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I hope this essay provides some food for thought. It is not my intention to insult or belittle anyone, but using humor and cold logic, to help people understand an abstract topic with many counterintuitive principles. The ultimate goal is to protect what you have and make some more (in that order).
Gold is money. We have published a video to make the point that one should use gold to measure the economic value (i.e. price) of everything else including the dollar.
So what does that make the dollar? It is a form of credit, and its quality is constantly falling because the Fed is incessantly forcing more counterfeit credit into the market. The price of the dollar is in long term decline, starting at around 1.6g of gold in 1913 to around 21.3mg (yes milligrams) today.
The price of the dollar sometimes rises for reasons that may not be obvious. The financial system today is highly leveraged. Small changes at the margin, such as intermittent pressure on debtors, can be amplified by this gearing. In the casino of FX markets, traders chase momentum. The occasional crisis somewhere in the world can put enormous (if short term) buying pressure on the dollar. Fear, misinformation, and even delusion can make the crowd run the wrong way. How many people sold their gold on the rumor that Cyprus might sell 10 tons of gold on the market?
The dollar is not suitable to measure the value of gold. It is too volatile, not to mention that it is generally falling. This idea has profound implications on investing and trading. I address one of them in this article.
The central fact of gold today is both self-evident and non-obvious. Most people find it hard to get their heads around the fact that a rising gold price does not produce gains for gold owners. Our whole lives, we’re trained not only to think of the dollar as money, but to think that the dollar price of everything is its value. It is a deeply held belief that if you increase the number of dollars you own, then you have a gain. It is time for this illusion to be dispelled.
Consider a simple trade. First, you buy gold. Then the price of gold goes up. Then you sell the gold. You have a profit, right?
Wrong.
You have more dollars (and the government will tax you on the increase). Each of them is worth less, in precise proportion to the number of them that you gained. To underscore this, let’s look at it from outside the dollar bubble. A rise in the gold price from $1350 to $1500 is really a drop in the dollar from 23mg of gold to 20.7mg. If you bought an ounce of gold with 1350 dollars you still have one ounce worth of dollars when the dollar has fallen to 1/1500 ounce (or 1/5000).
This means that a strategy of buying and holding gold for the long term does not produce wealth. It protects wealth, because gold does not fall. To get richer, you must either invest to receive a yield in gold, or speculate on an asset with a rising gold price. Producing a yield on gold is the reason why Monetary Metals was formed. Speculating on rising asset prices is challenging because as we head into this greater depression, demand is falling. I recommend checking out www.pricedingold.com, which has charts of many different things priced in gold.
It is possible to trade the short-term volatility in the dollar. To frame this objectively, it is buying the dollar when it is down and selling when it is up. I deliberately did not state this as people commonly think of it today: buying gold when it is down and selling gold when it is up. Gold is not going anywhere; it is the dollar that is volatile and falling.
Your first choice is whether to use leverage. Leverage would allow you to profit from the rising gold price because you will gain more dollars at a faster rate than the dollar is losing value. Let’s illustrate this with two examples.
The first example uses no leverage. You buy 100 ounces of gold for $1460 per ounce, a total of $146,000. The gold price eventually doubles to $2920. You have twice as many dollars, but unfortunately each of them is worth half as much. Your net worth in gold is still 100 ounces.
The second example uses 5:1 leverage. You buy 500 ounces of gold at $1460 per ounce, or $730,000 worth of gold, but you only need the same $146,000 as in the first example. The bulk of the capital, $584,000, is credit. Then, the gold price doubles to $2920. Now your 500 ounces is worth $1,460,000. You can sell 200 ounces to pay the debt, and you are left with 300 ounces free and clear. Your net worth tripled from 100 to 300 ounces.
However, there is a dark side to leverage. When the price falls, leveraged accounts are subject to margin calls. The trader must immediately put in more dollars or else the broker will sell everything, and the trader could lose everything. Just ask anyone who was leveraged a few weeks ago when gold was near $1600 what happened, and if he still has a gold position, or any capital left in his account at all.
This kind of event is exceedingly hard to predict. We did not predict it from our analysis of the basis (though we did make a bold and controversial prediction and trade recommendation that has performed quite well). Following April 15, the basis allowed us to see that large quantities of physical gold and silver were flushed out of someone’s hands and into the market. And as we go forward, it will allow us to see the changes in scarcity of gold and silver.
Not counting the Keynesians, or the perma-bears who have long thought that gold should collapse to $250, some technical analysts put out bearish calls on gold and a few called for a significant and rapid price drop.
Trading the downside in gold is very difficult because no matter how the technicals look, there is a risk that some central bank or big player could make an announcement that would drive the gold price up sharply. Indeed, we predict that volatility will rise as we go forward. For this reason, and of course the upward bias to the gold price, we never recommend a naked short position in gold or silver.
If you do not use leverage, it is difficult to produce a real gain. Remember that a generally rising gold price is just a generally falling dollar. You can’t make a profit from this. You rely on short-term volatility. You buy gold at a lower price and then sell it at a higher price. And you must hope that the gold price falls again. If not, then your strategy has failed.
There are other downsides to the unleveraged strategy. One is that you must hold falling dollars at times. You buy gold, hold it for an hour or a day or a week and then you sell it. You’re left holding dollars, hoping for a lower gold price. During that time, you are exposed not only to the falling dollar, but also to the credit of your bank or broker as well. We would prefer a strategy that allows one to sleep at night, especially Friday, Saturday, and Sunday night.
I corresponded with a gold dealer in Cyprus following their collapse. He recommended to people to buy gold. Not one person took his advice. Now, of course, they regret their decisions. This is not because consumer prices rose in Cyprus, but because what they thought of as “money” has turned out to be just bad credit, a defaulted piece of paper. Gold does not default.
At the end of the day, when the dollar collapse takes on a more vicious dynamic and rapid pace, the gold price will be rising sharply, perhaps exponentially. What will you do then? If the charts say that gold is overbought, will you take your profits? Will you sell at a record high price? Will you trade all of your gold for dollars immediately prior to the dollar becoming utterly worthless?
With or without leverage, trading any market without better information and/or a superior understanding than the other traders is a sucker’s game. Having faith in a $50,000 gold price and a conspiracy theory that a Dark Cabal manipulates it down to $1460 is not information or understanding. It is just hope plus words of comfort to use after each wounding.
The gold market has price moves that cannot be predicted in advance and in some cases do not have an obvious cause in contemporaneous news coverage. In my article on the gold price drop, I do not point the finger at the rumors of Cyprus being forced to sell its gold, Texas or Germany demanding their gold, etc.
Today, at $1460, the question is: are there dissatisfied traders who held on during the crash, and who are now waiting for a slightly higher price to sell? Will these people outweigh the hungry buyers who look at the current price as a sale, in the short term? We would not care to make a prediction on this. The long term is much easier to predict. The catch is that without leverage, you cannot profit from it and with leverage you can get squeezed out in a price drop before the price rises.
Technical analysts that we respect now say that massive damage has been done to the gold and silver charts, and there is a likely to be a further drop in the prices. Some technicians are calling for a price at or below $1100. Will it happen? Maybe, and if it does, it won’t be caused by the Dark Cabal.
It will be dollar-oriented traders, eager to sell low because gold is “falling”, and the destructive dynamics of stop orders, margin calls, momentum chasers (who do sometimes short gold naked), etc. As when gold’s price was rising, now that it’s falling traders are trying to outguess the others in the market, who are trying to outguess them. The picture of a Ouija Board is not too inaccurate.
It is possible to trade gold professionally, to make a profit measured in gold. If you want to trade, then you ought to know about the mechanics of the market (e.g. arbitrage, about the concept of relative gold scarcity (i.e. the gold basis), and about monetary science (e.g. pressures on markets related to changes in credit). Develop your trading strategy around them, rather than on whispers of big London or Chinese buyers, and curses at Dark Cabals.
“…because the Fed is incessantly forcing more counterfeit credit into the market.”
When does the “money” printed by the Fed becomes counterfeit credit? With the current inflation being low despite the QE1..n means that bad money hasn’t entered the economy at all? Does that mean the FED has no power to create inflation at all if people do not/can not afford to borrow this thin-air money?
To ask more succinctly, could you give me an example of instances when the US government introduced inflation? For example, in the 70’s and early 80’s there was massive inflation. So what bouts of counterfeit credit injection events caused that inflation?
Before 2008 (i.e pre-QE era) the FEB balance sheet was really small still there was inflation in the past. That’s the bit I don’t get. Could you elucidate?
steevan: The credit provided by the Fed is counterfeit when issued. NB: I do not define inflation as either “rising prices” or “expansion of the money supply”. I define it as an expansion of counterfeit credit. Fed purchases of Treasury bonds give the government credit where there is no willing lender. I wrote a paper on this, easily findable on Google.
On my site keithweinereconomics.com, I am publishing one part at a time of a multipart paper on my theory of interest and prices under irredeemable currency (it’s not here because it’s less relevant to markets and trading). From your questions, you may be interested in it…
“Consider a simple trade. First, you buy gold. Then the price of gold goes up. Then you sell the gold. You have a profit, right? Wrong.”
Keith, I don’t quite understand this. I mean, I understand the assumption that gold is wealth, and if you accept that, then the above is correct. But I would say wealth is not gold, but the things you can buy with gold.
So if I buy an ounce of gold for $1500, and sell it for $1600, prices at my local tailor hasn’t risen by the same percentage, and I can buy a suit that is $100 more expensive, thus I have profited from the trade. Or I can buy a $1500 suit *and* a pair of $100 shoes. Thus, I have profited (by a pair of shoes).
Similarly, if I hold 100 ounces of gold as my savings, and an asteroid strikes the earth and destroys half of all human wealth (consumer goods (food, cars, houses, etc.) and producer goods (factories, machinery, etc.)) I would think prices would double, so what cost 1 ounce of gold now costs 2 ounces of gold. Thus, I would hold the same amount of gold (100 ounces), but I would be poorer, because I can purchase less with the gold I have, right?
“So if I buy an ounce of gold for $1500, and sell it for $1600, prices at my local tailor hasn’t risen by the same percentage, and I can buy a suit that is $100 more expensive, thus I have profited from the trade. Or I can buy a $1500 suit *and* a pair of $100 shoes. Thus, I have profited (by a pair of shoes).”
The problem with this argument is that…yes, prices at your local tailor haven’t risen by the same percentage, but neither have your wages. So you aren’t gaining anything by saving gold. You have mitigated against the present loss of your wages by saving in the past. You would have lost by an even greater amount if you hadn’t saved. But you still didn’t make a positive gain.
Of course, this depends somewhat on how much gold you have saved. If you have a lot of gold saved back, it may be that the fall in the gold-price of consumer goods is so great that the gain in purchasing power from your savings is greater than the fall in the gold-price of your wage. In this case, your standard of living would improve. However, it would only improve because the standard of living of others would be falling, and you would be gaining at their expense.
If this process continued, and if you taught your children and grandchildren to save gold like you had done, your grandchildren might end up being feudal lords in a future dark age. This is certainly better than being peasants in a future dark age. And, there’s even a sense in which you could say that they might be better off than you are in the present – they would have greater social status and political power, for example. But economically, they would really be worse off because the society they lived in would be more poor than it had been before. There would be no air conditioning, Internet, or television, for example.
I think this is the point that Keith is making when he says that “To get richer, you must either invest to receive a yield in gold, or speculate on an asset with a rising gold price”.
There are no assets right now that have rising gold prices, at least not if you look at them over more than a five-year time frame. And lending your gold out at interest is very risky since there is no legal system to protect you in case of default (thanks to the legal tender laws).
I know Keith provides a fund that people can invest in to get around this problem, but barring that solution, there’s really no way to gain in the long-run by holding onto gold.
If you want to become richer, what you need is a growing economy that allows you to invest your gold so as to get more gold in return. That way, the purchasing power of your wealth goes up without impoverishing someone else, because the entire economy is growing.
But that isn’t possible politically. So your only option is to hold gold so that at least your standard of living doesn’t shrink as fast.