Something's Funny With Gold And Money

Something that gold investors often fail to realize is that the aboveground supply of gold can increase just as fast as – or much faster than – the supply of money. This is an important part of why the view of gold as a “solid currency” is a fallacy.

Gold inventories are currently the highest they've been in the history of the world. And throughout the twenty-year bear market in base metals, gold exploration skyrocketed. Even in 2003, 75% of mining exploration was allocated to gold, up from 50% only three years earlier.

I do not have the current CRB Commodity Yearbook figures, but it is without a doubt that gold exploration has dramatically increased since then, with new mines coming on stream, in response to high market prices.

In other words, the supply of gold is huge and expanding, especially relative to that of every other commodity. And since gold is an element, it cannot be destroyed. Compare this with a commodity such as crude oil, which gets used up and can't be renewed.

Here is a graph of gold production:

As you can see, production skyrocketed after 1980, even when prices went into a multi-decade bear market. The current numbers are probably substantially higher than what is reported there, possibly going right through the top of the chart, in response to such high market prices.

As for the demand side, the demand for gold used in jewelry – the commodity's staple use – is so small that the CRB Commodity Yearbook doesn't even bother to report the figures anymore. All demand for gold has been falling – except for use by financial speculators.

I have no idea where the gold price will go, but with the market at a thirty-year high, today's buyers have no margin of safety. And in terms of supply and demand, I can hardly see why gold investors would be concerned about the money supply: unlike the supply of gold, the money supply has not increased by several hundred percent.

If we look at M2, the monetary aggregate used to forecast inflation, it has only expanded by about 10% from where it was a year ago:

Individual money market accounts are included in M2, but wider measures of the money market – like commercial paper and repurchase agreements – are included in M3.

The Fed discontinued its reporting for most of the components of this latter aggregate, but my guess is that the extreme stress in the credit markets probably would have shown M3 sharply contracting, hence the need for a massive liquidity injection.

While the Federal Reserve can print money, so can the giant mining companies ramp up gold exploration and production. And the facts show that the latter have been much more successful in supplying the market.

While this may be a vote of confidence for the free enterprise system, it presents an ugly picture for today's buyers of gold.

Jim Rogers: A Retrospective

After thinking this morning about commodities and inflationary prospects, I watched a Jim Rogers interview from 1995, which I have included below. You will have to fast forward a bit, because he appears toward the end. Here are a few of his predictions from 1995:

“Next year and the year after, I don’t think we’re going to have good times in the American stock market.”

“Inflation is coming.”

“Commodity prices are going through the roof.”

Best country to invest in right now: “Iran.”

“Everything in life comes down to timing.”

Well, it looks as if Jim's timing was profoundly wrong.

In fact, much of this flies in the face of what he said in Hot Commodities, published a decade later, which was to the effect of “if you went through the 1990s and didn't touch shares in technology companies then you missed out on massive gains," essentially meaning that it was a mistake caused by not being open to new things.

But, as you can see, he was saying the exact same stuff back then as he is today. And he certainly wasn't talking about technology.

Anyone who continues saying that inflation will come or commodities will rise is bound to be proven right at some point. This not to single out Rogers as being wrong, but to emphasize my stance on how difficult it is to predict macro events – unless, that is, you only have one perennial prediction.

What history shows is that, aside from short-term macro shocks, the best asset class to own, by far, is stocks. And if you can buy those stocks at depressed prices or in periods of intense fear, then your total return can be magnified significantly.

Land, labor, capital and commodities are combined to create businesses that increase productivity. And while any one of those factors may become relatively attractive during a boom, owning excellent businesses – or fractional interests, called stocks – is the best investment over the long haul.

Keynes predicted that the great financial fortunes – paper fortunes, such as the Rothschilds in his day – would be destroyed by long-run inflation. Clearly, this has not happened.

Quite the contrary: the countries with the most developed financial systems have always been the most prosperous, whether the Medicis in Renaissance Italy, the Rothschilds in 19th-century London, or today's commanding skyscraper in Lower Manhattan that reads, simply: "85".

Thus, while the gloom and doom is persuasive nowadays, I remain highly skeptical that the world – financial or otherwise – is coming to an end. I lean more towards John Paulson's prediction that massive returns will accrue to buyers of solid, yet beaten-down financial stocks, as the smoke clears and we emerge from this crisis.

Einhorn on Inflation

David Einhorn is now buying gold, the yen, and calls on long-term interest rates. In fact, he sounds a lot like Jim Rogers nowadays – the Fed is going to debase the currency, Ben Bernanke is obsessed with money printing, and so on.

http://www.businessweek.com/print/investor/content/jan2009/pi20090128_208724.htm

But there are a couple of problems with this line of reasoning.

First, it’s not at all what we’re seeing. The risk of a depression is higher than the risk of hyperinflation, at least right now, so to a large degree the Federal Reserve is doing the right thing. They contracted the money supply and didn’t support banks after 1929, and the result is well known.

Second, gold is a horrendous investment under all other scenarios except for high inflation. The supply of gold is massive – there is more gold available now than ever before in history – and demand has dwindled to basically nothing more than use as an inflation hedge. It is one of the most inferior commodities in terms of fundamentals.

If inflation does not occur as predicted, you have no margin of safety. You are left holding a nonproductive lump of metal. In buying gold at current prices, roughly the highest in thirty years, there is not much room for error.

Yet it sounds much more reasonable to tell your investors that you’re holding gold, as opposed to sugar futures or lead futures or whatever else. The fact is that Einhorn’s investors may be better served if he simply held the Rogers Index instead.

Third, higher inflation appears to be turning into a consensus view, and the consensus view is rarely correct. You have to question why investors like Einhorn would even get into these big macro questions, and what competitive advantage they have there.

Incidentally, here are some of my views on inflation. I have held similar views to what Einhorn is currently expressing, since early 2006. But now I am playing the devil’s advocate even with my own reasoning.

The interest rate trade definitely makes sense: coming out of this crisis, rates must rise. Moreover, the yen will continue to strengthen as the carry trade continues to unwind; but it seems that Einhorn is a little late to this party as well, as the yen was probably a better trade in 2008 than it will be in 2009.

I am with Buffett in saying that you’re going to do a lot better with picking great businesses than you will in trading macro events. The latter are just way too difficult to predict.