Gold Fundamentals
by Adam Hamilton
In this frenetic world of ours, we spend most of our time trapped under the tyranny of the present. The urgent preempts the important and life is a mad dash from one activity to the next with little opportunity for reflection. But in this season when one year is yielding to the next, all of a sudden the past and future return to focus.
When year-end and a new year force us to briefly emerge from the haze of the present to survey the big picture, a precious opportunity arises. When we briefly regain strategic perspective over our lives, we are blessed with a chance to ponder our past and steer towards the most desirable future. This impetus is very strong in the realm of finance and portfolio design.
Often the busiest months of the financial-market year are December and January. As the urgency of the present temporarily fades and the past and future return to focus, many important investment decisions are made. As you consider your own investment portfolio and whether it is prudent to add or remove positions, I urge you to consider gold.
Gold belongs in every investment portfolio, regardless of an investor's age, goals, and risk tolerance. It is an anchor of indisputable, timeless, and universal intrinsic value in a dangerous financial world where any paper-asset prices can plummet overnight. If you don't own gold, or your gold position is too small relative to your portfolio size, then you are not truly diversified and you are accepting much more overall risk than you need to.
I've been a gold investor for many years now, and have ridden our current gold bull in my own investments and speculations since it launched. On the very trading day before gold carved its multi-decade secular bottom in early April 2001 I concluded an essay with, "History, economic fundamentals, and logic dictate gold is amazingly undervalued and due for a monstrous rally. My capital will be ready for the coming gold rush!"
The next day gold briefly fell under $257 but it has never looked back since. As of this past May's $720 high, since 2001 gold's bull has climbed about 182%, really an incredible gain for the safest and most enduring asset in world history. So hundreds of weeks of research and thousands of percents of realized gains later, I am not a newcomer to this gold bull. But I do still meet many folks who are just starting looking into gold as an investment.
It is for these investors kicking the tires of gold that I am penning this essay. The most common questions I hear from these folks are usually variations of the following... Why is gold in a bull market? When will its bull market end? Am I too late to buy gold since it has already risen so far? What are the core fundamental drivers of this gold bull? Will central banks cap the gold price and therefore crush the gold investors?
After endless studies considering these very questions, my own personal worldview for gold still remains very bullish for the long term. Despite how far we have come I still believe we are in the midst of a massive secular (long-term) gold bull that will likely run higher for another decade or so. There will be periodic corrections of course just as in any bull, but on balance gold seems destined to rise for many years to come yet.
To attempt to address some of these key questions for newer gold investors as well as explore the gold fundamentals that make it so bullish, I've broken down the rationale behind this secular-gold-bull thesis into ten broad-overview reasons. If you carefully ponder and digest these, you will understand why gold's fundamentals are so bullish and why every investor's portfolio should have material gold exposure.
1. Supply and Demand. The ultimate arbiter of any price is supply and demand. When demand exceeds supply, prices are forced to rise. These rising prices work to address a chronic deficit simultaneously from both sides, providing an incentive for producers to increase production while also providing a parallel incentive for consumers to decrease consumption. Eventually the rising prices bring supply and demand back into equilibrium where production and consumption are balanced.
In gold's case, its global investment demand is growing much faster than its global mined supply, so the only possible economic resolution for this deficit is higher prices to bring supply and demand back into balance. I'll discuss the reasons why gold's demand is rising below, so for now let's focus on why its mined supply simply cannot rise fast enough to meet demand growth.
Unlike almost every other business, gold mining is totally dependent on highly local geology. Obviously you can't build a gold mine unless there is gold to mine! Since gold is so scarce in the natural world, it is very difficult to find a site with enough gold to mine economically. And even if you manage to find such a site after endless exploration, you are totally at the mercy of local and national governments, all of which are corrupt and love to extort profits from captive mining ventures. Since mines cannot be moved, governments prey on them.
And if you manage to find a suitable gold deposit and can somehow jump through all the flaming bureaucratic hoops, you still have to raise tens or hundreds of millions of dollars to build roads, erect buildings and infrastructure, sink the shaft or pit, and buy the necessary heavy equipment. And even if you beat the odds and manage to secure financing, it still takes several years at best to spin operations up to full speed.
So not only is gold mining an extremely tough business plagued with geological quirks and government harassment and enormous up-front capital costs, but even if you can overcome all of these stellar hurdles you won't be selling any of your gold for years. Thus, no matter how high the gold price travels, it will still literally take years for producers to find new deposits to develop, mine, and sell. There are no shortcuts in this industry.
Global gold mined supply is therefore very inelastic (unresponsive to price) and highly constrained over anything short of a half decade or so. Today's higher gold prices will take at least several years for producers to respond to, but only after these producers believe that this bull will be persistent enough to make a big bet on it. Thus the rate of mined gold supply growth cannot and will not grow very fast in the coming years.
2. Long Valuation Waves. The general stock markets move in great 33-year cycles known as Long Valuation Waves. For the first half of these cycles, like from 1982 to 2000, stock valuations and prices rise in massive bull markets. But in the second half, like from 1966 to 1982 or 2000 to 2016, stock valuations relentlessly mean revert back down below long-term averages. We are in this brutal valuation wave winter today.
Although stocks make horrible long-term investments during the latter half of these Long Valuation Waves, thankfully commodities and hard assets thrive. Commodities also move in roughly one-third-of-a-century cycles over time, but they tend to oscillate 180 degrees out of phase to the equity valuation waves. Thus, secular commodities tops like in the early 1980s coincide with secular equity bottoms. And secular equity tops, like in 2000, coincide with secular commodities bottoms.
Our current Great Commodities Bull launched in 2001, just after the secular top in the general stock markets capping a mighty equity bull lasting for half of a 33-year valuation cycle. Market history is very emphatic in demonstrating that the 17 years after this parallel commodities bottom and equities top should be great for commodities but very poor for equities. Since we are now about 7 years into this usually 17-year trend, this precedent suggests commodities should be strong and equities weak for another decade or so yet.
And indeed on the supply side commodities capital investment was neglected for two decades prior to 2001 so global production remains relatively low while world demand for commodities is skyrocketing, particularly out of rapidly-industrializing Asia. Just as with gold specifically, for commodities in general constrained supply growth accompanied by accelerating global demand guarantees higher prices.
So why languish in a secular stock bear when your investments can thrive in a secular commodities bull? As more and more investors come to realize this, their demand for gold and other commodities-related vehicles will only grow greater and greater. We may as well bet on the horse most likely to win in the next decade!
3. King of Commodities Investments. Out of all the ways to invest in a Great Commodities Bull, gold is the single easiest and safest. Physical gold is easy to buy, requires no upkeep, and a great deal of wealth can be secured and stored in a relatively trivial volume. Unlike many other major commodities, physical gold is not perishable and can be stored indefinitely. Gold has always been the ultimate commodities investment.
For pure investment purposes, every other commodity falls short of gold. You can easily hide $1m in gold coins in an old unused pipe section in your house and no thief would find it in a thousand years. If you buy $1m in wheat though, you will have to purchase land and bins to store it, and insects and humidity could destroy it in less than a year if it isn't stored perfectly. Oil may be the king of commodities in general, but try to get zoning permission to build a giant tank to store $1m worth of crude oil in your backyard!
Silver is ultra-volatile and one of the greatest speculations in history, but it is inferior to gold as a store of wealth. In addition to its brutal gut-checking price volatility, its value-to-volume ratio is vastly lower than gold's. $1m worth of silver weighs far more and takes up a great deal more room than $1m in gold. For investors wanting to deploy capital directly into this secular commodities bull, gold is the most logical choice today just as it always has been.
4. Ultimate Alternative Investment. Some investors will buy gold to ride the commodities bull, while others will buy gold to escape the equities bear. This distinction may seem subtle, but it is very important. Gold is a natural destination for equity flight capital since it is the ultimate alternative investment in world history.
Mainstream financial investments are virtually all intangible paper. All of the stocks and bonds we own, even all of our bank accounts, are ultimately nothing more than someone else's promises to pay. If these promises are not honored, then the stocks and bonds are worth no more than the paper on which they are printed. During the descending half of Long Valuation Waves, after enough years of punishment, investors' confidence in paper assets wanes. Remember the 1970s?
Gold is the ultimate alternative investment because it is tangible. It is a real physical asset that has intrinsic value in and of itself, never dependent on someone else's mere promises to pay. Since gold is fully independent from the paper financial system and its underlying fragile web of promises, it has long been perceived as the most ideal safe haven when investors flee paper.
Unlike paper investments which have brittle foundations of faith alone in some relatively new and fragile institutions, gold's real purchasing power has remained strong for over six millennia. Gold has outlasted every currency, investment, and government that has ever existed. No other investment, alternative or mainstream, has even come close to transcending the ravages of time like gold has. Gold also transcends political boundaries, it is universally valued everywhere on the planet.
Interestingly, as equity flight capital bids up gold prices in the years ahead it will create a virtuous circle that attracts in even more capital. Gold, like all investments, becomes more attractive to more people the higher it goes. This is contrary to normal supply-and-demand profiles, where demand becomes lower at higher prices. In gold's case, investors bidding up its price end up putting it on the radars of even more investors, who bid it up farther and accelerate this bullish cycle.
5. Relentless Fiat Currency Inflation. Speaking of paper, every national currency on the planet today is pure fiat, just paper monopoly-money backed by nothing but faith in the issuing government. Since today's monetary supplies have no roots in reality, governments can and do grow money supplies much faster than the underlying pools of goods and services on which to spend money. The US dollar has not been backed by gold since 1971.
When money supplies grow faster than underlying economies, soon relatively more money is bidding on relatively fewer goods and services. This monetary competition drives up general prices. This increase in money supply is, of course, the scourge of inflation. Inflation is a diabolical and immoral stealth tax imposed by governments on their unsuspecting populaces. People work hard for a lifetime saving money, but when they retire they sadly find that their money will buy a lot less than it did back when they were saving.
As more and more investors perceive the dire threat of systemic inflation to their families' futures, they will naturally migrate into gold. Gold keeps pace with inflation, buying roughly the same amount of real goods and services regardless of currency in circulation. In the 1920s one ounce of gold would buy a good men's business suit at $20. Today this same ounce of gold at $625 will still buy the same grade of suit, but the original $20 in paper won't even buy lunch! Fiat paper currencies are virtually always a terrible long-term investment.
While paper money supplies tend to perpetually grow by 7% to 9% annually in the First World thanks to irresponsible and unaccountable central bankers, the newly mined physical gold supply rarely exceeds 1% a year in growth. This stable and naturally-limited very low growth rate is why gold has been the ultimate form of money for six thousand years now. With fiat currency growth rates far exceeding the gold supply growth rate, it is inevitable that relatively more paper will chase relatively less gold, bidding up its nominal price.
6. Negative Real Rates. A key corollary to fiat inflation is today's brutally low or negative real rate environments, where bond investors either break even or actually lose purchasing power by the mere act of lending out their hard-earned capital. When the rate of underlying true monetary inflation exceeds the nominal interest rates available in the markets, bond investing becomes a losing proposition.
Now please realize I am talking about the true inflation rate here, which is the growth rate in broad money supplies, not the watered-down government-reported inflation numbers. The government aggressively lowballs the CPI by choosing to exclude items rising in price and by using hedonic statistical wizardry. The lower the reported CPI growth, the lower the growth in the government's non-discretionary inflation-indexed welfare-like payments which leaves more discretionary funds for politicians to spend on their pet projects.
Free markets hinge on the crucial concept of mutually beneficial transactions. The bond markets are where savers, who consume less than they earn, meet up with debtors, who earn less than they consume, to consummate capital transactions. True free-market prices for this money, or interest rates, provide a reasonable return to the saver and a reasonable cost to the debtor, a mutually beneficial transaction. Interest rates should always be set by the free markets instead of the unconstitutional abomination known as the Fed.
But with today's artificially low interest rates, it is nearly impossible for bond investors, savers, to get a fair return on their capital. If they can only earn 5% on their capital but true monetary inflation is running 8%, then they actually lose 3% of their purchasing power every year. They are punished for being savers, something central bankers absolutely revel in for reasons that escape me. It is saving that should be encouraged and debt that should be punished if a nation truly wants to experience great prosperity and wealth!
As such, when central banks artificially manipulate interest rates too low, bond investors gradually pull out of the rigged market. Since they can't beat inflation in bonds, they gradually migrate into gold so they can at least maintain their purchasing power. Negative real rate environments are one of the most bullish scenarios imaginable for gold investment demand, since they drive capital out of bonds and into gold.
The Long Valuation Wave winter will drive exasperated equity investors into gold, but the unfair and artificially gutted interest rates will drive fed-up bond investors into gold. It is foolish to allow a central bank to force savers to subsidize wanton debtors. The savers may as well just buy gold to ride out the inflationary storm and say to heck with the debtors trying to rob them blind.
7. Investors Trump Central Banks. One of the most unfortunate attributes of gold investors as a whole is our incessant and illogical paranoia regarding central banks. I am amazed how many new gold investors write me after getting nearly scared off by something they read on the Web regarding central bank gold sales. The truth is central banks are nothing more than fellow gold traders, they cannot control the gold market, and any anti-gold schemes they hatch will ultimately lead to a bigger and stronger gold bull.
Of the roughly 150k metric tonnes of gold thought to have been mined in all of world history, today central banks only control about 20%, 30k tonnes. Since central banks rightfully consider gold to be a threat to their dishonest fiat-currency regimes, investors sometimes fear central bank intervention in gold. Not surprisingly though since they are run by bureaucrats, central banks are probably the worst institutional gold traders on the planet.
One of the most foolproof indicators that a secular gold bear is ending or a secular gold bull is getting underway is central bank sales. Like the Bank of England's 2001 fiasco of dumping gold at a multi-decade bottom, for some reason central banks tend to sell at exactly the wrong time. Central bankers, amazingly enough, are human too and subject to the same greed and fear as all traders. It is only at the end of long demoralizing bears when they start believing the Keynesian propaganda claiming that gold is a barbaric relic and think about selling.
And when they do sell, their gold sales are always very temporary in impact. The only way to control a global price is to put a gun to the head of every single buyer and seller on the planet of that particular commodity. 120k tonnes of gold, or 80% of world supplies, are not controlled by the central bankers. We investors buying and selling this vast majority of non-official gold ultimately determine world prices through our own supply and demand. The central bank tail can't wag the bull for long!
Betting against central banks on gold is a great contrarian play. In the early 2000s they were selling aggressively and remember what happened? Did gold plummet from $255 to $200? Nope! Instead it soared from $255 to $720 despite the sometimes aggressive central bank liquidations. Expecting central banks to seriously hinder a secular move is like expecting a bureaucracy to be efficient, a fool's bet. They are all talk with very little if any direct long-term influence on gold prices.
And just as central banks tend to sell at the bottoms, they tend to buy near the tops. We are already seeing more central bank buying and less selling of gold at this young stage in our gold bull, and these trends will only accelerate with the gold price. Thus the same central banks that sold gold in the early 2000s will be buying it back in the coming years at much higher prices, ultimately driving this bull higher than it could have gone without them.
Why would central banks buy back gold? Around the world they are diversifying out of the falling US dollar, which makes up the lion's share of their reserve holdings, and buying gold. In addition they find gold more attractive when its price is rising just like all investors. By the time this bull is on its last legs a decade from now, I would not be surprised if central banks in aggregate hold much more gold than they did in early 2001 when this bull began. Ultimately central bank buying is going to really help gold.
Central banks have always been involved in the gold markets and always will be. They are merely traders just like the rest of us. It is totally irrational for gold investors to fear central banks. We investors, holding 80% of the world's gold, have always controlled the balance of power and we always will. Rising global investment demand will easily overpower central bank selling anytime, as we have witnessed abundantly in recent years.
8. Free Market in Information. For all of history until 1995, large organizations like governments had a vast advantage over individual investors when it came to information. But since the World Wide Web started growing popular outside of academia in the mid-1990s, the inherent information asymmetry working against individuals has vanished. Today a cheap computer and broadband grants you information-gathering capabilities vastly superior to even those commanded by superpowers as recently as fifteen years ago.
Gold is the ultimate free-market asset and currency and thrives in eras when information flows the most freely. Today's Information Age is witnessing the greatest free-flow of information in all of world history, far beyond the wildest expectations of empires past. Thanks to the ease of learning about anything instantly from the comfort of your own home today, governments can only pull the wool over the eyes of their citizens who willingly choose to remain ignorant.
Today investors around the world can easily learn about monetary history, stock-market history, gold, the immoral stealth tax of inflation, and countless other crucial core topics essential to long-term wealth building. Thanks to the Internet governments no longer have a monopoly on financial truth. Investing in gold is the inevitable outcome of learning more about the treacherous history of markets and money, not to mention governments. The deeper you understand these topics, the more you will respect and want to own gold.
The dazzling Information Age is also facilitating the rebirth of private 100% gold-backed currencies, this time in the form of digital gold. Why store your transactional money in the form of rapidly inflating government fiat paper when it could be stored in digital gold and hence never losing purchasing power? As gold-backed digital currencies gain popularity, demand for physical gold to back them will continue to grow.
9. The Rise of Asia. With China destined to become the next superpower while the West wanes, the locus of global economic might is shifting to the Far East. Unlike Western cultures like us Americans who are brainwashed into thinking of gold as a barbaric relic, inferior to paper assets, Asian cultures still have strong affinities for physical gold. A great example is Indian families storing extra income from harvest each year in the form of intricate gold jewelry.
As Asian investors grow wealthier, their traditional love for gold will ultimately lead to huge amounts of capital shunted into physical gold as they diversify their investments. Asia's hard-working ethic will lead to greater general affluence, and its aggregate gold investment consumption will utterly dwarf that of the West. While an average (read non-contrarian) American investor may have less than 1% exposure to gold, an average Asian may want 10% or even 20%+ of his portfolio invested in physical gold.
Even if the average Asian remains poorer than the average American in an absolute sense for decades to come, the combined effect of many hundreds of millions of newly-liquid Asian investors buying small amounts of physical gold could be staggering. I suspect that if Western central banks are dumb enough to dump their entire 30k metric tonnes of gold in the years ahead, the awakening Asian giant will collectively swallow it all up without so much as a hiccup.
Asia is probably the single biggest gold investment demand story in world history. It should ultimately dwarf US equity and bond flight capital and could very well lead to the biggest gold boom the world has ever seen. The net impact on gold demand from half the world's population rapidly industrializing and building wealth cannot be overestimated. It will probably ultimately blow away all of our wildest expectations.
10. Technical Proof. The only sure way to understand true underlying supply and demand fundamentals is to observe price action over a secular period, at least several years. If global gold demand is really growing faster than global gold supply, then the gold price has to rise. There is simply no other economic alternative in a free market! And make no mistake, the gold market is free until every single buyer and seller on Earth can be physically coerced by a single entity.
This chart shows our awesome secular gold bull to date, the proof of the pudding. For about six years now, a secular time span, gold demand has exceeded gold supply driving up prices on balance. If it was the other way around, if supply, including central bank selling, exceeded demand, this would be a downward-sloping bear trend.
Gold has climbed higher in US dollar terms for six years in a row now, with annual percentage gains noted on the time axis. Bull to date the Ancient Metal of Kings is up 182% as of this past May. Gold's long-term support lines have held rock solid for its entire bull, running parallel with its strong upward-sloping 200-day moving average. Gold has carved seven major higher interim highs and seven major higher interim lows, an unmistakable secular-bull fingerprint.
This gorgeous secular gold bull chart would never have happened if gold demand was not growing faster than gold supply. Nor would it have happened if the periodic central bank selling since 1999 was anything more than a temporary nuisance. A multi-year secular trend is beyond argument, as it reflects persistently bullish underlying supply and demand fundamentals for gold.
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