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 19^th 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.