Tuesday, September 30, 2008

The Financial Times Sings Praise of Gold. They're wrong.

From FT Alphaville:
Amid the rubble, gold shines
When it comes to talk of market outlooks, one of the few places on the planet you might find some bonhomie and optimism is - believe it or not - in Kyoto, scene of the annual meeting of the London Bullion Market Association (yes, they’re still doing alright for themselves..)

As Javier Blas, the FT’s commodities correspondent, reports from the scene, the mood is definitely bullish, amid a joyously firm belief that gold prices will rise next year as the financial crisis pushes more investors into the precious metal safe haven.

The gold industry forecasts bullion prices at about $958.6 a troy ounce by November next year, according to the annual LBMA poll among delegates. The poll, which has been a reliable indicator in the past, compares with current prices just above $902 (on Tuesday, spot gold drifted lower to $900.90, down 0.3 per cent at 0410 GMT)....MORE

From the FT's Lex column:


The financial meltdown has gold bugs buzzing with delight. Often slightly eccentric, gold investors have long warned that the end is nigh. Today, however, their fears are being discussed at dinner tables across the world. As markets have tumbled over the past fortnight, the price of gold has rallied by about a fifth to almost $900 per ounce. Over the medium term, however, there are many reasons to limit the number of bars being buried in the garden.

Certainly gold looks like a one-way bet for now. Due to its relative rarity and indestructibility, gold is a perceived safe haven in times of crisis. Inflows are pouring into gold-backed exchange traded funds and the ultimate doom-sayers are hoarding the physical metal. More important, however, gold as a monetary asset is benefiting from a weak dollar and high inflation....MORE

On Thursday we posted: The Great Deleveraging (and what it means)
Deleveraging is Deflationary. Ignore the talk of any immediate Inflationary effect. That comes later. Anyone telling you to buy gold now is a fool, a liar, a knave or a nut. The time for AU will come but it is most assuredly not now.
Gold promptly went up 5%.
Gold is not a hedge against deflation. Over the years goldbugs have come to believe it is, based on the performance of Homestake Mining's stock during the Great Depression. Here's an example from Gold Eagle:

Gold Stocks did well during the Great Crash and aftermath… indeed exceedingly well. Please note that from August through October 1929 Homestake Mining did decline in value, but no where near the percent plunge in the general stock market. And by yearend Homestake was again creeping up in price. For the first few months of 1930 the gold mining industry proxy was relatively flat. However, from mid-year on Homestake began to increase in value as the DOW and DJUA rapidly and relentlessly melted away. During the next five years the Gold Mining Industry's surrogate soared in value - while stock prices were decimated by the Great Depression.

It is relevant to observe that Homestake's price appreciation was not a market anomaly, but was consistent with its growing annual earnings per share and increasing cash dividend payout. Yearly E.P.S and cash Dividend payout data may be seen in the above Homestake chart. While nearly all industries revenues and earnings dwindled, the gold mining industry thrived. Homestake's E.P.S. increased from $4.19 in 1929 to $32.43 in 1935. During the six desolate years of the Great Depression, the gold mining industry's proxy enjoyed an E.P.S. growth rate of 41% COMPOUNDED ANNUALLY. Furthermore, while the banks paid a paltry 1% in "earned" interest on the meager savings of those few hapless souls who still had money, Homestake share holders were indeed enriching themselves. The 1929 cash dividend of $7.00 increased to a cash payout of $56 PER SHARE BY 1935. Consider for a moment the awesome investment significance of it.

Had an investor the foresight and guts to buy a share of Homestake in the throes of the 1929 Crash, he would have gotten it for about $80. During the next six years while stock values worldwide were melting away - and preciously few companies were able to pay even a declining trend of dividends - Homestake soared relentlessly to $495 a share by yearend 1935 - THAT'S NEARLY 520% CAPITAL APPRECIATION (34% compounded yearly increased value). And during the six depression years of international economic suffering, Homestake paid out $128 in cash dividends. In 1935 alone, the gold mining proxy paid a $56 cash dividend per share - which represented 70% of the 1929 Crash Price of the stock!

Many market analysts and financial students erroneously suggest that US president, Franklin Delano Roosevelt's action of increasing gold's value in 1934 from $20.67 to $35 an ounce was the prime reason for Homestake's stellar performance during the Great Depression. NOT SO. Please observe the Homestake chart again. Homestake's stock price was rising strongly much before FDR's decision to stimulate fallen commodity prices by increasing gold's value. Nevertheless, gold's price hike did indeed add more impetus to Homestake's dynamic performance, while world economies continued to struggle in the morass of deflation.

To put the relative market performances of the stock market vis-à-vis gold mining shares into proper perspective, please view the following two charts superimposing the DOW with Homestake and the DJUA with Homestake. There is absolutely no room for mis-intepretation - THE ONLY PLACE TO BE IN DEFLATION WAS IN GOLD STOCKS.

That is rather enthusiastic and more accurate than most analyses, at least he focuses on the equity rather than the metal. But the focus is still wrong.
After the mine closed in 2002 I went out to Lead to answer the question "Is gold an asset you want to own during deflation?" I was quite possibly the last person with access to the company records from the '30's. The skeleton staff that Barrick had in place for the shutdown were literally boxing documents for the archivists as I sat there.

There were three contributors to the move in the stock price:
1) A high-grading mining strategy proposed by a young engineer, Don McLaughlin in the late '20's began bearing fruit in the form of higher recoveries. Mr. McLaughlin went on to the presidency of the company.
2) A flight to safety after the October 1929 stock market crash.
3) The Gold Reserve Act of January 30, 1934 raised the price of gold 69%, from $20.67 to $35.00 (conversely devaluing the dollar by 41%).
3a) Homestake was thus paying salaries and other expenses in devalued dollars.
This combination of more gold produced, higher price per ounce and lowered expenses (in real terms) was what moved the stock, not some inherent magic in gold.

A good explication of gold's valuation is Roy Jastram's study of the purchasing power of gold, "The Golden Constant: The English and American Experience, 1560-1976". The main point is that gold tends to retain purchasing power over long periods of time. A secondary point is at apparent varience with my conclusion. Jastram says that gold's purchasing power increases under deflation.
The apparent contradiction is resolved by the knowledge that during his period of study, gold was money. During deflation, any unit of money increases in purchasing power. No one backs their money with gold, that link is broken.

Friday and yesterday's flight to safety move up has been largely reversed, today, gold is down $29.30. From Kitco
Click to enlarge Click to enlarge
Gold will shine but not until the printing presses have overcome the contraction in credit/money.
In the meantime, if you are of a mind to invest for the Apocalypse, buy some bullion silver coins or Silver Eagles. The lower valuation should make buying a fifty pound sack of flour easier than it would be with an ounce of gold.