Three reasons to avoid gold

The yellow precious metal has little going for it

The price of the precious metal dropped $23/oz in trading today, Friday, June 15, 2018.

Gold is often touted as a must-have investment for the most intense of risk-mitigation situations, a “when all else fails” hedging instrument. Indeed, pick an ailment: Inflation? Hedge with gold. Economic and political crises? Hedge with gold. North Korea goes nuts? Hedge with gold. Collapse of modern society? Say it with me, folks, “Hedge with gold”.

With the global economy still as seemingly shaky as it is, multiple countries in conflict or otherwise in the midst of one crisis or another, and plenty of uncertainty to go around as to what the future holds, gold continues to make the rounds as a necessary investment portfolio holding despite the fact that its value in US dollar terms has been steadily declining or somewhat flat over the last seven years after reaching a peak in 2011 of over $1,800 an ounce in nominal terms, or just north of $2,000 an ounce in inflation-adjusted dollars.

In the wake of a good deal of political drama (worldwide trade spats; a North Korea summit — no, wait, no summit…hold on, yes there will be a summit…no…yes…yes; and so on) and the Fed’s path of raising rates and withdrawing accommodative market measures, here are 3 reasons to actually avoid gold, both as a physical or paper holding, apart from a very small percentage of a well-balanced and diversified passive or lazy investment portfolio:

  • It’s a highly emotional and psychological asset.
  • There’s no historical evidence that it hedges well against any risk.
  • It has very little practical use.

The yellow metal is a highly emotional, psychological asset. Its pricing doesn’t comply with a supply and demand structure as does crude oil pricing, for instance. As all oil-producing nations continued pumping out oil despite an existing supply glut over the couple of years leading up to the start of 2017, and the global economy continued to struggle with economic activity and recovery, we knew prices would stay low because supply outweighed demand.

As those dynamics changed over the last year or so — voluntary production restrictions were instituted once again — so did oil’s going price per barrel; it has gone up. At what exact price level oil will find itself at as time goes on, who knows, but that’s not the point.

The real point is that we know oil prices will change with adjustments to the production limits that relevant countries agree to at OPEC meetings (there’s one coming up and Russia and Saudi Arabia are under the spotlight), and/or given new evidence of how heavily oil is being used by industry and motorists.

When we invest in the equity of a company, we do so thinking that the corporation is going to grow or, at least, pay us dividends and otherwise protect the value of our investment while providing us a return. Investors demand growth or stability, and the company supplies it, otherwise it loses investors.

With gold the commodity, there is no such relationship of supply and demand. Interestingly enough, as authors Erb and Harvey point out in their scholarly paper “The Golden Dilemma” (2012): nobody really knows how much gold exists above ground (already mined throughout history); nobody really knows how much exists below ground yet to be mined (and changes in technology can change estimates); and the production of gold has been rather constant year upon year.

Indeed, its production is rather insensitive to its price.

This means that in spite of what has already been produced, what could be produced, and its going price, metal mining companies continue to produce an amount of gold within a certain range. As the authors note, “Remarkably, the new supply of gold that comes to the market each year hasn’t substantially increased over the past decade even though the nominal price of gold has risen fivefold.” Doesn’t that seem strange?

What’s more, of all the three primary uses of gold — jewelry, investment, and technology — only investment in gold seems to have a strong price elasticity of demand, and a positive one, at that. Jewelry has a negative price elasticity of demand (but it’s not that strong), and technology demand seems to be price inelastic.

What this means is that demand for gold for making jewelry goes down slightly as the price of gold increases. This makes sense as the raw material, and hence the products, become more expensive and thus some customers are simply priced out of the market since they can’t afford those goods anymore.

Technology demand doesn’t really seem to change much no matter the price; whatever gold is required to make technology products, it is purchased as needed, no matter how expensive the yellow metal is.

However, as for investment demand, well… As the price of gold increases, so does the amount of investment. Think about that. As the price of gold goes up, more people invest in it, chasing positive returns on their investment that others have already realized.

This is officially known as momentum investing and, while some would argue it’s a legitimate trading method, others might say it’s just a psychological and emotional trade (“I want to make money too!”); it’s just a bunch of lemmings heading toward a cliff.

As for buying physical gold coins, you can’t really spend them easily, can you. Walking into a grocery store to buy some lettuce with a gold coin will get you some strange looks and most likely no lettuce.

So what does buying gold buy you?

Psychological peace of mind in case the world falls apart, apparently. The value of that peace of mind is extremely personal and doesn’t translate well to commerce markets, though.

Besides, in that apocalyptic world, will you finally be able to easily spend your gold for those things you need? How will you and your trading partner establish the value of a gold coin in the absence of currencies, governments, and financial institutions such as banks? As for the next transaction you have with somebody else, will they agree to the same value of a gold coin? Probably not.

In such a world, seeds could be of more value than gold, or even plain old survival know-how: hunting and gathering, shelter-building, plant identification, and so on. Furthermore, investing in something for emotional or psychological reasons is not really sound trading behavior.

You may buy gold for psychological and emotional reasons because it brings you peace of mind, but how will you feel if gold goes down in price? Will you still feel psychological or emotional well-being, or will you just feel stupid?

Historical prices since gold has been a tradeable asset (inflation-adjusted dollars). Source: MacroTrends.

From the publication, The Golden Dilemma, we also learn that, historically speaking, gold has not hedged inflation or general crises consistently or frequently. Basically, gold may or may not be a good store of value in bad times. That’s not the kind of hedging instrument to trust and invest in, that’s called gambling.

The authors examine various situations and time periods and find no correlation between rising inflation or even hyperinflation and rising gold prices. As for general crisis-hedging potential, there always seems to be a crisis occurring in this world. Has gold ever been the answer to any of them: an investment savior?

How have we seen gold behaving as a safe-haven investment in recent years?

  • When the stability of the entire European Union as a world-body was threatened by the failure of Greece’s economy and potential exit from that organizational structure, gold was actually declining in value.
  • As concerns over China were increasing during its period of severe stock market turbulence in 2015–2016, the price of gold really didn’t.
  • With the worst refugee crisis (Syrian) in history since WWII still underway, the price of gold has remained fairly cool.
  • Gold pricing does not appear to respond much to the bumbling-along of BREXIT.
  • For the entire 2018 calendar year thus far, the price of gold has been falling within an extremely narrow band, in spite of all conversations regarding North Korea, Yemen, Syria, Russia, Venezuela, China and trade wars, how Trump obtained the presidency, and any number of other hot-button topics.

Frankly, gold doesn’t seem to be a reasonable answer to any crisis. Will it save us from a migrant crisis? A climate change crisis? An overpopulation crisis? A lack of clean water crisis?

Take the following story from The Golden Dilemma on the Hoxne Hoard and how poorly gold may serve as a safe-haven investment in tumultuous times:

A possible second condition for a safe haven [investment] is that during times of stress it should be possible to access the safe haven asset. Consider the famous Hoxne Hoard which is currently on display at the British Museum. The Hoxne Hoard is an example of what can happen when trying to make a safe haven investment. The Hoxne Hoard is the largest collection of Roman gold and silver coins discovered in England. Evidence suggests that the hoard was buried sometime after 400 A.D. by a wealthy family seeking a safe haven for some of its wealth. The 5th century A.D. was a time of great social stress and political turmoil in England as the Western Roman Empire unraveled. The fact that the hoard was discovered in 1992 means that the family failed to reclaim its safe haven wealth. Indeed, the Hoxne Hoard is an example of an “unsafe haven”.

Finally, gold has little practical use. It’s mostly used to make jewelry, then as something to invest in, and then a distant third as a manufacturing input for technology goods. You can’t really spend it in your neighborhood, it’s not that straightforward to borrow against, and you can’t easily transfer its value electronically to pay bills or purchase things.

People who inherit it don’t know what the hell to do with it, while people who purchase it in coin form do so knowing full well they are not planning on spending it in their daily lives, but rather under wild emergency circumstances, all black-swan style.

Personally, I’d like to see that. I reassert that in such times, there will be other things of much greater value than gold coins.

Besides, if you own gold, you may see it confiscated by your government. It has happened in the United States before. At any rate, let’s face it: gold is heavy and difficult to haul.

As an aside, what about central bank purchases, you ask? Well, it’s true that some of the world’s central banks continue to buy gold, although no country is on a gold standard anymore and some countries are even net sellers rather than net buyers of the precious metal.

Some of these net buyers buy gold, year after year, no matter the price, probably because it’s what central banks do. Why interrupt the inertia?

Practically speaking,

  • it may be something they agree to doing because gold preceded fiat currencies and can make financial negotiation (whatever the underlying reason: debt, trade, etc) between governments possible in the event of the failure of a major currency or the fiat system altogether;
  • or, because it maintains faith in a currency issued by a government that owns gold.

Who really knows, though. Ben Bernanke has been quoted as stating simply that it’s because of “tradition”.

With respect to fiat currencies, individual currencies are “failing” all the time and yet they resurface, eventually. Anyway, if the whole fiat currency system fails, signaling the coming apocalypse, you’ll want to be able to take care of yourself in the most visceral of ways rather than own gold for reasons already mentioned above.

For those of you who believe that cash will be trash, including the $USD, keep in mind that the US maintains the largest store of gold in the world and that it has been suggested that that amount constitutes some 70% of the country’s reserves.

One sure thing about gold is that it is poorly correlated with other assets. Its use as a means of further diversifying a well-balanced lazy portfolio by a suggested slice of approximately 2%, give or take, is definitely worth something.

If it leads to an increase in the value of your portfolio, fantastic, but don’t count on it as some type of infallible lifeline when disaster strikes wide. Better off knowing how to feed and shelter yourself, and meet your other most basic of needs first.



Philip Valenta, MSF :: [mezcalindo]

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