There are few investments more divisive than gold. Unlike stocks or bonds, gold produces no dividends or interest payments, and unlike most other commodities, gold has few industrial uses. As a result, investing in gold requires one to construct a narrative to explain why someone will pay more for your gold tomorrow than what you bought it for today. And for gold enthusiasts, that narrative usually goes something like this: governments, unable to make the hard choices on spending and taxes required to stay within their means, will resort to printing money. And that money printing will lead to massive inflation and the debasement of government-backed currencies, causing the relative value of gold to rise.
In the years following the financial crisis, this narrative hewed closely to reality in many respects. Government debt ballooned while central banks, especially the Federal Reserve, took unprecedented action, buying up government and mortgage debt in an effort to keep interests rates low, and expanding the money supply many times over in the process. As a result, the value of gold, which had been appreciating in the decade before the financial crisis, exploded, more than doubling in value between 2007 and the peak of the market in August 2011.
But while the first part of the goldbug narrative — large government debts and extensive central-bank intervention — did materialize, inflation has not. The reason is that while the Federal Reserve can create reserves at banks through debt purchases, it can’t force banks to lend those reserves out. In the end, most money in circulation is created when banks lend to creditworthy borrowers, not by the Federal Reserve itself.
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As investors have slowly learned this reality and understood that, at least in the short term, government spending and central-bank activism won’t lead to significant inflation, the price of gold cratered, and is down more than 30% from its August 2011 peak. But even as gold continues to fall in value, the inevitable question is, What is gold’s fundamental value? And when will the losses stop?
The short answer to this question is that gold has no fundamental value besides our collective belief that it is valuable. And in the long run, the return on gold as an investment isn’t very attractive relative to other types of investments. That being said, at some point, the price of gold will stabilize and reverse, and many market observers are looking at what might bring about that change. Barry Ritholtz of Fusion IQ wrote this week that gold “has fallen so hard that a counter-rally is overdue.” He goes on to describe the mechanics of such counter-rallies:
How do the typical countertrend rallies work? Well, the forced selling by margin clerks and futures traders becomes exhausted. A distraction may capture the investing community’s collective attention, allowing some stabilization to occur. As prices stop falling, the fear falling asset holders have been living with dissipates. A little bit of good news, a small reversal in price, and the prior [now discredited] narrative reasserts itself.
Note this scenario is nonspecific — we see it in stocks, bonds, commodities, real estate and yes, gold … Here comes the bad news: the bounce in a commodity like gold — or its primary trading vehicle, GLD — is less likely to achieve that sort of happy ending. The bull market is broken, the prior narrative has utterly failed, and is no longer taken seriously, except by yellow-metal jihadists and other assorted suckers.
Ritholtz foresees a possible rebound for gold in the short term, but that ultimately the metal will far further, possibly erasing all the gains made during the postcrisis period.
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But for true believers of the gold narrative, buying gold has always been a long game. “Once again the Establishment is using the decline in the price of gold to validate its misguided policies and discredit its critics. But none of the problems that led me and other modern-day goldbugs to buy gold 10 years ago have been solved,” writes Peter Schiff, CEO of Euro Pacific Capital and a longtime gold booster. He continues:
The sad truth is that as bad as things were back in 1976, they are much worse now … I am confident that the price of gold will rise much higher, and that its final ascent will be that much more spectacular the longer we continue on our current policy path.
According to goldbugs like Schiff, high government debt and easy money will inevitably lead to the debasement of the dollar. They don’t believe the Federal Reserve will be able to manage the money supply appropriately once economic growth picks up to the point at which inflation is a concern again. Indeed, investors like Schiff believe central banks will be forced to keep buying government debt in order to finance lavish government spending that politicians will be powerless to rein in.
The problem with this analysis, however, is that it is based on faith that a debt crisis is inevitable. According to this logic, citizens will vote for more and more government spending beyond our means to pay for it. This will lead to runaway inflation and, most likely, severe social unrest. But even if you believe this is the path we’re on now, how do you construct an investment portfolio based on this scenario? Other investments represent hedges against ordinarily high inflation, but few investments can protect you against revolution.
In other words, if one truly believes present political dynamics are going to lead to the breakdown of our monetary and political system, a better investment might be a bomb shelter and canned food, rather than gold. In the meantime, the recent convulsions in the gold market should be enough to convince ordinary investors to stick to more traditional asset classes that are easier to value, and free of the emotional taint of politics.