Buying Gold: Pure Speculation
Buying Gold: Pure Speculation
In a recent interview with the Financial Times, Oaktree Capital chairman Howard Marks had the following to say about gold:
'Gold is very problematic because you can’t value it. Gold, oil, diamonds, art, houses and currencies are assets that don’t produce income and as such it’s very hard to put a value on them. So it’s easy to sit here and to say, “Well, there’s concern about the dollar, there’s concern about inflation, there’s uncertainty about what the future looks like and so gold is a good idea”.
But you would have said that if the price was a thousand, you would have said that if the price was six hundred. Now I say to people, “So you’re saying that today when the price is fourteen hundred”? They say “that’s right”. I say, “Would you say it today if the price was twenty-eight hundred”? They say “no”. I say, “Then price matters”. They say “yes”. Then I say, “So how do you know today’s price is ok? How do you know that it’s ok to go into a good which you can’t price? How do you know that all of these reasons to do it aren’t priced in today”? And you can’t.'
Too true. If you want to buy an asset that doesn't generate any income, that's fine. But don't call it investing. It's speculation, pure and simple.
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Comments
You mean this? ;-)
http://www.frankvoisin.com/2010/11/22/the-gold-market-video/?utm_source=...
Steve
Its funny you posted this today, as it was only yesterday when I watched the video of Mr Marks making the very same comment. His eloquent observation is up there with Buffett’s “anyone watching from Mars”.
I hold a small amount of gold in my portfolio and it is a position I continually struggle to feel comfortable with because I acknowledge every day that it is speculation (as if repenting for a sin).
However, I will continue to hold some gold so long as I see the leaders of this world continue to dig us deeper and deeper into a hole. I fully expect I will wear a loss on the position if this situation changes abruptly, but obviously there is a part of me that would be surprised if that happened. The solution to too much debt is not more debt…
The best ‘valuation’ for gold that I have come across is courtesy of Dylan Grice at SocGen. It is almost a year old now, but I am yet to find something I like better:
(sorry, this is a cut and paste from a pdf because its too long to retype, so the formatting might be a bit messy)
“So gold isn’t intrinsically safer than any other asset. There is nothing mystical about it either.
Like all other assets, it goes up and down according to its fundamental drivers.
But what are these fundamental drivers? How can something with no cashflow or earnings
power be valued?
The simple answer is that it can’t be. Intrinsically it is pretty much worthless. Indeed, when I
tell people I buy gold the most common complaint I hear is that it has no real industrial use.
Surely I’d be better at least buying a commodity that industry needs to make stuff with, like
silver or platinum?
The more verbose answer is that this ’uselessness’ is exactly what gives gold its value
because it makes it the perfect currency. If you own silver, a recession will cause the price
(and therefore its purchasing power) to fall because industrial demand has fallen. The same is
true for platinum or palladium. But the price of gold will be unaffected by any decline in
industrial demand because there is no industrial demand!
To value gold it helps to understand that paper money was traditionally based on the stock of
gold (and silver). Depositors of bullion would receive a receipt proving their holdings and it
soon became easier to use those receipts for commerce than it did the physical gold. So while
the use of paper money had become commonplace by the 18th century, that paper was
always redeemable into gold or silver. The money supply was always gold-backed.
Full redeemability was increasingly watered down after WW1 so that by the time the Bretton
Woods system was imposed following WW2, only central banks had the right to convert paper
for gold. But when that broke in 1971 because dollar holders had become distrustful of US
promises to restrain its dollar printing, the link between paper money and gold was severed
completely. Since then, paper money has been backed by nothing more than central banks
promises to maintain the money supply at a stable level
So one way to value gold, therefore, is to ask at what gold price the value of outstanding
central bank paper would be completely backed by gold. The US owns nearly 263m troy
ounces of gold (the world’s biggest holder) while the Fed’s monetary base is $1.7 trillion. So
the price of gold at which the US dollars would be fully gold-backed is currently around
$6,300.
[chart]
The chart above shows the extent to which the USD has been gold backed since the late
1960s. It currently stands at 15%, close to the all-time low 12% reached in 2001 but far from
the all-time high of 140% reached in early 1980. Interestingly, during that inflation panic the
value of gold rose to such a level that the dollar became over-backed (the red line is higher
than 1). The market value of gold held by the Fed was worth more than the paper money it
had issued!”
Dylan Grice, SocGen, Cross Asset Research,18 November 2009
‘A Minskian roadmap to the next gold mania’
http://www.scribd.com/doc/37435017/Minskian-Roadmap
Having said that, I also have to appreciate the point of view from another blog I read awhile back:
"the bugs who see $5000 gold are expecting something so bad that they are better off buying lead, for bullets, because that will be far more valuable than gold."
http://seekingalpha.com/article/75325-gold-as-an-investment-think-again
cheers
Justin S
Gold, silver, oil, diamonds, art, and property are assets that don’t produce income but that is not the point or the reason to hold any in your portfolio. It is to preserve your wealth. All of these items have a finite supply which cannot be increased without investing time, effort and capital. If you want to value 1oz of gold then calculate the amount of AUS$ spent in exploration, mining and refining to acquire 31.103g of it. That it why an aureus gold coin minted 2000 years ago in the reign of Augustus still has a value today. Is your value investing fund making no consideration for inflation and the effects of printing money (sorry, quantitative easing)?? As an economist this can't possibly be a new concept for you Steve.
l have argued that the best solution for goldbugs is to buy gold-producing stocks rather than bullion .
The gold in the ground is worth more than the bullion it might represent courtesy of a dividend . N'est pas ?
Avinash
It's not a new concept. It's just not one I buy into. The argument assumes that there are only two assets in the world: gold and paper money issued by governments with no tangible asset backing. Faced with such a choice, I'd agree with you.
But they are not your only options. Faced with the choice of paying US$1400 an ounce for a metal that can be dug out of the ground for a marginal cost of US$500 an ounce, and buying US office property yielding in excess of 10% per annum, I'll take the later. Land, too, provides good protection against inflation. And I collect some income while I wait.
Surely total costs rather than marginal operating costs is what counts in the long run. I don't know the numbers, but the capital costs have been paid on perhaps a few years' supply. Beyond that, real money needs to be spent. Capital plus operating costs would be much closer to $1,000, and the marginal total cost of expanding that production would be quite high (the best prospects get developed first). BTW, read a post on this once (can't remember where) where the writer explained how, through the gold bear market of the 1990s, the gold companies have conditioned investors to focus on operating costs rather than total costs, and now they're being quite sneaky pushing certain operating costs into capital costs. I don't know the details sorry.
I have always believed that the value of any investable 'thing' can be expressed as IV=DCF+IU, where IV is intrinsic value, DCF is the discounted cash flow valuation and IU is the intrinsic utility of that thing, which may range from zero (for a stock or bond in most companies) to the entire value of the item in question (for artwork and most other commodities), and points in between (like stocks that have a "buzz value").
IU can represent anything from sustenance-value that someone is willing to pay for a loaf of bread (relevant to the value of wheat), to the status-value that some fop derives from gold-plating his Hummer (I have actually seen one clown in Abu Dhabi who actually did this!).
My idea has plenty of fairly obvious shortcomings because it fails to accomodate the supply side of the demand-supply equilibrium into the equation, it fails to accomodate differences in the level of utility derived by different people for the same good and it is also not particularly practical because IU is so inherently subjective.
Nonetheless, I still believe that my way represents a substantial improvement on the "IV=DCF" ethos that underpins most value-investors' thinking because it at least opens the door to the possibility of commodities and other non-cash-generative assets having an intrinsic value.
Comments?
When we talk about 'intrinsic value' as investors, we are referring to a monetary value - period.
I can buy a painting because I love it, and because I love it I never plan to get rid of it. This is not investing, and to assign a monetary value to it is meaningless. I will pay as much as I can afford or am willing to spend - period.
To try to assign a monetary value to our wife, kids and favourite goldfish, is pointless.
If we are investing (including seeking to 'preserve wealth') then the only intrinsic value that matters is DCF. When we buy gold (unless we are buying jewellery) we are not buying out of love. The expectation is that someone will be willing to buy it from us at some point in the future - and so it has a monetary value, which can be defined by DCF.
Ofcourse, the issue is knowing what someone will be willing to pay tomorrow. That's not very knowable, and so is speculative.
I have an old wedding ring, think I'll cash it in soon and buy red wine with the proceeds.
Interesting post. I admit I have always struggled with the idea of buying a commodity, particularly gold which has no industrial purpose.
I wonder however, does the problem with gold exist in the fact that it isn't useful or is it that it doesn't directly produce an income?
If the problem is that it does not produce an income (like a property would), does the same argument apply for a more widely used industrial metal like silver or for that matter oil? Is it pure speculation to buy these commodities also?
If however the problem exists in its lack of useful purpose, is gold's use in jewellery not a useful purpose? It is hard to imagine gold being surpassed as the material of choice in jewellery. Does gold not have a durable place in society for use in jewellery? Is this not sufficient enough to view it as useful?
I can identify with the alien from another planet type view, but on the other hand, society seems full of things that would seem useless to an alien from another planet but which play a large role in society and will continue to do so for the foreseeable future. Take Coca Cola for example - or for that matter, what about cigarettes or poker machines or beer? Are these any more useful than gold?
I recently ame across a post on the total cost of gold, in which the author writes - "Currently, the price of gold is only a little over the price of producing it. Does that sound like an overvalued commodity?"
Worth a read.
http://www.adventuresincapitalism.com/post/2010/03/20/The-Real-Cost-Of-G...
Of course gold serves a useful purpose for jewellery and it has through the ages and this will never change.
I can see the bubble argument for gold at these prices, but I could also argue the other way.
Gold looks like more of a bubble when measured in USD.
Measured in AUD its rise is not as significant.
Gold measured in Australian house prices over the last 20 years would make anyone ask 'wheres the bubble then'?
There is no reason gold (or other precious metals) should not have a place in a conservative portfolio.
There have been occasions in many countries over the last century where gold has been the only investment worth having.
I'd certainly rather have some gold under the mattress than a wad of fiat money, which is losing value every day.
We can argue about the utility of gold, or anything else, until the cows come home. From an investing perspective, however, I’m not sure that this is really the crucial point.
It's really very simple. If you cannot form an opinion about value on the basis of rational thought and careful assessment (or whatever words Ben Graham famously used) - then it is speculation.
The point is that the value of a future income stream, as generated by some assets, is much more likely to be ascertained in such a manner. Guessing what someone will be willing to pay in the future, for an asset that doesn't generate an income, is much more likely to be, well...guesswork. That makes it speculation.
So Mars
Not to wish any ill upon your loved ones, but if your wife, kids and favourite goldfish were kidnapped, how much would you pay to repatriate them?
I like Shum's equation including IU as it recognizes the individual subjective element of value of some assets.
I would pay as much as I was willing to spend or as much as I could afford.
As I said before, this has nothing to do with investing.
I agree with you Mars that buying it to sell it at a higher price is speculation. However so too would be holding cash in the hope it doesn't erode too quickly. Could gold be a useful home for the percentage of your portfolio you don't want to actively invest?
I work in a corporate advisory firm and we do the occasional 'unique' valuation (with regards to the income generating asset being valued, not the valuation technique). The term we might apply to the 'IU' concept is, I believe:
'fair market value less special value'
where special value represents the price one would pay based on that entities particular circumstances/desires/beliefs.
Basically just saying that, for a particular buyer, someone would be happy to pay more than what would be justified by a (income based) fair market valuation.
As such, someone might knowingly pay a high price for a 'strategic asset'. The obvious consequence of paying more than fair market value is a substandard return on investment however.
Thinking about this as it relates to gold:
Yes, I am happy to accept a substandard return (i.e. no income/cash flows = effectively no fair market value) because I am putting a special value on it, that being, i expect it will be a form of currency that holds purchasing power if a round of crazy inflation strikes.
Ultimately still accept that it is speculation though, but 'considered' speculation at least!
cheers
Justin
The main reason this topic can get contentious is because speculation is a dirty word for value investors as it has the implication of gambling.
Maybe instead of speculation it could be called hedging or portfolio insurance instead.
I believe thats what most holders see it as anyway, and there is no denying that it moves inversely to many other assets.
Another reason why its not silly to hold some in a conservative portfolio.
John & Phil, you both make valid points. I have no doubt that there is intelligent speculation and un-intelligent speculation. I don't think it's a particulalry dirty word.
If I hold cash it's in the hope that I will find something of value (by my estimation) in the future. I don't hold it to preserve wealth (or 'in the hope that it doesn't erode too quickly'). Sure there is uncertainty in the value of that cash going forward.
But if I hold cash, or buy foreign correncies, or gold, or anything else that I cannot determine if it is currently over or under valued, for the purpose of preserving wealth, making a gain or even hedging - then how can I not be speculating? It may be intelligent speculation - but speculation nevertheless.
Mars
Firstly, I agree that gold is a "speculation".
Nonetheless, if the fictional kidnapper of your loved ones would give them over ("sell")them to a 2nd kidnapper for say $10, the 2nd kidnapper may be making a judgement that you would value them more highly than $10. In fact a market could be created for such an asset.
As such, we cannot do a DCF for your loved ones but we may make reasoned judgements regarding their subjective value to others such as yourself.
Speculation I agree, chance of getting a good return on the $10, high I suggest.
Yes, so that is an example of intelligent speculation. Some Somali pirates seem to have been doing quite well in recent times. If you determine what it will cost you to train the pirates and run the acts of piracy, and you can make an intelligent speculative guess about how much the family of your victims will be willing to pay and how long it will take for them to actually deliver the cash, then you can most certainly can do a DCF.
But you would want substantial margin of safety to cover you for the various risks involved. DCF is just the tool. It can be applied to speculative ventures as much as anything else.
Now if you had been running these piracy operations for many years, you might have a good data base of past operations, so that your DCF's might be far less speculative, and may infact be more like investing.
If the financial controller of the pirates has a good understanding of whether he is over or under paying for his next operation, then he is probably thinking more like an investor. When you buy gold, do you have such an understanding?
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