Trees Don't Grow Gold

If you’re the sort of person who keeps a diary, put a star in the corner of this week’s entries. Ten years from now, you’ll look back on this week and be amazed at what people were saying. What will be even more amazing is that some people were doing exactly the wrong thing at the right moment. More on that below.

First, the facts. The gold price plummeted nearly 10% on Monday, or about $147. Its two-day loss of 13% was the biggest in 30 years. Gold is not alone, either. The U.S. stock market is also slumping. On Monday, the Dow Jones industrials suffered its biggest one-day loss since the U.S. election in November last year. Within the S&P sectors, materials and energy both fell by nearly 4%. What’s going on?

The fall in the materials and energy sectors was not matched by the finance sector. Financial stocks were down, but not nearly as much as anything commodity related. That’s worth noting. There are at least some sectors of the market taking note of underlying events in the real economy.

Energy and materials are not sectors likely to be driven by enthusiasm for more quantitative easing by the Federal Reserve. In fact, the fall in commodities and most of the stocks in extractive industries can be seen as a market repudiation of the healing power of QE. Bernanke may be pumping up financial stocks and financial earnings, but he’s doing a whole lot of nothing for the well-being of the real economy.

It should be noted that all of this price action in gold, commodities and the stock market happened before two explosions near the finish line of the Boston Marathon late Monday afternoon. Markets have become less sensitive to these types of events over the years. But the explosions in Boston will certainly contribute to a sense of fear and uncertainty in the markets. In the past decade, those two sentiments have usually been accompanied by rising gold prices. But gold is currently in the grip of an epic liquidation.

Who is selling and why? Those are interesting questions. But ultimately, both are unknowable. It could be leveraged hedge funds who were long gold or who used gold as collateral to lever up on stocks. It could be owners of large positions in ETFs. It could be manipulation. It could be panic. Yet look at the chart below.

Gold Price vs. APPL Share Price

Shares in Apple are down 42% in the last eight months. After the last two days, the gold price is down exactly half as much — 21%. Which one has crashed? Or have both simply corrected? Our friend Marc Faber made this point (the inspiration for the chart) in an interview with Bloomberg TV. Dr. Doom said:

“I love the markets. I love the fact that gold is finally breaking down. That will offer an excellent buying opportunity. I would just like to make one comment.

“At the moment, a lot of people are knocking gold down. But if we look at the records, we are now down 21% from the September 2011 high. Apple is down 42% from last year’s high. At the same time, the S&P is not even up 1% from the peak in October 2007. Over the same period of time, even after today’s correction gold is up 100%. The S&P is up 2% over the March 2000 high. Gold is up 442%.

“So I am happy we have a sell-off that will lead to a major low. It could be at $1,400, it could be today at $1,300, but I think that the bull market in gold is not completed. Nobody knows for sure, but I think the fundamentals for gold are still intact.”

What are the “fundamentals”? That gold is an asset that is no one else’s liability, for starters. Beyond that, the last month has provided you with evidence that in a pinch, the political and monetary authorities will confiscate your savings. Central banks across the planet continue to print money and monetize government debt. These are all facts too.

It tells you that the people who control and profit from the printing and use of paper money are willing to do just about anything to retain their rank and privilege. It’s their system, and it works well for them. They do not like the gold price acting as a signal of public confidence (or lack thereof) in paper money or public finances.

But take all the emotion of wild price swings out of it, if you can. Ask yourself whether you think paper money will gain or lose value over the next 10 years. And then ask yourself if you would rather have money in the bank or precious metals in your hands. The answer to that question will tell you all you need to know.

Besides, speaking from experience, this is the first time in almost 10 years that we can remember gold being a hated asset. It was hated in the early part of the decade for all the same reasons: It had no real economic use… it produced no yield, but imposed storage costs… it didn’t do anything other than sit there and look pretty in a cold, dark room.

The people who didn’t understand gold then don’t understand it now. The only difference today is that the horrible price action has brought out the gold bears from the woodwork. They are exacting their verbal revenge. The crowd is bleating for lower prices.

Of course, it could be that we are so embedded in our own position, so wedded to our own beliefs and so complacent after 12 years of rising bullion prices that we’re incapable of considering the evidence in front of us. It is possible we’re refusing to see the gold bear market because we’re emotionally attached to a long-term gold bull market.

Yes, of course, it’s possible. It’s important to know your limitations as a human being and not to mistake good fortune with personal brilliance. But we suspect gold’s days as the premier monetary asset are far from over. In fact, we suspect that gold will be around long after the yen, euro and dollar are being used for toilet paper.

Even artists — not famous for their interest in financial matters — seem to know this. One of the exhibits we relished at Hobart’s Museum of Old and New Art took some time to sort out. This is as it should be with a good piece of art, whether it’s a book, a movie or something else. The meaning — if there is one — shouldn’t come right out and hit you on the head. If it’s too obvious, it’s either a soup label or a traffic signal.

The exhibit in question looked like a long line of leaf patterns on colored paper, at least from a distance. As you got closer — and you’d have to lean in really close to examine the paper each leaf was matted on — you could see that the colored paper was really a collage of old paper currencies. Most of them were from places in South America or Southeast Asia.

This work of art conveys many different emotions and messages, depending greatly upon the individual mind that absorbs it. But for the narrow purposes of today’s essay, the leaves of defunct paper currencies convey a monetary, and perhaps ecological, message. All those forests cut down to make paper currencies that are worthless. Something real turned into something unreal. Something valuable lost; nothing worthwhile gained. That is one meaning you might extract from this canvas.

Paper money possesses value only because everyone tacitly agrees that it does. When that agreement breaks down, the money becomes worthless. That’s why paper money is ephemeral, everywhere and always. It has always come and gone through history, because those who print it cannot resist the temptation to print more. They always do.

But gold is untreelike. It doesn’t grow on trees. And you can’t extract more of it from a printing press. That’s why people have always used it as a store of wealth and a medium of exchange. Its physical properties give it a reliability you can never get from paper money that’s backed by nothing but the “full faith and credit” of a government.

Are we articulating an overly orthodox or unfashionable view of money? It certainly looks like it, based on the last few days of trading in the gold market. Does gold care? Not a jot. Will today’s paper currencies be the museum exhibits of tomorrow? Only if they don’t all get burned to produce something useful first, like heat.

For now, however, all the heat is on gold owners.


Dan Denning
for The Daily Reckoning

The Daily Reckoning