Ad Hoc Commentary – stay away from gold

sg2014111244397Last week, gold made a low at 1132, and had since been hovering just above 1150, a level that yours truly targeted many months ago based on mid-1970s drawdown:

“…gold fell from 185 in Dec 1974 to 105 in Aug 1976. That’s more than a 40% move. If we do the same from Sep 2011 when uncle Ben disappointed us, then the target from 1920 gold is 1100 gold…”


“…gold is slowly but surely trending towards our target of 1150…”


The fundamental problem with gold today is it took too long to get to 1150. This means bulls are too stubborn. This in turn means that we likely need sub-1000 gold before we can safely buy gold as an investment. Paulson is likely the ‘chief stubborn’ or simply just stuck, being too big to trade:


Thus, you should do your own homework when gold bulls tell you to buy just because billionaire John Paulson is buying:

“…In recent months, Paulson has expressed his concerns about inflation. That’s probably why he has purchased over US$1.3 billion in the SPDR Gold Trust. Paulson has also bought huge stakes in gold mining companies like Goldcorp Inc., Silver Wheaton Corp., and Yamana Gold Inc….”


The gold bulls have a new story too:

“…Switzerland is scheduled to hold a referendum on whether the Swiss National Bank will be required to hold more of its assets in gold. Right now, most of the bank’s assets are backed by euros and U.S. dollars. Today, less than 8% of its assets are backed up by gold. If the measure passes on November 30, the Swiss National Bank will be forced to bring its percentage of assets backed by gold up to 20%. This will amount to it purchasing 50 million ounces of gold over the next few years, equal to roughly half the world’s annual mine supply. That would put an enormous bid underneath gold prices…”


This is the official gold holdings (ignoring ETFs):

Country/Organization Gold Holdings (tonnes) Share of reserves
United States 8,134 72%
Germany 3,384 68%
International Monetary Fund 2,814
Italy 2,452 67%
France 2,435 65%
Russia 1,150 10%
China 1,054 1%
Switzerland 1,040 8%
Japan 765 3%
Netherlands 613 54%


Let’s look at the gold bull’s new story first. Yours truly response is: What about France and Germany? The sovereign debt crisis is currently targeting the Franco-German core of Europe. Would that lead to gold divestment since gold is more than 65% of Franco-German forex reserves? Selling the family gold seems like a reasonable thing to do. Countries had sold gold before. We remember 1999-2002 when Gordon Brown sold UK gold giving rise to the infamous phrase “Brown Bottom”. Why would France not ‘diversify’ its forex reserves?


Next, we turn our attention to the old story of inflation. We remind ourselves of Irving Fisher’s MV=PQ. M is the quantity of money, V is the velocity of money (whether you hoard or spend the money), P is the price level, and Q is the quantity of goods and services. Inflation is when P rises, deflation is when P falls. But then this is incomplete.


Irving Fisher died in 1947, well before Richard Nixon introduced the floating exchange rate system in 1971. In a floating rate regime, currency inflation is possible. When a currency depreciates, most good and services will increase leading to currency inflation. That is what happened in the 1997 Asian Financial Crisis. But then this is also incomplete.


Goods and services are just part of the real cost of living. Taxes are important, especially so in this age of taxation. So, we should include taxes into Irving Fisher’s quantity theory of money:

MV = PQ + T

Assuming MV unchanged, higher taxes will lead to deflation. That is logical because money you paid for taxes could have been used to buy say, the new iPhone 6 Plus. That is the first order relationship. Yours truly understand that there is a slower second order impact. Taxes impact the willingness to invest. If government is going to take away 90% of your income, most people will be unwilling to invest in new factories or work. Economists had documented this unwillingness to work under repressive tax regimes through the Laffer curve. The Laffer curve is just a plot of tax revenue on the Y-axis and tax rate on the X-axis. There is a tax maximizing tax rate, and that is not 100%. At 100% tax, most will not work, giving us the fundamental problem of communism. As we can imagine, in communistic regimes, we will eventually end up with high inflation because production of goods and services suffers. However, that is a story for another day.


So, the next time someone assert that we should buy gold because Paulson expressed his concern about inflation. You ask him:

1. M: Are central bankers going to print more?

2. V: Is average Joe hoarding his money?

3. Q: How is the demand and supply curve looking like?

4. T: Are taxes increasing or decreasing?

5. Currency inflation: Are major currencies getting stronger or weaker?


Thinking through the questions above, yours truly see a higher possibility of deflation in the short term and thus is not buying this dip in gold. Having said that, we remind ourselves that gold is not a hedge against inflation or deflation. It is a hedge against government implosion. However, many had bought and sold gold on the inflation-deflation story, so yours truly respects that.


Good luck in the markets.