Gold Ahoy!

I have to admit. It’s not my forte. And that’s why I decided to put some research into it. With the gold prices going sky high and some well known investors like Jim Rogers and David Einhorn recommending that some part of the portfolio be dedicated towards gold, it certainly deserved serious attention from an investor.

A bit of background

Gold has been valued from the early Bronze Age. The first known gold objects, dating possibly as far back as 5000 BC were Egyptian ornaments, ritual vessels, and personal jewellery. Gold’s high melting point and resistance to corrosion made it indestructible and very useful indeed.

Goldsmiths in the 17th century issued certificates representing gold on deposit, which were among the earliest forms of gold backed paper notes. When the Bank of England was created in 1694, it mainly financed government debt by issuing these notes.

Safe Haven

“Europe collapsed and North America collapsed!”, said the Indian finance minister, Pranab Mukherjee as he announced India’s purchase of 200 tonnes of gold from the IMF. This purchase was the single largest central bank purchase in 30 years over as short a period as a fortnight.

This must have been a BIG decision by the country’s think tank considering that this constitutes over a 50% addition in its gold reserves. After the purchase India now has close to 560 tonnes of gold (about 6% of the reserves in value), that’s the ninth largest gold holdings amongst central banks. China on the other hand has grown its gold reserves by 75% vs. last year (as of now China has around 1000 tonnes of gold, constituting around 2% of its reserves). Compared to some of the other nations like Germany (69%), Italy (66%), France (70%) – this is still a miniscule percentage.

And therein lies the logic of the gold purchase by India and China – diversification of risk to assets other than USD. At a governmental level, it pays more to safeguard the country's assets than to look for returns.

Gold and Dollar are considered the world’s primary safe haven investments. If the confidence in Dollar collapses, gold then takes over as the world’s sole safe haven investment. In that sense, gold has historically provided a low and even negative correlation with most other asset classes and has been used as a portfolio diversifier whenever there has been a perceived high level of risk.

As the following chart shows, gold rose from USD 100 per ounce in the period ‘75-’78 to a high of USD 750 per ounce around the early ‘80s. This was a period marked by high credit (average annual credit grew by 11%) and at times higher inflation (average inflation rate of 12% in 1974 and again in 1979-1980). Investors flocked to buy gold as confidence level in the world economies fell.



Just immediately after this, gold’s price fell massively (in 2000 it was back to around USD 250 per ounce) as monetary order was restored and the economy and stocks soared.

Moving back to the present times, with the US Congress spending billions of dollars in stimulus funds to jump-start the economy funded almost entirely with debt, the dollar has become weak since currency investors tend to shy away from high-debt countries - just like in equities where (all other things being equal) we would not prefer to invest in a company that is highly levered.

In the case of a country, a high level of debt also causes higher inflation, another reason for investors to stay away from USD and hence moving into the only other known safe haven – gold.

Resultantly, the yellow metal now rules over USD 1100 per ounce. This means a return of over 50% over last year.

Crystal Ball gazing

So with gold now at the USD 1,100 per ounce levels, bets are being placed on what could be the next probable price target. Wild guesswork is at work, as is usual. And some say that even US$ 1,500 by the end of 2010 does not look like a very tall order.

It was reported that Barrick Gold, the world's largest producer of gold is moving to completely close its hedging operations as it does not believe that gold prices could fall a great deal from here. The company feels that global output has been falling by roughly 1 m ounces a year (approx 33 tonnes) since the start of the decade and hence, there is a strong case to be made that we are already at 'peak' gold.

And with central banks around the world also turning into net buyers of gold in recent times, supply crunch is likely to worsen a great deal more, taking gold prices even higher.

Barrick is not the only one betting on higher gold prices in the future. Marc Faber, one of the world's pre-eminent investors has also jumped on to the bandwagon. "We will not see less than the US$ 1,000 level again", he is believed to have said at a conference today in London. "Central banks are all the same. They are printers. Gold is maybe cheaper today than in 2001, given the interest rates. You have to own physical gold", he is reported to have said.

Even the best can’t be right all the time

The average investor is blindly following these noteworthy men.

But as the earlier chart depicting the gold price showed, gold as an investment suffers from the same malaise as any other investment. Buy at a high and the probability increases that you will lose.

Notwithstanding what Barrick believes, the Fortune magazine has reported that gold miners invested more than $40 billion into new projects since 2001, and they "are now bearing fruit." Bullion dealer Kitco "predicts that these new mining projects will add 450 tons annually -- or 5% -- "to the gold supply through 2014, enough to move prices lower." The demand also brings out sellers of scrap gold, which adds even more to the supply.

All this while world demand for gold (as in the demand from the ordinary consumers) has dropped 20% in the past year. In fact according to the World Gold Council, India's gold demand dropped 38% in the second quarter, with jewellery purchases down 31% from a year earlier. For India! This is where everyone loves gold!

By the above logic, if the supply is going to move up and the consumer demand is down, the only reason that the gold will continue to rise in the future is if the investors continue to buy more gold.

Don’t know if it is the right comparison, but this sounds like a giant Ponzi scheme. As long as there is fresh demand from investors, the prices will rise. And we know these don’t last forever. Remember oil DID NOT reach USD 200 per barrel from the USD 130 levels or so, despite a lot of the so called experts preaching that it might.

What can turn the tide?

Very clearly the return of the US economy back on track.

As mentioned earlier, all things considered, gold is essentially a bet on the collapse of the current monetary arrangement based on paper currencies. And although the US dollar might look like it is overvalued and prone to collapse, what if the US economy does not collapse and actually recovers and the Fed starts raising interest rates?

Mr. Buffett is already betting on it.

“It’s an all-in wager on the economic future of the US. I love these bets... America’s best years lie ahead, no question about it” so said the sage of Omaha, Warren Buffett as he announced the acquisition of Burlington, a US railroad company at a total price of USD 44bn, his company's highest investment thus far. Ever.

As for gold, he had the following to say:

“It gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”

(Fittingly one commentator used the above to say this about printed money: “It comes in abundance from trees with little to no efforts, we print as many as we want and assign whatever value to it, but we make certain it contains official looking faces and logos so that we can pay people with it to stand around guarding it!)

So there. After all the research, I have to admit that I still don’t know how to value gold like I would value a company. Which means that if I can’t invest in (Indian) equity, which at this point in time seems the case, then gold doesn’t look the right choice of investment either. Back to square one.

Umm, and Indian equities?

Well just because the US economy is looking to come out of the doldrums and Mr Buffett is betting big time on it, I am afraid it does NOT mean that the Indian equities will follow suit. This could well mean a flight of capital from emerging markets like India and back to US (I referred to this in my last blog entry too), with obvious effects on the market levels.

Meanwhile, the best strategy in my view is to keep smiling that golden smile and hold on to the cash. The time to invest will come.

Whither the markets?

Whither the markets?
November 1st 2009

In the Indian family context, until the first child is born, the question that a couple is most often badgered with is - when is the good news coming? Atleast that was the case over a decade back (thats when we had our babies, so obviously after that thankfully we stopped getting those questions).

And in the context of the stock markets, though the 'good news' had been discounted for a long time (remember the 'green shoots'?), yet when it actually came, there was much excitement around it. I am referring to the latest numbers reported for the US economy showed that the US GDP had grown by 3.5% YoY during the quarter ended September 2009 (3Q09). See the graph below.



For real?

Many though, are still doubtful whether this is sustainable. This is given that a large part of this growth in US GDP has been brought about by the government's stimulus program that has helped raise consumer spending, and housing and automobile demand.

For instance the cash for clunkers program. This is the program wherein the US government was offering a cash subsidy to consumers to exchange their old cars for new ones and was done with a view to bail out auto companies, which stood on the brink of bankruptcy. This has pushed up the automobile output during the September quarter by a massive 158% YoY, which in GDP terms, according to the US Bureau of Economic Analysis, added around 1.6% to the US GDP growth figure reported. Thus without it, GDP growth would have been only 1.9% (3.5% minus 1.6%) during the third quarter.

Sauce-Bearnaise Syndrome

I heard of this term only recently. Basically if you end up eating something that violently disagrees with your system and you end up vomiting, you'll likely find yourself suffering from Sauce-Bearnaise Syndrome. Otherwise known as taste aversion, it causes us to associate the taste of the food we've puked up with the illness that caused it to such an extent we're unable to face eating it again.

If from my notes you get the distinct feeling that I am being too pessimistic in my views of the stock market, then you know the equivalent of the Sause-Bearnaise syndrome is working on my mind where investing is concerned. I still haven’t quite forgotten the paper losses of just a few months back.

People who came out of the Great Depression in the US are known to have been highly risk averse when it came to investing. Including the great Ben Graham, the eventual teacher to some of the greatest minds on the investing landscape, including Warren Buffett and Walter J Schloss. So I am in August company where this feeling is concerned.

The sky is falling!

I read somewhere that losing in the stock market is an everyday reality: Stock prices go up and down daily. Inflation corrodes the purchasing power value of investments-day after day. The challenge-and the opportunity-is to lose less.

General George Patton said it this way: "Let the other poor, dumb son-of-a-bitch give up his life for his country." They are all talking about the same thing: Don't be heroic. It doesn't pay.

I am not the only one with the feeling that notwithstanding the streaming economic good news, all is not well in the stock markets.

Renowned economist Nouriel Roubini said on Oct 31st that we can possibly have a market crash all over the world. The reason? He is of the opinion that everybody is currently busy shorting the dollar, borrowing and investing in assets all over the world. That has helped push the dollar to a 14-month low.

People are essentially borrowing at zero percent interest rates in the US and investing in other countries, which is even more beneficial for them because we currently have a falling dollar. But according to him, the dollar will eventually rebound. And when that happens, everyone will have to close their short positions and dump their assets, and this is how we can have a market crash all over the world all over again!

A journalist on the FT, who I respect for his views also said that the next ‘correction’ in the stock markets will be caused by the foreign exchange markets, predominantly the US Dollar.

There is no doubting that the greenback has taken a beating. The rupee has gained ~5 per cent since this time last year, the euro has gained ~18 per cent, gold has risen in value by 17 per cent against the dollar since the start of the year etc.

The oil-exporting world is worried, since oil is priced in dollars. As is the Indian infotech industry since the bulk of its earnings are in dollars. The Chinese are practically paranoid, for they are the world's biggest lenders to the US. You would be too, if you had invested $2.27 trillion mostly in US government bonds. The governor of the People's Bank of China, wrote in a recent essay that the world needs a new global currency to replace the dollar.

Some of the dollar's recent losses are, of course, a manifestation of the perceived return to normalcy in the financial world, and a reversal of global capital's "flight to safety" in the dollar last year at the height of the financial crisis. As appetite for riskier investments returns, capital is moving out of the dollar comfort zone in search of better returns.

But more deep-seated concerns about the structural weaknesses in the US economy -- principally, a toxic mountain of debt and the absence of a strategy to overcome it -- are giving rise to a chorus of concerns that the dollar is at risk of collapsing and being dislodged from the pedestal of its global reserve currency status.

As if till now you weren't convinced of my negative views on the markets, I am going to quote another interesting article - this time something that I saw on the Wall Street Journal. This one said that the markets in the emerging economies could be headed for a downturn irrespective of how the developed countries fare in the future.

Basically as per this theory, if the US and Europe continue to grow sluggishly, countries relying on exports such as China and Brazil will be hit hard. So if the world economy slows further, commodity prices will plunge. On the other hand, if the US economy for instance starts growing at a strong pace, interest rates will head upwards and the dollar will appreciate thereby taking the sheen off emerging markets.

Damned if I do, damned if I don’t!



Despite the interesting insights that these theories provide, why should we concerned on this? Because foreign money flows into the Indian markets are the ones that move our markets. As seen from the chart above, there emerges a very close connection between how FIIs (foreign institutional investors) have behaved in the past and how the Sensex has danced to their tunes. And as compared to the FIIs, inflows from Indian mutual funds have been relatively steady and small.

When Warren Buffett was asked in 2006 whether there was a bubble in commodities, Buffett observed that, like most trends, it was driven by fundamentals at the beginning and then speculation takes over. 'As the old saying goes, what the wise man does in the beginning, fools do in the end.'

This was in the May 2006 period when the stock market was booming, just ahead of its correction. Every second fund manager was aware of the market's potential fragility and Buffet's analogy resonated with many investment people. 'It's like being Cinderella at the ball,' he said. 'You know that at midnight everything's going to turn back into pumpkins and mice. But you look around and say “one more dance" and so does everyone else. The party does get to be more fun-and besides, there are no clocks on the wall. And then suddenly the clock strikes twelve, and everything turns back to pumpkins and mice.'

For us, this means that till the time the FIIs decide to stick around, well and good, but when its time for the clock to strike midnight - for whatsoever different reasons - could be the dollar, could be their reporting periods or their percieved attraction to another market - they will go home.

And?

Well, while everyone has to have an their own independent line of thinking on investments. From my standpoint: Wait.

Mohnish Pabrai, said in an interview recently that one of Warren Buffett’s key trait that he has followed is that “you make few bets, you make big bets, infrequent bets and you only make bets when the odds are heavily in your favor.”

I so whole heartedly agree. I was having difficulty finding real values in the Indian stock markets. And notwithstanding the recent ‘correction’ in the Indian stock markets (probably caused by the exit of some fickle fund money), I am not waiting with bated breath on the big crash which may or may not happen. I would invest when the odds are heavily in my favour.

It is in times like these when interesting opportunities usually start to appear. I hope I can write soon about those.

Because that would be the real good news.