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  • Reasons for Investing in Gold & Silver Market

    Posted by Frugal on August 2nd, 2006

    Gold & silver, or more often referred as precious metals (PM) in general, are one kind of commodity. Investing in pure physical commodity usually cannot be done as a long term investment. A commodity has no other value besides its intrinsic value. It will never increase in quantity nor quality as an investment or product, unlike stock, ownership in a company where the corporate earnings can potentially increase with time. So why am I investing in such stupid and “boring” investments?

    My primary reason for investing in precious metal & its associated mining stocks is for the inflation protection from fiat currency expansion and its relative undervalue. Yes, gold is undervalued even at today’s price of about $630 per troy ounce. On an inflation-adjusted basis, gold needs to exceed $2090 in 2006 dollar to overcome its 1980 peak.

    Comparing to price of crude oil, the price of gold is again undervalued relatively speaking. Oil has almost tripled while the price of gold only doubled since the recent low. Especially with a potential Peak Oil in the global oil production, when oil rises, gold inevitably will rise together.

    Comparing to Dow Jones, the cycle of paper stocks seems to be over while the cycle of tangibles like gold has begun. In fact, if you reference to the chart 13 on pg.18 of “The Return of the Bear” by Martin Pring, the well-known technical analyst, you can see that the trend line of S&P 500 over gold has been solidly broken. No matter how you parse it, either gold goes up or stocks go down.

    You can read more details on the arguments for investing in gold in this article by Eric Hommelberg. It has an excellent summary for investing in gold.

    Fundamentals in the Coming Years

    With all the huge US budget and trade deficits, how can the US government still wage wars in Iraq, while promising more drug benefits to seniors? With all the entitlement programs that need to be paid, the least painful resolution for US government is to print money by inflating the monetary supply. While the benefits don’t get cancelled, they won’t get the promised matching increase with inflation either. By essentially diluting the value of $US, the government can also dilute the real value of debts that it needs to repay. Since US consumers are also heavily in debt, devaluation of $US can shift the majority of loss to foreign holders of $US and US bonds, albeit creating more inflation due to the rise of price in the import goods. Such US currency policy, gradual devaluation with empty talk of strong $US currency, is indeed the best for US. It keeps both the US as the debtor and foreign creditors afloat temporarily, so that US can keep its spending spree by borrowing global savings. Creditors in the meantime will not face a sudden huge loss on its bond portfolio.
    The US debt overhang is definitely bullish for gold and fortells that inflation will not go away anytime soon.
    A Technical Picture

    Some people claim that precious metals have made its top in the recent bubble run, and it should be downhill from now on. I disagree strongly. Although the latest run up in PM is quite parabolic (one of the characteristic for financial bubbles), based on the percentage ownership of all market participants, I believe that the bubble has barely begun yet if there is one. At the height of a bubble, not only the news should be making headlines, but also mass of investors should flock and chase right into the top. However, that is definitely not the case. Instead, precious metals have corrected substantially back to the 200 days of moving average (click to see chart), and again is reasserting its bullish trend. While it is possible that gold may retouch the 200 days moving average line again later at the four year stock market cycle near September, the relative strength in precious metal market compared to the general market is simply undeniable (see chart here). I expect that any rally, especially due to a pause in the interest rate hike by Federal Reserve, will be accompanied by a stronger showing from PM market.
    The Case for Silver

    Many may argue that silver is not a monetary metal, but rather an industrial metal. While they may have a valid point, silver nevertheless tracks the price of gold somehow. What’s really amazing about silver is that it has been in production deficit for 60+ years, with an accumulated defict of some 10 billion ounces. The price has not increased but instead has been falling for the last 20 years. A production deficit requires a drawdown in inventory. While some silver usages do get recycled, this sustained deficit is still quite big by any measures. By the way, some people challenge the validity of the silver deficit (for example, Zurbuchen’s article). While I dare not to say how big the silver deficit is exactly, the current gold to silver ratio at about 55 is most likely out-of-lined from the historical average of 31. This ratio is expected to decline in favor of silver as the precious metal bull market continues to unfold.
    According to Theodore Buttler at, the silver naked shorts at COMEX have not covered their 100+ million ounces while the market seems to have bottomed. Physical deliveries of silvers are facing delays of months, showing strain of supply. We will see whether the current situation unfolds as a supply crisis going forward.
    My Own Strategy

    Majority of my precious metal investment is in mining company stocks instead of physical gold & silver bullions. I invest in them for additional leverage, explained in my post on Intro to Investing in Natural Resources. And obviously, with leverage, it also comes with additional risk beyond physical bullions. To learn how to invest in gold & silver, you can check out my post on Intro to Investing in Precious & Base Metals.
    Some Counter Arguments

    No article will be complete without examining some opposing arguments. Here are the two best sources for counter arguments for investing in gold that I have found so far. While both are cautiously bullish on the commodity markets, neither seemed to subscribe to the concepts of Peak Oil or Commodity Super-cycle which are widely believed by commodity bulls. Both are extremely well articulated.

    I have not finished the above book, but it tries to dispel hypes in the commodity investing. I highly recommend anyone to take a look and understand what are the hypes and what are the truths.
    The other source is Energy Mania and Actuarially-Driven Investors & Financial Fads by Bob Hoye at His last call to get out of precious metal market was right on the money, and made his arguments even more convincing. He doesn’t subscribe to Peak Oil in his Energy Mania article. However, he is definitely a long term commodity bull from his interview and from his own articles.
    More Information

    Here are a couple of articles from the mainstream media that explains why you may want to own gold:

    1. From CNN: Hedging a decline in $US using gold.
    2. From USA Today: How to hedge against hyperinflation using gold.

    P.S. I want to thank Eric Hommelberg at for making all the figures available for this article. I myself is a subscriber to his golddrivers newsletter, and I can attest to the fact that a couple of his recommendations that have truly hit the jackpot (10X return). The volatility can be extreme (+1000% to -90%) for junior mining companies if bought at the wrong time. With the potential high returns, it is always accompanied with high risks. I will not recommended investing in junior minings for any beginning investors.

    More related posts:
  • Gold/silver may have a correction coming
  • What will happen after silver mini-bubble crashes?

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    20 Responses to “Reasons for Investing in Gold & Silver Market”

    1. BlueDaze Says:

      Excellent post, esp in the end-balancing part.

      FSN did a recent interview with Jeffrey Christian.

      Personally, I have lingering doubts that global growth (ie. China and demand for commodities) is robust enough to withstand a US slowdown or recession.

      The World Gold Council also came up with a June 2006 report on “Short-Run and Long-Run Determinants of the Price of Gold”.

      A few key findings:

      “Whether investors in any particular country gain or lose by holding gold depends on the start date when gold is purchased and the length of the holding period. More specifically, it is far more likely to be profitable to invest in gold when the nominal price of gold is below its inflation hedge price. Conversely, it more likely to be unprofitable to invest in gold when the nominal gold price is above its inflation hedge price.

      Finally, we turn to the policy implications of this analysis for potential investors in gold. One important implication concerns a likely US dollar depreciation required to restore balance to the US current account. There appears to be a consensus that US dollar depreciation is inevitable – the only issue being when it will occur and whether the adjustment path will be smooth or disorderly. Jarrett (2005) lists fourteen estimates of the dollar depreciation that would be needed to restore the imbalance in the US current account deficit. These estimates range between 12 per cent and 90 per cent. If gold is a long-run hedge against inflation, and if it is true that real dollar depreciation against other currencies is inevitable, US wealth holders should profit from holding gold during this period for two reasons.

      The first reason is that the dollar depreciation will lower the price of gold to investors outside of the USA, and this will raise their demand for gold and raise the US dollar price of gold. That is in addition to the long-run relationship between the US price level and the price of gold. The second reason is that dollar depreciation will likely raise US inflation rates, and gold would act as an inflation hedge during this period.”

      While gold is/will be an important anti-inflation hedge and against US-dollar devaluation, if the investor is from a country whose currency is expected to appreciated strongly against the dollar than gold may not be that great a buy.

      Paul van Eeden also provides another perspective on how to calculate gold’s true value.

      On silver, there was a series of articles in strongly challenging the so-called “silver-deficit”. I see if I can dig it out…

    2. BlueDaze Says:

      Found it.

      The Real Silver Deficit by David Zurbuchen.

      His opposing claims:

      1. Silver is not rarer than Gold.

      2. The gold to silver rarity ratio is about 1 to 5, not 5 to 1.

      3. Finally, there is nothing factual about the statement that silver is rarer than gold, UNLESS you qualify it with the condition that you are only referring to market accessible silver in the form of bullion. But this is an unfair comparison, because you are including all gold in jewelry form while excluding all silver in jewelry, sterlingware, and privately held bullion/coin forms. Granted, the market price of silver will need to rise a greater percentage than the market price of gold before either its jewelry, silverware, or privately hoarded coin forms become available to the market in large quantities, but the fact still remains that this form of silver is available at some price.

    3. frugal Says:

      Yes, the silver deficit is also challenged in the book of Commodities Rising. I am still doing more research & readings.

      Thanks BlueDaze for all of your great comments.

      Personally, I also have serious doubts about commodities withstanding a China slowdown. I believe if such event occurs, one should get OUT of the commodity market.

      Although you may not gain as much if your country’s currency is strong compared to $US, I believe that the gold bull market has taken the next stage of rising against all currencies. Put it in another way, the inflation rate dominated in all currencies will go up, which translated into lowering of the living standards in the first world countries for the benefits of improving living standards in the third world countries.

      Again, there are many things that are debatable in this post, such as whether gold really ties to inflation rate, and preserves the buying power. I was a little short on time to put more pros & cons together. There are just too many things that you can talk about why or why not you want to invest in gold/silver.

    4. Brandon J Says:

      I’ve looked into gold since 2003. I saw it at $265 and wanted to buy gold. However, being a small investor like me, I couldn’t find a good way of getting a gold position without a significant deposit. The majority of companies require at least $25,000 and a yearly maintenance fee.

    5. Reality Bytes Says:

      I wonder if you wouldn’t mind bringing this back to a more general level. How can gold as a commodity keep it’s value? Doesn’t a digital economy make gold irrelevant? It’s used less and less in industrial processes, is it not?

    6. Frugal Says:

      Brandon J,
      I think the easiest way for small investor is to buy numismatic coins such as gold eagle or silver eagle. Those don’t require a big investment.

    7. Frugal Says:

      “Investment” in Gold is really for monetary reasons. Especially in this digital age, it takes a mouse click to create billions if not trillions of dollars or paper money. How can one prevent one’s wealth to be diluted by government? The only ways are to stick with hard assets. The value of the hard assets like gold is relative to all other hard assets and its intrinsic rarity. But paper money is not rare. There will be simply more of it, even though the amount of hard assets is pretty much fixed.

    8. Reality Bytes Says:

      Thank you, I appreciate the answer. Please excuse me, I’m like a child to this. How does gold keep it’s intrinsic value relative to other hard assets? Aren’t there other hard assets that have higher demand in this era? Do we really use much gold for anything? Wouldn’t something like silica for solar cells or the ores used in fuel cells have higher demand and value?

    9. Frugal Says:

      The intrinsic value is hard to determine. Like the value of stocks, I believe current market price is always the best current opinion. Certainly, rarity is one of the factors. Of all the elements from the periodic tables (from the chemistry), silicon (avail. from sands) and carbon are relatively abundant on Earth. So I don’t think they would have a very high price in their raw form.

      Certainly, it doesn’t need to be gold or silver. But any tangible assets will be way better than paper money in the case of hyper-inflation. I’m not saying that US will go into such scenario. But everything is all relative and based upon current economic confidence in a particular stock or goods.

      Personally, I believe that the twenty years of bear market in commodity is probably over. And you can see how I invest my money according to my belief at My Networth page.

    10. Bill Carson Says:

      Idiot that I was, I owned KGC in fall ’01 @0.88 now over $11.00. There are cheap gold stocks out there. I first n noticed BGO at the beginning of the year under $3.00 and GG pre aquisition under $20 with small dividend and all and that has been north of $40 a share.

    11. Bill Carson Says:

      Any ideas on a good water company? Water will eventually bee more valuable than gold as salt and spices were in ancient times based on the fact that drinkable clean water is an essential for life whereas gold and silver are not. Water could be trading by the gallon in the near future.

    12. Frugal Says:

      I have a couple water companies. You can try the ETF PHO. I got most of my water thru newsletter subscription & professional management, and I feel compelled to protect their interest.

      It’s really going to be just water infrastructures. Water is very abundant on Earth. All you need is energy to filter/process them (for example, from sea water), and pipe to transport them.

    13. Says:

      What the hell is inflation?…

      So what is inflation? You can find the dry and boring definition here but let’s keep it straight and simple. Inflation is a general increase in prices in the economy. You have probably noticed that for some goods, prices tend to go up year by year a…

    14. Adventures In Money Making Says:

      I believe in this data too. but now i’m addicted to buying those
      stupid french gold 20 franc coins on ebay now! even though i own
      AUY, GDX, GLD and NTO I can’t stop buy those damn things. All they
      do is fill up my bank safety deposit box!

    15. Jeremy Eaton Says:

      Inflation originally more accurately meant an increase in the money supply.

    16. Frugal Says:

      You got it Jeremy.

    17. Frugal Says:

      Adventures In Money Making,
      Maybe those coins won’t be stupid one day.

    18. Harm Says:

      Gold still doesn’t pay dividends.
      (Gold mining COMPANIES do, of course)
      I’d say dividend paying companies are a better deal, here, like
      the etf DVY.

    19. Frugal Says:


      I won’t say that I’m right because I simply don’t know whether I am really right about investing in gold. But I’m at least convinced enough to put my own money into it.

    20. Frugal Says:

      I’m closing comment section for this article. It’s getting too old in time now (although the content is meant to be valid for the next 5 to 10 years).