GOLD..GOLD..GOLD

Below is an email exchange on gold between a friend. Thought some of you may find it interesting reading. Gold is due for a pullback but I still like the long term risk reward scenario.

Original Email
Jason, gold question for you from the metals novice…I'm sure you will have much to say, but I'll allow you to summarize.

See attached gold graph. Taking 1979 price of 800 and growing 2% per year for inflation equals about 1,200. So peak inflation to peak inflation. The next two attachments show core PCE and actual PCE price indexes hitting 10% and 11.5%, respectively in the 1970s. Does that imply we need inflation to go higher than 10% to move gold above 1200? And why not buy some of the beaten up commodities that are not nearly 300% higher from 2002?

I think I've got a few guesses, but I'll allow you to reply first.

My Response

Lol - your right. I do have alot to say. I could probably type an hour but will try to summarize my general thoughts. I get so frustrated watching people on tv who don't understand what is going on with gold at all. In October and November they kept commenting that the day of the gold bugs had come and the fact that gold didn't move showed that gold was no longer a legitimate asset class for safety. WRONG. It is a legitimate asset class for safety for certain scenarios. Even the gold bugs don't get this. Banks blowing up and going into depression isn't one of them until it starts impacting currencies. During the Great Depression gold did not perform well because it was a deflationary event and governments were worried about the sovereignty of their currencies. Money supply went down. Gold doesn't protect you from this and if this is what was happening I would be shorting it. What is happening now is far far different.

So if your buying gold you have to mentally grasp on to the fact that there is a paradigm shift back to gold as a currency or at least as a store of value. This is at its very beginning stages but as currencies around the world collapse gold will become a second reserve currency. In a worst case scenario it will become the first reserve currency.

So the only reason you ever want to buy gold is because of inflation. Well you look around everything is pointing to deflation. Why is gold going up? This is what the commentators on tv including many money managers don't get. It is a type of inflation that is different than anything we have experienced in the United States going back to at least the 1800s and on a world scale at least several hundred years. It is what I poured my efforts into in trying to explain in my letter. It is an inflation based off the deterioration of trust. It is an inflation that can occur even as economic activity continues to tank. As trust deteriorates in the Euro as the currency is teetering on collapse where do Europeans go to store value? To at least buy insurance? Japanese Yen, US Dollar, Gold. What happens when the Japanese economy collapses as is happening and a heavily indebted government starts teetering, you go to gold and the U.S. dollar. On up the chain if the US government just keeps printing and printing.

Okay so if you buy this paradigm shift those inflation graphs you gave become meaningless. How so? Because you could have CPI flat or negative over the next year but have true currency inflation where gold goes up 100%. Think about that for a second because it shouldn't make sense right away. It was what I spent months tossing around in my brain. So you say why not buy copper or oil or nickel which are much beaten down. Won't they also perform well. Answer is maybe but I wouldn't bet on it. It definitely won't perform on par with gold (at least I don't think it will). The reason is because the inflation that will occur will be a currency inflation where people try to find what will store value. Nickel doesn't do this despite it is a hard asset unless you have a steady demand. What happens if world industrial production goes down 25% in 2009, possible. So you have this metal nickel that the demand continues to fall off making it less valuable even as currencies decline in value in relation to things that store value. Nickel may go up in dollar terms or it may not depending how the supply demand graph of nickel interacts with the supply demand graph of the dollar. Nickel is going up in Euro terms, in Pounds, in Pesos but not in US. dollars. Gold is going up even as the US dollar is going up because the market realizes what is happening (at least my opinion). Actually the US dollar is going down. If you say all currencies are relative and then make gold a currency (which it is hasn't been an official currency in 50 years) than the dollar is going down as the market has once again made gold a defacto currency. I really think that sentence sums up what so many people are not getting and to them the gold move doesn't make any sense. It is why money managers who see inflation but don't really see the type of inflation coming are wrong messing with oil. Oil keeps going down and they are pulling there hair out as gold goes up. But once again a huge tank of oil in economic terms is worth much less if world industrial production were to fall 5%, 10% 25% in currency terms it may be worth more. Which wins? But if currencies are a relative thing than a bar of gold that has now become a currency is worth much more despite what happens to industrial production.

So I think gold is going to 2,000 an ounce in the next 18 months but I don't really know. Someone asked me how I was coming up with a price target and I don't have an answer. You can't value it which drives most value guys nuts as it should. My answer was tell me how much trust gets taken out of the system, quantify that, and I will tell you how high gold goes. Obviously that can't be done. So I don't know where gold will end up but as a handicapper I think my margin of safety is huge that it is much higher from here though we are due for a pullback.

One more anecdote on why I am long gold and not looking at other commodities. If your playing poker and you have four cards out waiting for the last card. You want as many outs as possible for that last card to be a winner. The more outs the bigger you should bet. Nickel in my mind has very few outs. Gold has numerous outs. You can give me all kinds of scenarios and I can explain how gold could be a big winner. There is really only one scenario where it is a big loser and that is money supply stabilizes, the risk to the sovereignty of nations stabilizes, and we go through a deep recession or 1930 depression. I don't see that happening.