I feel compelled to pen my opinion of gold as a long term investment. Today, February 18, 2009, Gold has suddenly become the popular investment. When Jim Cramer (the ultimate contrary indicator) starts beating the drum for gold on CNBC, the game is all but over.

What is wrong with gold or other precious metals like platinum or silver, as an investment? One word: productivity, or more precisely, the lack thereof Gold is passive It doesn’t do anything, has no fundamental uses, or promote economic growth in any way It is symbolic alone, even as jewelry It is the ultimate “safe haven investment” So, at times like now with rampant fear, gold will outperform relative to other investments But unlike equities, those gains will not, can not stick Because gold is safety in a stormy sea, once the seas calm, the need for gold is gone And down it will drop like it has many times before.
We need only go back to 1980 to see the last time gold served as a safety valve for a world fearful of energy crises and out-of-control inflation in the world’s biggest economy, America On January 21^st of that year, gold peaked at $850 The next day, it was back down to 737.50, a whopping 15% drop in 24 hours Soon thereafter, Paul Volcker alleviated concern over the declining value of a dollar by jacking up interest rates, eventually to 20% in June 1981 This not only changed the perception of inflation, but also provided a very attractive alternative to gold in terms of return: US Treasury bonds By the end of 1980, gold was back under $600 not to return to that level until 2006, over 25 years later.

This time around, gold bugs are in opposing corners in their reasoning for gold: the thesis goes it is a great investment, a) because the economy is collapsing and we are heading for global deflation, or b) the global governments are printing paper like crazy to “reflate” and we are heading for global inflation as that printing inevitably overshoots The fact that both theses arrive at the same conclusion, which is “buy gold”, is suspect Deflation should devalue all hard assets, including gold, as paper currencies strengthen Reflation is currency neutral, causing neither appreciation or depreciation of the dollar in respect to gold, as printed money replaces money supply lost to debt writedowns Only significant inflation (more than 5%) caused by money supply expansion overshoot as in the late 1970s, should logically result in higher gold valuation in respect to money (the dollar).

Another anomaly that must be resolved to make a long term case for higher gold prices is the current disconnect between gold and oil A long term 50 year plot of gold prices against oil prices shows they move in tandem by a ratio about 15 to 1 (oil barrel to gold ounce) This is logical Both are hard assets Oil actually provides more economic value than gold, but as a commodity, it is seen in markets as being an alternative to paper currency, as are all commodities in the long run (wheat has been used as currency in the distant past) Gold and Oil ran together by the 15:1 ratio until October of 2008, a date also marked by financial panic At that time, they diverged in a big way As fear subsides, this divergence MUST be resolved at some point, through higher oil prices, lower gold prices, or a little of each (which is my choice)

Still, as the title suggests, there is a strong short term SPECULATIVE case for gold that can be made As long as we live with all our economic uncertainty, gold will shine I have argued in the past on several occasions going back to 2003, for gold to spike to a 1:1 ratio with the DJI, which it last achieved in 1980 This could happen during a super spike to $7000 (or maybe $5000 if the DJI continues to decline) Gold with its very small supply base, can do this when it becomes the crowded trade, which it is quickly becoming But remember that the day the next Paul Volcker arrives with a brilliant plan to change the paradigm and correct the economy, gold will dive and dive fast as the 1980 chart shows Those looking for a chair on that day will have a hard time finding one and will be left standing, out of the game The exit door for gold is small and only a few can get out at a time Prudence dictates that investments in gold should be hedged with puts, which diminishes the already questionable return.

Be forewarned you gold bugs: this time is no different and will end as it always has before: Badly!

Related posts:

1. Gold: An Investment for Decades to Come
2. Is Reflation Policy Bullish for Gold? Unlikely
3. Energy, Gold and BRICs
4. Refuting the Arguments of Gold Bugs
5. A Look Back to Help Find the Way Forward