Is Gold Another Fiat Currency?

This week gold surpassed $1100 an ounce in the futures market. This is certainly good news for gold bulls, and it’s difficult to argue with this powerful trend. However, there are some things that bother me about the latest impulse move up. Maybe it’s just my contrary nature. Before I get a bunch of angry emails, I want to establish that I am a long time gold bug. I started trading gold more than 30 years ago and I strongly believe in the principals and arguments favoring gold. But timing is another matter.

I just drove to Costco and during the 10 minute drive there I heard two commercials urgently urging listeners to buy gold now to protect their wealth. On the way home I heard three commercials, two on one channel and another upon changing the channel, again urging listeners to buying gold now. I admit I was in a bit of a Seattle traffic jam on the way home so it may have been a 15 minute drive. I just wonder if urging the public to buy gold at $1100 is going to be a sensible investment. I heard few commercials urging buying when gold was under $300 not that long ago.

One argument that gold bugs make is that gold is a hard asset that can’t be created at the whim of a politician or fed chairman. Soybeans and pork bellies would also fit as a real asset, but gold is non-perishable and very resistant to degrading over time. Soybeans and pork bellies are more useful as they are commodities than have a use. Well, gold does have some uses. A miniscule amount can be used in industry, such as electrical contacts in important components which makes gold unique due to its anti-corrosive qualities. A much larger use is in jewelry. But the vast majority of gold is held in vaults as a store of value. It seems ironic that gold, that was once in the ground, requires such a huge effort in terms of human labor often in dangerous conditions to extract it from the Earth, only to return it to vaults and safes, often located underground as well.

But what about gold as a store of value. It is difficult to mine so it can’t be created out of thin air, as being the case with paper fiat currencies. It is durable. It can’t be debased as the actual gold content can be determined. Even with all that going for it, there really isn’t much in the way of intrinsic value, other than the small amount used in industry and for jewelry. The value of gold is really set by supply and demand. Traders riding trends have a big say in how high or low gold can go. Demand is fixed to some degree by the difficulty of getting the gold out of the ground. On the other hand, most of the gold ever mined is still available to dump on the market, so supply is available if those hoarding decide to sell. Very little gold is used up. Much of the demand side comes from the perception of safety. Those who bought at the peak in the early ’80s and held through more than 20 years of a bear market might have a different perception of the safety of gold. Adding insult to injury is the fact that the general stock market had its largest bull market in history during the very long gold bear market.

But how safe is gold as a store of value when the price can be set by people, much the way people set the value of a currency. A paper currency is nothing but a promise based on nothing but good faith. The price of gold isn’t really based on much more than that if you think about it. What is to stop a central bank from dumping a huge quantity of gold on the market? What is to stop traders from riding a downtrend, forcing prices lower and lower? Demand can change quickly. There is no intrinsic value to guarantee that gold won’t go back to much lower levels. And there is certainly no guarantee that prices will keep climbing, as promised by all the gold ads. People set the value of a currency. And people set the price of gold. The price isn’t set in the heavens. It is perception creating supply and demand. It isn’t absolute. If all the gold suddently disappeared, nobody would miss a meal. The Earth would still rotate. Life would go on.

As governments can’t possibly pay for all the spending and deficits, it seems logical that all paper currencies will continue to decline, and that so called hard commodities will at least hold their own in relation to those paper fiat currencies. But for those who believe that gold is a good hedge against irresponsible governments, timing gold purchases is probably still a good idea. Piling on the bandwagon after such a lengthy price increase might mean buying at too high a price. In the very long run as currencies continue to decline gold may still be a safe bet even at these nosebleed levels. But one might be better to wait until the bandwagon tries to knock off the speculators and prices come back down to Earth.

In previous posts I pointed out a few divergences that might suggest gold could be ready for a pullback. The above chart shows another. In the upper sub-graph is the etf for gold, and in the lower there is the etf for silver. Gold and silver have had a symbiotic relationship for a very long time. There are times when one commodity is in favor over the other, but they generally move in the same direction. Sometimes, but not always, a clue to a turn can appear when one of the commodities makes a new high while the other fails to do so. This is the case now between the gold and silver market. In many of the impulse moves in the past silver would lead the advances as well as the declines. This can get decoupled a bit when there is fear of continued recession at a time when inflation appears to be a threat, such as in the current environment. After all, silver is more of an industrial metal than gold so it is more sensitive to weak industrial demand. But divergences between the two should be watched closely, as is the case with the mining stocks that I pointed out previously.

Calling tops in a greed driven bull market is very difficult, and I am not trying to call a top here. I’m just pointing out some warning signs. The trend is still up, but that could change quickly if the dollar should have a rebound rally and all the traders in gold rush for the exits at the same time. I’ve seen it many times in the past. This time probably won’t be different.

3 thoughts on “Is Gold Another Fiat Currency?

  1. Though i understand the concerns of the radio adverts suggesting to buy gold – to use this as a basis as evidence of a top even intermediate one has many flaws. (I know that is not what your doing but many commentators do).
    Not too long ago literally hoards of contrarians were worried that Jim Cramer had said he was buying gold. And yet gold still romped on. Poor Jim Cramer is he not allowed to get one thing correct?
    I agree sentiment is important but it just is to fuzzy to measure in a scientific way. But if you want me to play this game well – I have 60 people who work in my office and NOT one has bought gold. What does that suggest?

    PS This is far from an angry email from a gold bug , love the work keep posting.


  2. Thanks for comment. I didn’t take it as angry at all. I’m a long time gold bug and very bullish longer term. I’m just contrarian by nature and try to point out the other side of the argument when markets are getting very one sided. The market has a way of punishing investors when they loaded on one side of a trade. Maybe gold is not there yet. I still have a long position, but I’m watching it very closesly to at least take part off in here. I’ll probably always keep my core position not matter how high it ultimately goes.

  3. I agree with this. Gold cannot be simply created out of thin air like money can be (and is being), but unlike food or energy it has few real uses. And it’s obvious that the difficulty of its creation does not mean it cannot go up and down. It was a few hundred bucks a decade ago, right? The perceived value of a fiat currency can be set by investors and the entity backing it and gold is much the same way. It is a trading instrument with little real necessary value. I am sure a better hedge against inflation would be investing in real commodities. If things got dire, backs to the wall, the only people still buying gold are those with excess wealth (using it to hedge). Everybody else would be jacking up the prices of *real* valued items (e.g. food) and pulling their money from gold to do so.

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