed the purchasing power of many of these countries so that they could continue to export cheap goods to the U.S. (a dumb decision, in my opinion), a return to prominence of precious metals could help rebalance things and equalize purchasing power to a fairer level than it is now.

    • says

      Hahaha.

      To be fair, Andrew, every time IS different… which is why one can’t just extrapolate the past onto the present. Nonetheless if you start dumping in lump sums at high prices, you are quite liable to get burned.

  10. says

    Really interesting post. I’m surprised to hear that you think people who buy or even store gold have been considered odd in the past as I always thought it was pretty well accepted in US society. After all look at Fort Knox!

    I know a lot of people have been calling for a return to the gold standard and it certainly makes sense when the US dollar is literally being made out of thin air (and devalued as a result) whenever the fed reserve feels it needs more.

    The problem with gold is, as Buffet eludes to, if there is a serious serious crash in the world, say clean water pretty much runs out or there is a catastrophic food crisis then this little rock will be worthless. Mind you the gold bugs you mentioned probably have enough food and water stored in their bunker for a few years and then can pop out with gold as a base cash (gold) when the world starts to recover!

    Like you said probably worth be cautious while it is running this high but who knows if things carry on as they are $3k may be a reachable value!

    • says

      Hey Forest,

      Gold was actually confiscated and illegal for private possession in the USA from the 30s to the 70s. I’m not sure if something similar happened in other countries, but for many people gold is an “exotic” investment, especially physical. At least among those who grew up here and did not come from another country, it tends to be associated with those “survivalists”, gun-toting or not. 😉

      The U.S. used to be on a gold standard, and it didn’t prevent credit from ramping up in the 20s (which eventually culminated in the bust) nor did it prevent inflation up until the 70s. Did you know that in Mandarin, American money is referred to as 美金 (Měi jīn)? This literally means “American gold”… as the U.S. dollar was once as good as gold. No longer.

      I find it highly immoral that monetary policy is used to finance wars and massive subsidies to businesses and individuals without even the indirect acknowledgment of paying taxes to support these activities, let alone voluntary payments. I think the solution lies not in a “gold standard”, but a free choice of currencies without laws forbidding you to transact or contract in certain currencies. Give people back their freedom over their money and wealth.

      • says

        Hey Kevin, I did not know it was illegal to own gold. I just thought it was illegal to own Gold Certificates which I know are now quite sought after for collectors items! That’s really interesting.

        Ditto on the war and money policy thing, it’s a mess!

  11. says

    Oh I very nearly purchased Gold at $800 a while back and was talked out of it because I was still in debt, oh well such is life!

    • says

      Wish I had dumped in some more at those prices, myself… heck, wish I hadn’t been a poor student through most of the 2000s, when it was relatively quite cheap! 😉

  12. says

    Great post. I thought gold was overpriced at 1100, too bad I didn’t buy then!

    This is a great example of why dollar cost averaging works so well (in my opinion). People like me can really miss out on a lot of growth because we look at one point in time and make our own determinations of value. Of course, nobody can truly know the value of something as the market determines that. Another missed opportunity for me! (I am truly too chicken now to invest in gold.)

    (I do DCA on most of my investments since I contribute monthly.)

    Very informative!

    • says

      I agree! The comparisons between lump sum and DCA assume that you have a fat lump sum lying around. For most people, this isn’t the case, so DCA works better.

      Have you ever read up on economics or taken some training? I find your insights to be quite breathtaking sometimes in that they just roll off your tongue like common sense!

      • says

        Kevin, your response to my comment made my day!

        My background is this: Grew up with next to nothing, got a Bachelor’s in Finance and an MBA in Materials and Logistics Management. Am a computer programmer/project manager when I work (which has been on and off for 19 years). I manage the money for our family, including bill paying and investing.

        Again, thank you so much!

  13. says

    As to the original question, is gold in a bubble, I suppose it could reach that point if you get a tip to buy gold from the shoeshine boy. To quote Bernard Baruch:

    “Taxi drivers told you what to buy. The shoeshine boy could give you a summary of the day’s financial news as he worked with rag and polish. An old beggar who regularly patrolled the street in front of my office now gave me tips and, I suppose, spent the money I and others gave him in the market. My cook had a brokerage account and followed the ticker closely. Her paper profits were quickly blown away in the gale of 1929″

    Right now, most folks are thinking about selling their class rings to Cash4Gold…

  14. says

    Every time is different Kevin. You’re right there. But buying what’s popular has always been a bad investment strategy. Stocks in the late 20s(popular) vs the early 30s(unpopular); stocks in the late 50s(popular) vs the mid 70s(unpopular); stocks in the late 90s(popular) vs 2008/2009(unpopular)

    I can sing the same tune with real estate and precious metals at virtually any point in history. Big money isn’t ever made following the crowd. A few hundred percentage points is a small gain, especially if it’s short term. But big money, I think, has always been made by betting big in the opposite direction.

    This time it’s different. History doesn’t repeat itself, but it rhymes. And there are always great academic reasons supporting why history is going to change. And throughout history, we’ve always had those claims. But none of them have materialized as paradigm shifts. So history does teach us plenty, I think.

    • says

      Great comment, Andrew. You don’t want to end up being one of these guys:
      Lemmings. Source: http%3A%2F%2Ffacesofforeclosure.com%2F2009%2F12%2Fi-would-like-to-be-lead-lemming-if-you-please%2F

      I still think we are going to be seeing a bigger monetary role for PMs in the future, but I am sticking to my asset allocation strategy instead of relying on emotion or investor sentiment to pick my buy and sell points for me. I liked your thoughts on value averaging and asset rebalancing, and I’ve found them helpful!

  15. says

    Hey Kevin,

    Hands down, this is one of your finest articles. This is extremely thorough in many regards. The Great Credit Contraction image is a huge eye opener as well.

    Thanks,
    Timothy

    • says

      Thanks for that comment, I really appreciate it! There will be a guest post next week by the author of that pyramid that will go more into detail.

  16. says

    Wow! This is one of the highest quality posts on golf I’ve ever read on a blog! Well done!

    Sure seems like the USD is screwed so Gold and other real assets should continue to perform. Gold $2,000!

  17. says

    Great post Kevin. I agree with your statement that now would be a good time to exercise some caution. I enjoyed seeing gold’s comparison with the broad stock index for both a long-term and a shorter period. While I have no regrets with respect to my investment strategy, it’s always fun to read articles like this.

    Best Regards,
    Shawn

  18. Enquirica says

    Ultimately, the question is not how high gold can go, its how low fiat currency can go. While the debate about whether gold is in a bubble or whether we are in a deflationary or inflation environment continues, the monetary authorities in the developed world have embarked on a well-publicized campaign of currency devaluation via low interest rates. Central banks can control interest rates or exchange rates – not both – and they are opting for record low interest rates with little concern for the debasing consequences. There should be no debate on this matter – central banks have a perfect track record in one area and that alarmingly is in currency devaluation. The US and Canadian currencies have suffered a greater than 95% loss in purchasing power since the inception of their respective central banks. Enquirica Research has published a report – “Guide to Inflation Hedging 101″ go to http://www.enquirica.com/index.php?option=com_content&view=article&id=11&Itemid=19 and signup for access.

    • says

      I agree that a big part of the story is due to declining currencies, and some if it may be speculation done off the backs of these currencies. The coming months and years will definitely be interesting times. Thanks for stopping by and commenting.

    • says

      Looks like it’s going through a corrective phase, though this might be about Ireland more than anything else! Well, these kind of cycles are to be expected…

  19. says

    Great post Kevin. In India Gold is a major investment, infact the only investment other than real estate for most families. And gold is one of the popular wedding gifts given by very close relatives (like from parents, inlaws, siblings). We never buy/sell them like investments though… We won’t sell them unless we need to.. like an emergency reserve. Only recently I have been contemplating buying gold for the purpose of selling later, but I can’t do that now, can I? I will be buying high… the price is already through the roof.

    • says

      Suba, on my last trip to India, I witnessed first had the passion that Indian women in particular have with gold. We visited a what I can only describe as a large gold and silver jewelry *department store*, several stories of jewelry, silverware, flatware, statuary, and all other kinds of goldy goodness. They were lined up two and three deep at the counters, and we found later the reason why: gold chains and some types of bangles were on sale for only 7% over gold spot price. Other regular bangles, of more inricate work, were the regular 15% to 25% percent, depending on your bargaining skills.

      • says

        I have heard much about the gold culture in India, and it’s fascinating how gold is passed through the generations and how wealth has been preserved in that fashion. I think it’s only in North America and maybe in Europe where gold was stigmatized. It doesn’t seem like this has happened in other cultures.

  20. Mike says

    IMO, what will surprise most is just how high gold ends up moving. Bull markets climb a wall of worry. Meaning, investors nervously jump in. Then, the first sign of a sharp move down, they jump out. Or, they wait for the correction that never comes.

    The “job” of a bull market is to move as high for as long with as few as possible. It does so with volatility. Without the volatility, you’d have a quick bang. IMO, gold will soon trade with $100+ swings. The volatility will scare many out of their positions. This is required and axiomatically part of a bull market. and usually what occurs before the greatest move upward. Not investment advice; just somewhat observable.

    • says

      Looks like we just saw the $100 (nearly) move down. Will be interesting to see what happens next. It really does seem to be all about worry, fear, and greed sometimes!

  21. says

    When gold is all over the TV, radio and print magazines it probably isn’t the right time to buy. When everyone hates it, and has grown complacent that is the time to start preparing for the next economic crisis.

    • says

      Haha. It’s funny because I think we’re seeing both right now. Everyone hates gold, yet everyone is on TV talking about buying it… it doesn’t make sense. What a strange bull market…

  22. says

    Kevin,
    Just thought I would share some of my thoughts on gold. Do I think we will see $1500? Yes. Would I be disappointed if not? Not a bit. If we don’t see $1500 that means that the economy is getting stronger and my dollars are gaining in purchasing power. It means that the price of my gasoline and food have gone down. It likely means that the US stock market is rising and the value of my other investments is increasing.

    Personally, I feel that the metals and commodities bull market has another decade or a little less to run. I believe that Kondratiev was onto something with his long K-wave theories. I think human emotion and overshooting prices can explain many of his observations.

    One has to remember that it is impossible to predict the market and have a plan for whatever happens. I believe that I have such a plan in place and will benefit if gold goes up or down.

    • says

      That’s a good point that the gold bulls should remember. A rapidly rising gold price is symptomatic of a unhealthy economy, and there would be little to cheer about if gold was at $10,000 but we were in the midst of a great depression.

      Nonetheless, I think that the risk is there and real, and that gold may very well play a bigger role in our monetary future. I think that’s a good reason to hold at least some of your assets in gold and other precious metals (I personally aim for 10%). I don’t know what the future holds either, but I look at the exploding US debt with worry and apprehension, and I don’t like to keep too many eggs in one basket. I don’t see gold as a way to get rich (though if fiat currencies start collapsing this could happen) but rather as a way to keep from losing everything.

Trackbacks

  1. […] As gold nears the $1,500 per ounce level, Kevin of Invest It Wisely takes a look at some of the trends behind the recent move in the price of gold. […]

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