All that glisters is not gold*

Gold tumbled last week in a price move suggestive of a disorderly, almost panic-like repricing of the commodity, which many of my readers know I like to categorize as a psychological asset.

To get at the root of gold’s collapse, we first need to examine why this precious metal has risen so far so fast, and why so many people have made money in this commodity for so many years. Indeed, the price of gold has risen sevenfold since 2001. Investors buy the metal as a safe haven from turmoil in the financial world. This is especially true when inflation threatens or crises occur. When banks totter on the brink of collapse or government deficits rise to dangerous levels, gold comes in handy.

Investors have long had a love affair with this shiny precious commodity. Gold’s supply is finite. So, despite the best efforts of mining companies, the supply of gold rises at a slower rate than that of the world’s population. Secondly, gold has a long track record of being regarded as a store of value.

In fact, now, when I ask people why they like gold, that is exactly what they say. They tell me they hold it because it is a store of value against the government’s printing of money, i.e., inflation.

But last week, that reason for owning gold seemed to evaporate to a large extent when European demand faltered and reports indicated that Chinese demand was weaker than expected. Of course, as investors, we have to look at gold's negatives too. And this is where the crux of my argument lies.

There is no way to price gold against other asset classes. Stocks can be valued against earnings; they represent a residual interest in cash flows from successful products. Bonds can be measured against coupon yield; they represent future promises of fixed cash payments. Stocks, bonds and other asset classes can also be driven by euphoria and fear rather than by fundamentals or valuations. But in those markets, at least, we have fundamentals and valuations to guide us, to warn us, to entice us. Lacking such means of valuation, gold floats out there and is dependent only on what people think it is worth and nothing else.

It has no yield, no cash flow, does not grow, has virtually no use as an industrial metal. So how can we value it? What can it be measured against?

I would say the only answer is fear. Gold rises when people are afraid of something. That tells me gold is ultimately a psychological asset class. And to me, investing in such an asset class has always spelled danger.

When an asset class has nothing but fear to prop up its value, it will be at the whim of crowd psychology. And that is essentially what we saw last week. If news spooks the crowd, then we see a selloff like a snowball careening down a hill — it gathers more and more adherents until suddenly gold has lost 8% of its value, and no one really knows why.

*A line in William Shakespeare's The Merchant of Venice. Glisters is a 17th-century synonym for glitters.

No forecasts can be guaranteed.

The views expressed are those of James Swanson and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation or solicitation or as investment advice from the Advisor.



Anonymous said...

Gold is used in several industries, including but not limited to: denstry and electronics/technology.

Anonymous said...

Excellent observation! Perhaps the run-up was linked to a rise in tooth decay!

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