Friday, October 12, 2012

Gold: Why is it too cheap

In this article I will try to explain why I think that gold is way too cheap at this time. This is very long, but I guess there is no way to say this in a short few words. There are so many misconceptions about saving, investing, gold, money, and you need to clear so many concepts that this still will be too short.

Lets see some numbers first.

There is 170,000mt of gold in the world.
The mines bring out around 2,500mt every year.
4,500mt is used in major transactions around the world.
100,000mt is the total gold trade which includes paper gold.

I hope you know that price of any object is determined at the margin. Basically the amount of an object on sale and the amount of object required increases or decreases the price of the object.

So the price of gold is decided based on the 100,000mt on sale, of which less than 5% is physical gold 95% is paper gold. So what determines the price of gold, paper or physical? I guess its obvious that paper decides the price.

The interesting thing is that the vast majority of the paper gold is NOT a proxy for physical gold, ie the owners do not ever want the physical gold. It is just used for trading. But still quite a bit of the paper gold is as proxy for physical gold.

When the crisis happens, paper gold will collapse, because people will be getting out of all kinds of paper instruments including paper gold. At this time the price of gold will drop very fast, because it is determined by paper. It will go below the production cost of gold and mining production will stop, reducing drastically the physical available. Gold prices will continue going down, but you will not be able to find gold in the market, because nobody is selling it at that price point. At this time you still should be able to sell the gold at a much higher markup. But you will not be able to buy, unless you find a person selling it to you. Anything that goes to the jewelers will be absorbed by somebody running the show.

ECB marks its gold to market and its reserve depends on the price of gold. If the price of gold (due to the burning of paper gold) goes too low, ECB will be forced to cause a revaluation of physical gold. This will cause the price of gold to shoot up many many times.

We will do the calculation of how much a little bit later.

For now lets look at the price of gold from a different angle.

Why do you buy gold? Is it a life's necessity? Is it necessary in any industry? No. The total requirement of industry per annum is less than 10% of the output from the mines, ie less than 200tonnes. This is nothing. And much of the use can be replaced with something else. So in effect it is a useless metal.

So why do people buy gold. You will say jewellery. But why do you buy gold jewellery? Because you think it will be useful at the time of need. Basically you are storing your savings in gold. Indians have suffered under oppressive regimes for a long time. Independence did not give us much respite, with the high inflation. So people who are in their traditional businesses still value gold. The neo rich are the ones that are aping the west and have lost the traditional wisdom of why to save your worth in gold. I personally didn't know anything about gold a year ago. Many people don't invest in gold because they only know banks, stocks and land as possible investment venues.

When do you sell your gold? Only when you need the money right. If you are a trader you are better off with the paper gold, as you have no transaction costs. But most people are not traders. They buy gold to store their extra income. They might stupidly sometimes think that the gold will go down and sell it at a high, so that they would buy more later, but they are not traders.

So how does demand and supply affect gold? How does demand and supply affect the value of the piece of paper you call a 1000Rs bank note. The bank note is worth 25 litres of full cream Amul milk. Who gives this value to the bank note? Is it the govt, or is it the people. If Amul tried to raise the price of milk would you reduce your consumption or look for something else. The govt only says that its value is 1000Rs. It cannot say that the value of 1000Rs is equivalent to the 25litres of milk. Amul itself cannot set this value. It is you who give it this value. The govt also affects it by deciding how many Rupees are in circulation. If there are more currency notes in circulation the value of the currency notes will go down. How many are sitting in a politicians bed mattresses do not matter. The notes which matter are in circulation.

Similarly who decides the value of gold? You do. If you save in gold, the price of gold will go up. If you save in paper instruments it will go down. Paper gold brings it down much faster than any other investments. If you sell your gold it will also go down. Does the production and consumption has any effect on the price of gold? Not really. The production is only 1.5% of the worlds stock. The consumption is a measly 0.1% of the global stock. So what should be the price of gold. It is completely arbitrary. It depends entirely on peoples requirement for liquidity and people's extra income.

Gold is bought in currency terms not in weight terms. So if average saving of the world increases, the price of gold will increase, as much of the world's stock is not on sale. The gold's price must directly be related to prosperity, which inturn is directly related to technology.

Currently very rich people have a problem, they are not able to store their wealth in gold. If the very rich try to buy gold with a large part of their income, gold prices will increase very wildly, and will cause issues for USD. This inability increases the price of other store of value items like fine art and antiques. This is the reason why Scream fetched 25 million$. Auctions these days are fetching more money than would normally be expected.

The best thing about gold is that it is not used in any industry. It is basically as worthless as the Scream. The benefit is that like Scream its price can be whatever you want it to be. You can hoard it without holding hostage any industry. If you wanted to revalue gold 100x you can do so without damaging any industry. If you wanted to do the same with Silver, there are a number of industry that will be affected wildly. Gold is like paper money, but with the advantage that it cannot be printed. It has other benefits like fungibility and durability. Silver was also used the same way.

There are actually 2 reasons why Gold is much better than Silver. First is the above point. Second is that it requires much less space to store the same worth, presently 50 times.

This also means that Silver will lose its current store of value status. No wonder that No CB in the present times stores Silver. Silver will probably loose lots of its value, and the current 50x ratio will probably go much beyond 1000x.

Another question; do you think people will sell more gold if you raised the price of gold. Yes possibly, but the increase will be very small, because people sell gold when they need money. They will actually sell less in weight if the price of gold increases. In the crisis the gold on sale will increase, but the people wanting to invest in gold will increase many many fold. The price in effect will increase wildly.

Since most people do not store their worth in gold, would you say it is expensive. Not really. The other problem is that a major financial crisis is around the corner, where it is likely that a huge amount of paper investments will be lost. What will happen to the attitude of people towards gold. It will undergo a sea change.

Many people think that storing their wealth in gold is morally wrong. This is not a good position. The important thing to understand is whether you know where you are investing. If you are investing in a bank (ie savings account or fixed deposits or any other scheme), the bank is investing as a proxy for you. Do you think the bank is making the right decisions? The bank loans the money you invested to some person who will hopefully give interest to them. The person who got the loan may not invest in something productive, but may give it to a person to buy a house. This loan increases the price of house, as there is more money now chasing the house. Do you think this is a good use for your money? What happens if the person loses his job? Or if the person is not honest. Do you think the banks know very well if the person is honest. What happened in the USA in the housing bubble? Do you think they cared where the money was going? This investment even raises the price of house, which you might want to buy. Yes it will become easier but at the cost of making you a slave for a long time. When the person who buys the house gets the money, he in turn puts it in bank. So the bank gets the money back, it can now invest in other ventures. The Reserve Ratio forces to put some money behind to avoid the case where you come back and ask for your money. The ratio in India is less than 5%. This means that money created by the RBI is multiplied 20 times. Think about that.

When you put your saving in the useless metal gold, you are giving your money to somebody who needs the money. People do not sell their gold for trivial needs. They sell it only when they think they have a perfect opportunity to make money or they are in dire need of money. This way the money gets utilized very efficiently. Saving the worth in a useless metal does not impact anybody else. Its like storing our worth buying antiques or fine art. These are also useless. If instead we were to invest in copper or iron, we would impact the industry, if we really had much money. So saving in gold is good for the economy. Hoarding any useful thing is not.

I hope I have explained the basics of the value of gold. Now lets get a ballpark number of how much gold should increase in value. The price again cannot be predicted, because most currencies are likely to devalue highly during the crisis.

I would expect only around 1/5th of the existing paper gold to be a proxy of physical. This would mean that the gold will revalue at least 4 times the present value, in current currency terms, if nothing else happened.

During the crisis, people would be looking to put their money somewhere stable, so they are likely to put it in gold. Yes, real estate and other physical plane assets will also increase a lot.

Due to this change in perception and the revaluation due to paper gold crash, the value of gold is likely to shoot up 10x from present times.

During the crisis people will lose a lot of worth in paper instruments, but they will get a lot of worth from their gold. From this people will learn that they should not save in paper, and gold is a very good store of value. People will start using gold for storing their wealth. This is called Freegold.

Gold will be free of any shackles of paper. There will be no gold standard, and there will be no gold certificates. Not because govt will ban them, but because people will not accept them.

We will no longer get into a similar arrangement as we had with USD, ie there will be no reserve currency that is used by a country, not Euro nor Yuan. Central Bankers' are quite well aware of Triffin's Dilemma. We could possibly have SDR, but that is not likely to stay for long as it still doesn't solve Triffin's Dilemma completely. The biggest problem with that would probably be that nobody will be able to agree, on the actual content of it.

No country is likely to accept Gold Standard, because it is very much inferior to the way Euro is setup. Euro has about 70% of reserve as gold. This provides them the flexibiility of an inflatable currency, and also the safety of gold. The interesting thing is that they started with only 15% gold, and they did not buy much gold. The change is entirely due to the increase in the price of gold, and reduction in the worth of all other reserve assets. Most currencies are likely to move towards that. India is also setup that way, we also mark our gold to market, and have about 10% reserve as gold. This would go to nearly 100% during the crisis.

Another interesting thing will happen due to people understanding the worth (or the lack of worth) of paper investments. I am not talking about interprenuers or Investors, they will still continue to take risk and invest in worthwhile businesses. Investors know what they are doing. I am talking about ordinary people, and businessmen. These people do not know what they are doing when they start investing in stocks. These people will start storing their excess produce in gold on a regular basis. This would mean that people in countries that are having a surplus will naturally import gold, while countries which are running a deficit will be exporting gold. This will extinguish balance of payments naturally.

Since gold import/export will directly shows the worth of a currency, Gold will come to define the value of a currency. In effect countries will start valuing currencies, based on their price in gold, aka Reference Point Gold. If SDR is chosen, gold will likely get higher and higher weightage as time goes on.

Gold will become the most important asset for storing value. This effect will further raise the value of gold possibly to 30x, from present. This last valuation may take several years, depending on how much gold matters in international trade.

If you think this is just pipe dream, see what Central Banks are doing. They are buying gold since 2008. This is precisely, because they know that the system is at the brink of failure, and gold will be required to rebuild everything. Lots of People in the western world blame the Central Banks, but those are the good guys. The politicians are the bad people. They are not going to get any benefits of the revaluation. They have a job to do, ie keep the economy running smoothly, and gold is required for that.

The huge increase in gold prices means that jewelers will become very rich, but it also means that people will stop using gold in jewelery. It will be too expensive.

I hope this helps you get ready for the future.

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