Gold Part 2

Several more emails were exchanged on gold. I may be right I may be wrong. Definitely a great read if you really want to see where you come down on the argument. Warning - It is a book. (This is follow up emails in relation to the post below. Read the post below first)

Friends Response to My Email In Previous Post
A couple of thoughts/questions: Relating to the question of why gold vs. other commodities, you seem to judge other commodities based on their value in relation to production demand. I do agree that actual demand will fall off for these commodities, as well as gold. Based on the graph I sent you, gold seems to have a value of between 300 and 400 when people aren’t concerned about system shocks. I’m not positive, but I would think this range represents the intrinsic value of gold that allows gold producers to earn a fair return on capital. So, if I’m understanding you correctly, the difference in 300-400 and 2000 is due to its status as a currency.

But doesn’t its status as a currency only improve if there is actual price inflation? If the government keeps printing dollars, but prices keep going down, I would prefer to have paper currencies vs. real assets because my paper currency will buy much more stuff than it used to. The distrust you refer to stems from the fact that people believe their paper currencies might not be worth as much as they used to be if all governments keep printing money like crazy. The only way that a currency is not worth as much as it used to is if it buys less stuff. The only way it buys less stuff is if prices rise. In the long run prices typically rise if the supply of money expands at a more rapid pace than the economy’s ability to produce.

I do think that the money supply is expanding greater than the ability to produce which will cause inflation…in the long run. However, in the short run the velocity of money is slowing dramatically which is muting (or maybe more than offsetting) the impact of printing money…but never mind that, we’ll focus on the long run. So I pose my question again, what level of inflation do we need to justify 2,000 gold? I can already hear you saying that it is impossible to quantify. I would agree that if gold was trading below its long-run value as a production input of 300-400 then by all means buy up some gold. But it is already trading several multiples of that level.

I think my points can be summed up in the fact that despite my deep distrust of all governments for printing tons of money, if prices keep declining, I want paper currency vs. gold. Assuming that I think inflation will go bonkers, I want to buy real assets. The amount in which I pay for that real asset depends on how much I think my paper currency will be inflated. If you think that inflation will be greater than 11.5%, you can justify paying more than 1,200 for gold based on the price of gold in 1979. (And we’ll ignore the fact that gold was down more than 60% by early 1981.)

The other thing that I have trouble getting my arms around is that gold is now a consensus trade. Kind of like oil at $200 was a sure thing. Disaster now. All these guys who are saying buy gold are the same ones that have been saying buy commodities for the last two years and have proceeded to drive off the cliff.

My Response

I am judging other commodities in relation to the supply demand of industrial use as it interacts with the supply and demand of the US dollar. If demand drops equal to the supply increase of dollars than the commodity stays the same price. If the demand drops and the supply of dollars increases but the increase is smaller than the demand drop than in dollar terms the commodity falls in dollar terms......When your referring to intrinsic value your really referring to where MC and MR intersect citing the economic theory that commodity producers shouldn't make economic profits and that in the long term MC should equal MR. First I would say MC has gone up. Just as oil producers are now losing money at 35 a barrell oil where as 8 years ago 35 barrell oil was a gold mine (no pun intended) I would say the MC of gold has probably moved up to around $500 an ounce (I have no data backing that up but I would bet alot it has moved up since 2000 looking at all other metals). So what I am saying is the difference between the 2000 and say 500 is that gold is moving out of being considered just a plain commodity into having another use which is was for thousands of years, as a currency. Most of history gold mining produced millions in economic profits above the cost of capital because gold was not just a commodity as oil or wheat is. It has only been the last 50 to 75 years where this wasn't the case.

Sure its status will improve the higher the price inflation goes but you don't have to have price inflation for it to go up alot. But if the supply of dollars increase and the demand for any good goes up the price will go up. You have this dynamic for gold but not for anything else currently. In fact the supply of dollars are going up even as the demand for gold goes up as Asians and Europeans are wanting another currency option other than the U.S. dollar. Gold.....You right. You would rather keep paper currencies. You made the argument why I don't want to own nickel. But gold is gaining against both because demand is the same or increasing while the supply of dollars is also increasing. On a relative scale it is the most attractive option. How do I communicate this. Think of it this way. Where would oil be if the supply of dollars would have stayed the same from a year ago? 30, 28. 26? So oil may have gained in dollar terms, it has just lost more in economic terms. As gold is wanted for currency purposes it has gained in economic terms and in currency terms.

You said the only way that currencies are not worth as much if it buys less stuff but the only way it buys less stuff is the price rises. Invert that. Think of currency as the price. The price of currency can fall but the demand for a F150 can fall more. In Iceland the price of the currency collapsed as no one trusted the Krona. The demand for the F150 also collapsed but here the price of the currency collapsed more causing the price of the F150 in currency terms to go up.

You looking at gold as an Econ 101 commodity where MC = MR. I would argue for 5000 years it wasn't an econ 101 commodity and for 50 to 70 years it was. We are leaving that blip of history and it is no longer an Econ 101 commodity. There is a problem with that argument and I'll see if you pull it out but the basic point is that if gold truly becomes a currency again you could huge economic profits for the manufacturers for decades.

And I would say for all hard assets the demand is falling faster the supply for money is increasing currently. That doesn't hold true for gold and so you will actually get richer and gain on the increasing money supply. By holding paper money right now you will gain on almost everything even as you are losing (like I said if the money supply would have been held constant what would the price of oil be?). In gold you are gaining on everything while not losing. In fact gold priced in oil shows just how much oil has really fallen even as oil still bubbles around 35 a barrell.

Maybe your right. I disagree. I watch CNBC and no one has a clue in the understanding of why gold is going up. Fast money has gotten long it as a trade and I do think we have a pullback coming to shake some of that fast money out but a bubble is when an economic truth is chased by dumb money. The dumb money still has no clue why gold is going up. Smart money like Einhorn is pounding the table on it. At some point the dumb money will catch on and by then that is when you want to be selling.

His Response

I completely understand that the price of oil could be much lower if the supply of dollars wasn’t increasing. However, as you point out, the price is well below marginal cost, a relationship that will not hold in the long run and indicates that maybe oil is undervalued in the long run.

The only reason demand for gold isn’t plummeting is because people want to own it for reasons other than its productive use. If it wasn’t for this currency perception, gold too would be plummeting. To me that is the definition of a bubble. You literally have to believe that people will stop using currency and we will be bartering using gold. Then you have to be sure to get out before people realize that no one barters in gold and the price of gold is way higher than marginal cost.

In Iceland the price of the krona collapsed against gold and other currencies. However real assets located in Ireland were not impaired by this. To make my point I will use an extreme example. Imagine I owned all of the real estate in Ireland and last year that was worth 1 trillion krona. After the collapse, if the krona price of that land didn’t skyrocket, then someone in America who is holding dollars will be able to by all of the land in Iceland for, say, $1 million dollars. Or maybe someone with gold could by all of Iceland in exchange for one ounce of gold. We know that’s silly…therefore the price of land in krona should be going through the roof.

It stands to reason that if this happens to every currency, the price of all real assets will increase in every currency. Again this is back to my example that you might be able to by all of the land in America for a couple ounces of gold.

I would agree with you that if you believe we are going back to the gold standard, then gold will increase much more than other commodities. However, I think there is better margin of safety in other real assets that can be bought for less than marginal cost or that leaves producers with an inadequate return, just in case we aren’t going back to the gold standard.

My Response
It can last a long time. Look at uranium. It was below MC for over a decade. Close to two decades.

No you don't have to literally believe that people will use gold to barter. You have to believe that the trust in currency will go down, supply of paper currency will go up, or that gold will in some form or fashion back currency in some form or fashion in the future. Also what happens if the Euro or the Pound collapses. I would put that at a coin flip. The perception of gold as a currency will increase. Gold was never bartered with for the fifty years prior to 1960. It was just moved around between countries in large blocks as currency transactions took place. There doesn't need to be any bartering in gold.

Wrong!! Real assets were impaired alot in relation to other stores of value. Take your example in real estate. I agree Iceland real estate gained tons of value in Krona terms but it lost tons of value in US Dollar or Gold terms. That is a net loss in true value. The reason is because of a huge supply glut and even bigger demand fall off for real estate, commercial buildings, homes etc in Iceland. So the true value isn't worth as much unless you compare it to Krona which is even worth less and lost more value. Land lost value, it just lost less value compared to Krona. It stored value compared to Krona but not to other stores of value like the U.S. dollar or gold.

Agree. Once again take your extreme example. It happens to all currencies. Take a current 250k house in Dallas. Now it would take 250 ounces of gold to buy. All the currencies lose trust. Now it takes a quadrillion dollars to buy that same house in Dallas. So the house stored value but because dropping demand in houses as economic turmoil takes place it only takes 100 ounces of gold to buy that same house. So the house stored value in comparison to dollar terms but lost it in comparison to gold terms. Gold kept the same level of value.

In your last paragraph I agree in principal, just not the timing. At some point land will be a great investment to store value. I just think gold currently is going to gain in value in relation to land as currencies continue to implode so the true value of land will go down even if we level out in dollar terms.

His Response
Meaningless paper backed by gold is essentially bartering with gold.

And yes I get it that demand is falling across the board for ALL commodities (including gold for all other purposes than as the anointed store of value). I will repeat that I understand what you are saying…another way of putting it is assuming that the money supply in Iceland was stable, the price of land would be falling relative to gold because there is less demand for Icelandic real estate than gold.

My point is that the only reason demand for gold hasn’t plunged like real estate, oil, copper, etc is that there is added demand for it when people get scared. The price reflects the fact that people are scared right now. The added demand that is driving up gold is not sustainable because when people get happy, people are going to sell their gold investments. Looking for unsustainable revenue growth, margins, prices is how I find shorts.

What degree of scared, I don’t know..that’s why I’m asking what sort of inflation is being priced in to Gold vs. other real assets. Everyone knows that demand for all commodities is falling, so investors will factor that into their prices they will pay for commodity futures. They will also price in some degree of inflation. So I would think the real question is what commodity has the least amount of inflation priced in given your demand forecast??

And yes I realize that if we go back to bartering with gold that the added demand for gold is sustainable and justifies a permanently higher price.

My Response
Okay - saying people are getting scared is just the inverse of saying they are losing trust. So you could say my bet is that people are getting to get alot more scared or lose alot more trust.

If you want to say your dad and my dad and our grandfathers bartered with gold I can buy that. I was just thinking of bartering as something where I exchange my gold for your cow versus exchanging a currency backed by gold for a cow.

So while the industrial demand for gold is falling a whole new use or demand for gold is being created as people are getting scared. My thesis is this tidal wave is just getting started. Sure it is added demand but my guess is sovereign nations in Asia and the middle east are going to get on board of this "new" demand.

I understand your 2nd to last paragraph. It is the standard investment way of looking at it. I just think the paradigm shift (if I am right) makes it mute or at the least unanswerable because it is not going to be your typical supply demand inflation stoked world. It is a world where t in my inflation equation in my letter is going down. It is an inflation not seen in the United States since 1865 in the confederacy. I just don't know to what degree. I hope small.

Final Response
Ok nice conversation, I think I understand where you are coming from. Talking about this sort of stuff is good (for me at least)…forces me to think about what I believe.