economy

Why Warren Buffet is wrong about gold

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NB: This post first appeared at Beating the Index.  To read or add to the comments and discussion of this post please go here.

Following the controversial Warren Buffett on Gold Investing article, I thought it would be interesting to read a different opinion on gold.  I asked my fellow blogger and gold investor Peter from the Righteous Investor if he would like to provide an alternative view on gold investing and he kindly accepted. Thank you Peter for providing us with the view from the other side.

Money is a commodity which serves both as an intermediate of trade and a store of wealth.  Money must have the following characteristics to function properly: limited quantity, fungible, portable, available.

An increase in the money supply without a corresponding increase in production of goods and services leads to inflation; inflation of the money supply leads to price increases in the following order:  (i) commodities; (ii) consumer prices; (iii) cost of labor.  Inflation therefore results in a de facto garnishing of wages.  Thus, if a government sells debt which its central bank then monetizes (i.e., quantitative easing), then government spending benefits recipients through doing irreparable harm to savers and wage earners.  Thus, if possible, retail investors must protect themselves from this harm.

Humankind has used gold and silver as money since the dawn of history.  History has shown that gold is too rare and valuable to function as the only money, for the gold standard has led in the past to scarcity, making money too little available to common people. I’ve seen first hand how scarcity of money has lead to serious problems in the Central African Republic, where the local currency is tied to the Euro, which benefits international commerce but doesn’t really help the people on the street to conduct their daily transactions because there are too few small bills and coins.  The gold standard can also lead to this sort of scarcity and that is why in the late 19th century, there were many advocates who wanted to monetize silver.  Nevertheless, the great advantage of precious metals over paper currency is the inability of a government or a central bank to create it at a whim, and therefore they are far less susceptible to inflation.

Warren Buffett’s advice about gold has had a profound effect on retail investors.  He advocates common shares in stocks as better than gold; ironically, one of the most famous articles on how companies do poorly during times of a high inflation was written by none other than Buffett himself ( “How inflation swindles the equity investor”).  So he knows very well that stocks provide little protection from inflation.  So what are retail investors supposed to do?  They can’t buy bonds or common stocks, and in Buffett’s opinion, they are speculating if they buy precious metals. But I ask, why should Buffett care?  Remember, he’s an insurance salesman and he is out to get your money.  He himself has greatly benefited from the bailouts and the monetization of the US Federal debt.  I don’t think he has the best interest of ordinary investors in mind.  And I am not alone in this opinion.

Why there is no gold bubble

An investor, particularly the value investor, must seek to avoid overpriced assets.  Value investors want to find undervalued, underappreciated investments.  There are some pretty strong reasons to believe that precious metals are oversold and not overbought:

  1. Not that much global wealth is invested in gold (see Eric Sprott and Andrew Morris).
  2. There are too many anti-gold bugs.  Despite the performance of gold in the last ten years, there are still many who, like Buffett, do not understand why it is attractive.  There is also an entire school of economics, the Keynesians, who consider gold a “barbaric relic”, and this school has an enormous influence on governments, universities, and the media.  Keynesians have been adamantly opposed to gold and silver money, because it prevents them from manipulating and controlling the economy through monetary policy.
  3. Gold is just keeping up with other commodities and is also tracking the increase of the Federal Reserve money base.  The real bubble is not gold but the US dollar.
  4. Unallocated gold and gold derivatives make up an enormous and extraordinary portion of the supply of gold in the market.  Certain banks have supplied unallocated gold certificates on a fractional reserve basis to their customers (see this explanation by Avery Goodman).  It is difficult to say how much paper gold there is, but GATA’s Adrian Douglas has estimated that there is a 40 (or as high as 100) to one ratio of paper to physical gold.  This is the crux of the matter.  If and when a physical gold run occurs we could see gold jump to 40x the current price in a few days.  For this reason, every prudent value investor should invest in some physical gold and avoid all paper gold derivatives like the plague.  The same is true of silver, but according to analysts such as Eric Sprott and the National Inflation Association, the paper to physical silver ratio is much higher than it is for gold.  This is an important warning:  Do not believe any author who says there is a gold bubble but doesn’t deal with the question of unallocated gold.  In the end, the collapse of the unallocated gold, which is so deceptively co-mingled into the gold market, may become the financial disaster of the century, eclipsing the sub-prime mortgage crisis in its wake.

How I make money from the sector

The gold sector is not safe because of its great volatility.  Since I took my first position in 2006, gold has traded in the range of $600-$1400 per ounce, and gold mining companies have experienced an even greater range of prices.  So it is inadvisable to put all of one’s saving into precious metals in a single day.  The volatility, on the other hand, lends itself to the possibility of a profitable trading scheme.  So my strategy consists of both a base position of shares that I am holding for the long haul, and the trade itself.

(1) Base position:  I started five years ago by establishing a position in Barrick Gold at CDN $33.50.  I’ve never sold those shares.  I have also averaged down, when possible  (e.g., with NGD), to establish my current position.  Here are my current positions that I have accumulated over the last five years, followed by the average cost price:

Barrick Gold (CDN $34.185; +48%), Detour Gold (CDN $14.25; +121%), Lake Shore Gold (CDN $3.41; +19%), and New Gold (CDN $1.94; +471%), Sprott Physical Gold Trust (US $12.24; +2.5%)and Sprott Physical Silver Trust (US $12.65; +37%).

Gold and silver coins and bullion must be stored in a safe place, so I wouldn’t own any unless I believed that the economic collapse was imminent.  Therefore, the Sprott physical gold and silver trusts are a means of having direct exposure to the physical metal without having to worry about being robbed.

(2) Trading:  (a) I used to trade gold mining stocks, especially ABX and NGD.  I would try to buy on dips and take profits as enthusiasm picked up.  (b) One year ago, I started to sell put options because it was safer than taking long positions, though it would reduce the upside potential of my positions.  I have been selling these puts (in ABX, GG, NGD and DGC) since 2010.  I do this trading on the US market whenever possible.  I was of the conviction that QE would cause the mining companies at very least to remain static in value vis-à-vis the US dollar, and indeed, only one out of the multiple positions that I’ve taken in put options has ever been assigned.  I try to sell the puts on dips and I will occasionally buy them back if they make considerable gains in a short period of time.

P. W. Dunn holds a PhD in theology, has taught biblical studies at the undergraduate and master’s level in Africa and Canada, and now is a DIY investor who publishes his ideas about investing and how it relates to Christianity at theRighteous Investor.  His other posts on gold can be read here.

To read the comments and discussion of this post please go here.

Walter Williams on the Eighth Commandment

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“You shall not steal.”  Exodus 20.15

Walter Williams claims that if I find a needy, destitute woman and I take $200 from you at gun point to help that woman, it is stealing.  If I vote a democratically elected government which takes $200 from you and then gives it to that poor woman it is no less stealing; this is just simply the majority deciding whom it robs and to whom it bestows favors and it is equally immoral to stealing on an individual level.

But socialism doesn’t work.  The seeds of socialism’s own destruction is in its benefiting wrong behavior and punishing good behaviour.  For it takes from the productive and gives to the non-productive.  When a behavior is rewarded you get more of it; when it is punished you get less.  This is the point of sin taxes on tobacco and alcohol and even socialists understand this basic concepts.

Williams further supports limiting the government’s take of the GDP to 10%.  That’s a brilliant suggestion that could help socialist Western countries to get back on track.  In my view, the only legitimate roles of a federal government are: (1) defense; (2) justice; and (3) regulation interstate/interprovincial commerce and foreign trade.  They must get out of the business of cradle to grave socialism or fail completely.

Click on the picture to watch the video at Yahoo:

The Secret of Oz: Anti-central bank, anti-gold standard

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This film was certainly interesting and well-made.  It is in favor of fiat money which is controlled not by central banks but by democratic government.  The title is based upon Hugh Rockoff’s allegorical interpretation of the 1900 children’s book Wizard of Oz, setting the story in the political controversies at the time of the author, L. Frank Baum (1856-1919).  According to this interpretation, the silver slippers are representative of silver money in competition with the gold standard, the Scarecrow, who is actually smarter than people think at first, is the American farmer who is destroyed by deflation, the Tin Man is the American industrial worker, who is in need of liquidity (oil), who comes along side the farmer in common cause and the cowardly Lion is William Jennings Bryan who was in favor of silver money and the US government issued greenback.  The wicked witches of the East and West were two major banks, and the water that kills the witch is the easy liquidity of the government’s own ability to create fiat currency which is not debt-based.

In my opinion the films successfully show how the gold standard can be manipulated by big banks and can have depressive effect on money–which can (1) stifle the growth of an economy and (2) create serfs out of people who cannot pay back their debts because of inadequate liquidity in the system.

The film fails to show how giving control of fiat currency to government can stop the government from politicizing the money supply and ultimately from creating hyperinflation.  The film also mistakes fiat money creation for wealth creation:  While it is true that wealth creation requires liquidity, it is a mistake to confuse wealth creation with the creation of fiat money.

I would conclude that restrained form of monetarism could be the best system in that it would grow the money supply in conjunction with economic production–but that all systems of money are open to manipulation and greed–and this is why the Austrians point out that all paper currencies eventually become worthless.  The advantage of a system of money which is based on precious metals is that neither a central bank nor a government can steal people’s wealth through the excess creation of money.  A stable currency would also encourage saving, as currency would be store of wealth.  The disadvantage of the gold standard is that liquidity can be dried up and there can arise situations in which money becomes too scarce.

Hyperinflation is now here: throwing gasoline on the fire

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Kapitalcon cited my post discussing the $223 billion dollar US Federal deficit in February, and then went further to predict QE III:

Important to note is the Federal Reserve’s recent announcement that it may have to begin its third round of QE in response to sky-rocketing oil prices.  Atlanta Fed President Dennis Lockhart stated at the National Association of Business Economics in Arlington that “If [the rising price of oil] plays through to the broad economy in a way that portends a recession, I would take a position we would respond with more accommodation.”  As oil increases, so too does the cost of most, if not all, goods and services. This includes anything that requires petroleum in the production process, not to mention increased transportation costs for moving the product to market.  Such is the rationale for QE3.

Do I fear my commodity stocks going down like they did in 2008-9?  Not with people like Mr. Lockhart running the Federal Reserve Bank.  The problem of the commodities is too much liquidity chasing too few goods.  If the Federal Reserve Bank’s solution is to just throw more fuel on the fire, then I’ve nothing to fear.  QE, which I affectionately call the Bernanke Put, will be the ultimate cause of hyperinflation.  It is as though they are trying to fulfill this prophetic video that the National Inflation Association created a few months ago:

Jeet kune do investing IV: Venezuela

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The Globe & Mail presented a contemporary example of hyperinflation in article by Frank Jack Daniel:  “Trying to survive inflation? Ask Venezuelans“.  One point stood out to me:

Over the past 25 years, its citizens have developed all sorts of techniques for stretching their money and offsetting price rises. The main rule is get rid of cash fast.

“There’s no point leaving it in the bank, it’s better to invest. I bought this car for example,” said Caracas town hall official Jorge Juarez, who leaves home at 4 a.m. to beat the snarled traffic and uses his 2007 Fiat as a taxi after work.

Mr. Juarez is in many ways a typical middle-class Venezuelan. Through a mix of hard work and shrewdness he has kept up his family’s living standard even as his salary’s buying power shrinks.

Cars are a good investment in the Caribbean nation, where gasoline is subsidized to the point of being almost free and demand for vehicles far outstrips supply. As such, they increase in value as they age, faster than consumer prices.

Cars were seen as a good investment during hyperinflation in Chili, according to Gonzalo Lira, as I mentioned in an earlier post about  why I was buying Toyota RAV4 on 0% 36 month financing.  If gold is the measure of real estate, then real estate is suffering in price even while here in Canada it is experiencing phenomenal nominal gains.  This too accords with what happened in Chili according to Lira.

NB:  this post is part of a series on Jeet kune do investing, named after Bruce Lee’s martial arts, a style which is no style.