Seven Reasons To Avoid Gold - And Why You Should Ignore Them

August 07, 2008
Tim Iacono


So, now that the U.S. government is squarely behind Fannie Mae (FNM) and Freddie Mac (FRE) and the price of crude oil is barreling toward the well known "bear market" milestone of a 20 percent decline, investors seem to be losing interest in gold as an investment alternative, figuring that order will soon be restored to the global financial system and the recent energy price shock will soon be just one more in a long line of scares that, in the end, prove to be only a scare.

The proverbial "inflation hedge" that seemed like such a good rationale for buying gold just a few months ago now seems to have lost its appeal as well with headlines now blaring, "Gold Drops as Lower Energy Costs Cut Demand for Inflation Hedge". Now, some are even talking about deflation.

Add to this the nascent strength of the U.S. dollar, now appearing to form a solid base and set to move up against the currencies of other increasingly troubled western economies, and the yellow metal seems to have lost much of its luster. "King Dollar" has been down, but he is definitely not out.

And gold has become so expensive in recent years that traditional buyers just can't afford the stuff anymore. Indian jewelry buyers, one of the world's most important consumers through history, are now balking at higher prices and demand is way down.

Economic growth in the U.S. picked up in the second quarter as real GDP came in at an annual rate of about two percent and no one seems to know if we have been, are in, or will be in a recession. While things are certainly not going gangbusters, it doesn't look like the wheels are about to fall off requiring more intervention, which, by the way, is something that the U.S. government is getting quite good at.

And finally, the Federal Reserve will soon be raising interest rates, or so the market says. Before we know it, the current era of negative real interest rates will be just a memory and you'll be able to get a decent return on a Certificate of Deposit at a nearby bank.

Though there are surely a few outliers missing from the above list (oh yeah, gold doesn't pay a dividend), these are all the reasons cited for the yellow metal having performed so poorly after reaching four-digit territory back in March, now resting below the $900 level and looking down, not up.

But, do these commonly heard arguments against owning gold really make sense?

Perhaps a closer look at each one is in order.

Financial Markets Becoming More Stable

Yes, twitchy traders and unsettled investors who are quick to abandon whatever it was they were doing before crises emerge are the first ones to bid the price of gold higher when uncertainty and chaos rule financial markets. But, this is not really something that you can count on, nor should you - either the crises or the reactions.

Extrapolating the many calamities of the last year far into the future, calamities that have aided gold's 50 percent rise, is not a good reason to buy gold. If that's your thinking for the long-term, you might be better off buying bullets because, if every year is going to be like the last year, you may need them someday.

Falling Crude Oil Prices

The oil-to-gold relationship is very much overrated. Just as oil and consumer prices are related, oil and gold prices are related because energy costs are a critical factor in whether the metal can be dug out of the ground profitably. Also, a flood of petro-dollars surely boosts Middle East bullions sales.

But, aside from that, those taking their gold buying and selling cues from the price of crude are fooling themselves just as the financial doomsayers are. If Saudi Arabia announced it had no more oil on the same day that central banks around the world announced a ten-year plan to sell all their gold reserves, would anyone buy gold because oil was going up? Once again, traders too easily confuse correlation with causation.

Waning Appeal as an "Inflation Hedge"

Guantanamo-style torture of the inflation statistics by government economists over the years have permanently rendered the official inflation statistics almost meaningless, at least when viewed in a historical context. If that's what you're attempting to hedge against by buying gold, then you should really just use the government's inflation protection in the form of TIPS (Treasury Inflation Protected Securities).

If on the other hand, you already understand how the government "cooks its books" when it comes to prices, then you're also far too smart to call gold an "inflation hedge" - owning gold would be much more accurately described as protecting yourself from the government.

A Stronger Dollar

Sure, the dollar and gold often move in opposite directions, but they don't always. In fact, since 2001, a period during which the gold price has risen every year, the U.S. Dollar Index rose during two of those years. The fact that the dollar has mostly declined in recent years as the metal has risen is again confusing correlation with causation, just like those hair-brained hedge fund managers did when they confused the rise of "index speculators" with supply and demand when trying to explain why energy prices had climbed so high.

What difference does it make how the dollar does against other fiat money when it's all just paper? Of all the reasons to buy or sell gold, the movement of the U.S. dollar versus other paper money has to be the dumbest one of the lot.

Reduced Demand from India

OK, anyone thinking that the price of gold is going to go substantially higher because of its use for jewelry or industrial applications has surely missed something along the way. It is investment demand - people like you and me realizing that we had better do something about the declining purchasing power of our paper money, something about which the U.S. government doesn't appear to give a damn - that will drive the gold price higher.

There just aren't that many good places for people with lost of paper money to put it these days. A slowdown in physical demand must be compensated for by even stronger investment demand, but with the amount of paper money and rich people in the world today who desperately want to remain rich, the monied class will eventually figure it out and easily pick up this slack.

A Weak Economy is Improving

Well, anyone who believes that the U.S. economy is going to heal itself sometime over the next year or so has been drinking far too much kool-aid for far too long to think clearly about "alternative" investments. They'll be much poorer as a result. The U.S. economy is going to need massive amounts of stimulus (i.e., borrowed/printed money) to avoid another Great Depression between now and 2010 or 2011 and policy makers appear to be up to the task.

Anyone who doesn't think that trillion dollar deficits are a good reason to exchange U.S. dollars for something more tangible is probably equally unaware of the entitlement tsunami that will hit if another Great Depression is successfully avoided. When looking at the relative long-term prospects of U.S. money and God's money (just heard that one for the first time the other day), the decision about which to hold is a no-brainer.

The Fed Will Raise Interest Rates

No, the Fed can't raise interest rates. Not this year, not next year, and maybe not even the year after that. Actually, if they wanted to get this whole mess over with so we could all try to start over again, that would be a sure-fire way to get the ball rolling. Heck, if short-term rates were raised to 6 or 8 percent, I'd be the first one in line to sell my gold and park the money in a nice government insured CD that pays something within hailing distance of even the "official" rate of inflation.

Ben Bernanke and Congress will go kicking and screaming toward "baby-step" rate hikes that won't even begin until another asset bubble can be identified and sufficiently inflated. Surely, the last twenty years of history are clear on this point. Until modern economists have a "come-to-Jesus moment" where they realize most of what they were doing was wrong, things will get worse, not better.

A Golden Opportunity

None of the commonly cited reasons for excluding gold from an investment portfolio make much sense when you stop and think about them, but much of what happens in financial markets doesn't make sense either. Just look at how much devastation has resulted because people simply assumed that home prices would never go down - who would have thought that an entire industry, and perhaps the global financial system, could be brought to its knees by thinking that home prices went in only one direction.

Gold at $877 per ounce (as this is written) is presenting an opportunity of a lifetime, but, just like most people failed to see the stock market bubble or the housing bubble, most people still haven't got a clue, thinking that $1,000 gold was nothing more than another bubble that has burst - just like the last two.

Slowly, but surely, people will convert more and more paper money into God's money and the gold price will move much, much higher.

When and how far is anyone's guess, but, probably sooner rather than later.