Tuesday, April 16, 2013

The Kouk: Gold is a Novelty, Useless & Bubble to Burst

Back in December I wrote a post about some views that Stephen Koukoulas (aka The Kouk) had shared via Twitter:

His comments included claims that Gold was a dud investment, expensive to hold, no different to every other commodity and that it was in a bubble, soon to deflate to less than $1000. I countered these claims in my post and sought further clarification on his bubble and sub $1000 call via Twitter to which he replied an article would be on the way.

Yesterday in Business Spectator he wrote an article on Gold which outlines his views on the metal (would recommend a read through in original form before I cherry pick pieces below):

While I agree with some of his comments, I disagree with most. From the way he writes about Gold, referring to it as useless and a novelty in the first few lines, this talks to the shallow level of analysis the metal is going to get from his article. It reminds me of a quote from Bob Dylan "Don't criticize what you can't understand".

After calling Gold useless in the opening paragraph and openly admitting that he finds it difficult to comprehend why people consider it a viable asset class he writes:
To be sure, gold was first seen as a valuable metal a few thousand years ago when it was used to make coins and thus it became a medium of exchange. This trend has continued to this day where some coins are made from gold although very few of them are in circulation anywhere in the world. In other words, its value is as a novelty, not a medium of exchange.
I agree that Gold is no longer a medium of exchange (for the majority). However, the functions of money are as a medium of exchange, a unit of account and a store of value. While Gold has lost it's place as a medium of exchange, once depegged from Gold (it's link to something of intrinsic value) and after a substantial increase in monetary base, the US Dollar (and other fiat currencies) have lost their place as a store of value (over the long term). 

Gold may fluctuate in price wildly at times, but when measured over the long term we can see that Gold tends to retain a similar amount of purchasing power. Of course there is the overused "fine suit" example:

"With an ounce of gold a man could buy a fine suit of clothes in the time of Shakespeare, in that of Beethoven and Jefferson, in the Depression of the 1930s." Forbes

But one of the better examples I have encountered was the Australian weekly wage measured in Gold (see my post here) which shows it oscillating from overvalued to undervalued, but staying within a reasonably tight range (over 100 years and perhaps longer).

This divide we've seen in money where fiat currencies are no longer a store of value and where the ultimate store of value (Gold) no longer plays a role as a medium of exchange lends quite nicely to the theory that we might one day have a more officially recognised dual monetary system such as Freegold where the two functions are split (fiat currencies are used transactionally and Gold used as a store of value by the people and it's flow between nations to settle balance of trade).

If Koukoulas thinks Gold only has value as a novelty, I would love to hear some more serious thoughts on why he thinks that some of the most powerful nations on earth keep a majority of their foreign reserves in the metal (for example United States and Germany who both hold greater than 70% in Gold)? Perhaps he can explain why China, world's largest Gold producer, is not only hoarding their mined Gold, but are also a net importer? Perhaps he can explain why Russia has been aggressively adding Gold reserves over the past 5 years?

Koukoulas continues:
The price of gold is underpinned because it is reasonably scarce or rather, it is currently difficult and therefore expensive to mine. The price is also supported by the demand from people who want to buy it and lock it up in a vault or an exchange traded fund, hide it in their undies drawer or bury it in a biscuit tin in the back yard. It serves no purpose in this form.
To suggest hoarded Gold doesn't serve purpose (because it sits unused) is like saying building and contents insurance for your home serves no purpose. It serves purpose, you just hope you never have to use it in a practical fashion. The person burying their tin in the backyard probably holds it as last resort insurance. It's probably a stretch to consider needing something like this in Australia, but in less stable countries, hidden & portable wealth which could be dug out of the ground or drawer and relocated easily obviously could have purpose.

Gold serves purpose in different ways depending on who owns it and in what form:

"If we could get everyone in the West to vote in this poll, I think "gold is an investment" would win in a landslide. If we could get everyone in the precious metals blogosphere to vote, then "gold is money" would probably win. So, to most Westerners, gold is an investment. To the gold bugs and HMS crowd, gold is money. And to the bullion banks, gold is a currency (ISO code XAU) upon which credit is issued and traded. So what did A/FOA mean by the statement that gold is wealth, not any of these other things? I mean, surely gold is whatever its users think it is, subjective use value and all, right?

Actually, that's exactly right! Gold is whatever its users think it is. And the point A/FOA was driving at was that the vast majority of the above-ground gold, today somewhere around 165,000 tonnes, is held by people who understand it as wealth." FOFOA

Koukoulas continues:
The massively inflated price for gold is a reflection of it being fashionable on the one hand, which seems legitimate, but in recent years there has been the ongoing perception that it is a store of wealth and while enough suckers believe this, its price is likely to stay high.
Koukoulas talks about Gold's role as a store of wealth and says it's a recent development, but in his earlier paragraphs has already talked about the many thousands of years that Gold has played a role as money... so which is it?

Dropping labels such as "suckers" to those who hold some Gold in their portfolio is just childish. I guess all the Central Banks and prominent billionaires who've bought Gold are all suckers.

Koukoulas continues:
As with any item, the price of gold is determined by demand and supply. It is just another commodity and to that extent, it is little different from soya beans, tin or other commodities.
Already covered in the last post... there are many ways that Gold is different to other commodities, here is just one:

Gold acts more like a currency than a commodity (and it's attributes such as high stock to flow support this likeness, even if it's not used regularly as a medium of exchange).

Koukoulas continues:
One issue the gold bugs rarely if ever deal with is what happens to its underpinning, hedge against inflation or store of wealth if there is a massive discovery of cheap and easy to mine gold?
Even if such a discovery were made it would take years before the resource was properly defined through extensive sampling and drilling programs, following which it would take years and many resources (energy, labour, money) to build the infrastructure required to dig it out of the ground. Let's fantasize a massive discovery which once developed manages to double annual Gold production within 5 years. New Gold mine production is but only a small addition to the Gold market each year so even a doubling to around 5000 tonnes mined per year is only adding around an additional 3% to the existing 170,000 tonne stockpile which already exists. Compare that to Japan who has recently announced they will be doubling their currency supply within the next couple of years... should our investment actions be swayed by the highly unlikely or from the events that are taking place now?

Koukoulas gets downright silly when he writes:
It is hard to say how much the price would fall if the US Fed sold even half of its 8,133 tonnes of gold, or if the Bundesbank in Germany sold half of its 3,391 tonnes of gold holdings. It would be a bursting a bubble that would make the Nasdaq tech-bubble crash look like a picnic.
Sure, if the Fed or Bundesbank dumped half of their Gold onto the market (or even threatened to) it would likely result massive downward pressure on price, but equally if China decided to dump half a trillion worth of US Treasuries onto the market it would probably be the end of the USD unless the Fed was able to step in and buy the lot and many more being sold in the resulting panic... such fantasy scenarios are best left to ones imagination than written in an article we are supposed to take seriously. 

Koukoulas would do himself a favour by trying to understand why those Central Banks still hold their Gold and why Central Banks have turned into net buyers from sellers over the past couple of years:

Click Chart To Enlarge - Central Banks Buying Gold, Just For The Novelty?
Late in the article Koukoulas does make a case for holding physical (although probably without realising he's done so):
Making the gold price issue all the more complex, is that much of the turnover in gold is on paper – its traded in a futures market where the turnover is many multiples of all the gold ever mined. Its price can be influenced and distorted by derivative traders and punters and has nothing to do with its true value.

Does that sound familiar with other derivatives blowing up from time to time?
Mentioned is the futures market, which not only turns over huge volume, but operates in a similar way to the fractional reserve banking system. The COMEX doesn't have enough physical in the warehouse to cover a situation where all open longs sought delivery. The below are comments from Kyle Bass in 2011:

"And then we went and looked at the COMEX. The COMEX at the time they had about $80 billion in open interest between futures and futures options. In the warehouse they had $2.7 billion of deliverables. So $80 billion in open interest — $2.7 billion in deliverables. We're gonna own it a long time. You're on the board, as a fiduciary, what do you do? That's an easy one. You go get it. So you go take a billion of $2.7 billion and you let them worry about the rest."

"When I talked to the head of deliveries at COMEX NYMEX, I was like, 'What if 4% of the people want deliveries?' He said, 'Oh Kyle, that never happens. We rarely ever get a 1% delivery.' And I asked, 'Well what if it does happen?' And he said, 'Price will solve everything' and I said, 'Thanks, give me the gold.'"

If we were ever to see the paper or derivatives Gold market "blow up" as Koukoulas speculates, it would be beneficial for the physical price of Gold as everyone scrambled out of their "paper Gold" and into the real stuff. Perhaps unbeknown to Koukoulas, such an event is the wet dream of many Goldbugs.

Koukoulas finishes on this note:
If you want to buy gold and hold it – go for it!

I would say the same for those wanting to buy soya beans, pork bellies, iron ore, wine or fine art. Good luck to you – I hope you make lots of money. But for me, I’ll be sticking to something that has a stronger underpinning and is an important part of the real economy.
While I concentrate on Gold and Silver mostly in a speculative fashion on this blog, the investor with a diversified portfolio should perhaps only hold a maximum of 5-10% in the metals. The more adventurous might consider a 25% position in Gold as part of a Permanent Portfolio or similar. It's not necessarily about making lots of money, but ensuring that you have exposure to an asset class which plays an important role in various types of portfolios.

The other night on Twitter we agreed to a little wager, with Gold at roughly $1500 (now more than $100 lower!), if the price drops to US$999.99 (before reaching $2000.01) then I will send him a bottle of Mount Mary Cabernet or alternatively if it reaches $2000.01 before US$999.99, then he will owe me 3 ounces of Silver. No need for headline grabbing $100m bets or dropping of pants, just a gentleman's agreement which will be kept (as all my bets are).

While there is the possibility that Gold could drop to US$1000 (briefly) and remain in a secular bull market (the price of Gold halved in the middle of the 1970s decade) it would certainly challenge my belief that it remains so. Perhaps Gold above $2000 will challenge Mr Koukoulas' view that Gold is just a useless lump of metal with only novelty purposes (but probably not).

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