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 gold-eagle.com article by Eric Hommelberg. It has an excellent summary for investing in gold.
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.
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.
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 www.silver-investor.com, 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.
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.
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 www.institutionaladvisors.com. 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.
Here are a couple of articles from the mainstream media that explains why you may want to own gold:
- From CNN: Hedging a decline in $US using gold.
- From USA Today: How to hedge against hyperinflation using gold.
P.S. I want to thank Eric Hommelberg at www.golddrivers.com 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:
Digg it Del.icio.us Reddit Furl BlinkList Newsvine Yahoo MyWeb