The 10th Man: Three Steps Forward, Two Steps Back

I have been a gold bull, unrelentingly, since 2005. It has been quite an adventure.

Nine years ago, I was 31—still pretty young. I hadn’t read enough Austrian economics to even understand why I should like gold, but I did nonetheless. Besides, it was going up. And coincidentally, the folks at State Street had just come out with GLD, the SPDR Gold Shares ETF, and I was a market maker in it. Without GLD to invest in, I wonder if I would have had the inclination to learn about investing in gold futures or physical gold.

I also noticed that politics were starting to move left, deficits were getting larger, and the Fed had committed a policy error post-tech bubble in leaving rates at 1% for so long. 2005 was late enough to recognize that we were blowing a big housing bubble and monetary policy had certainly played a role in it.

Gold turned out to be a pretty good trade. I owned GLD up until the financial crisis, and I bought more on the 30% correction in 2008—with veins popping out of my neck because I knew that quantitative easing was on the way. It was by far the biggest position in my portfolio.

The narrative that developed at that time—“The US is printing money; we are going to end up like Weimar Germany, in hyperinflation”—made sense to me. It made sense to a lot of people. It has not come to pass, for some reasons we understand (it takes years to work off deflationary forces) and some we don’t.

That’s not to say that Milton Friedman’s quantity theory of money has been discredited. Money velocity has plummeted and keeps plummeting, for some reasons we understand and some we don’t.

Suffice it to say, the last three years have been very painful as an owner of gold.

Why You Should Own Gold Anyway

A lot of folks think that the price of gold correlates with the Federal Reserve balance sheet, and I think that’s partially true, but it’s not the whole story. I think it also correlates with the budget deficit.

When gold was at its highs, our deficit was at clearly unsustainable levels, over 10% of GDP. That’s at about the level that certain European countries started getting margin calls. There was this idea that our deficit would continue to grow, resulting in an oversupply of bonds and failed Treasury auctions, and that the Fed would have to directly monetize the deficit. Not unreasonable.

Then a miracle occurred: the deficit started going down.

It went down because we raised taxes, a lot, and became very efficient at collecting them. Also, after a period of years, the economy did start to recover, resulting in more revenues for the government. Our deficit went from $1.8 trillion down to $450 billion, about 3% of GDP, which is eminently manageable.

But I would argue that nothing has really changed in policymakers’ attitudes towards spending, that the federal fisc has been rescued by the happy accident of aggressive revenue collection and decent economic growth. I think discretionary spending has been momentarily constrained by political forces, but the long-term outlook for debt and deficits is pretty bad.

People talk about Social Security and Medicare being unfunded liabilities, that they are demographic time bombs, but we just added another one: Obamacare. If you paid any attention at all to what was going on in 2010 when it was passed, it allegedly had a cost of $1 trillion over 10 years. But that is only because it collects taxes for the first 10 years and spends for six.

On a going concern basis, it is, well, not a going concern.

And if we have learned anything from Medicare, which was projected to cost $9 billion by 1990 but ended up costing $67 billion, it is likely to get more, not less, expensive.

I am pretty pessimistic about the deficit, no matter which party is in charge. That debt monetization scenario I described is definitely within our future—it is only a matter of when.

Are People Too Emotional About Gold?

Practically speaking, I’ve given back most of my gains on gold. In fact, I was so sure that gold wouldn’t trade below 1,150 that I sold an (imaginary) one-touch to my clients at that price, which is basically a digital option that pays out when the barrier is touched.

The payoff is that I am forced to eat haggis, which, according to Wikipedia, “is a savoury pudding containing sheep’s pluck (heart, liver and lungs); minced with onion, oatmeal, suet, spices, and salt, mixed with stock, and traditionally encased in the animal’s stomach and simmered for approximately three hours.”

I ordered a can of it from Amazon, but it only comes in packages of three, so I will be eating a lot of haggis.

Gold is a very dangerous trade, because it plays into people’s core beliefs and how they perceive the world around them. If you are conservative/libertarian and you like hard money and hate the Fed, chances are you are bullish on gold. If you are a Keynesian/liberal and you like fiat money, chances are you are bearish on gold.

But most people aren’t bullish on, say, Yelp, because they are politically aligned one way or another. They evaluate Yelp on its investment merits. But people get emotionally attached to gold, or repulsed by it.

For example, Euro Pacific Capital CEO Peter Schiff is probably not going to change his mind on gold, no matter how low it goes. Neither is Barry Ritholtz, founder of Ritholtz Wealth Management. He will not change his mind on gold, no matter how high it goes. They may say they have intellectual flexibility, but they don’t.

Gold isn’t like oil. You might be bearish on oil at 140 and bullish at 70, but people generally don’t do that with gold. The people who were bearish on it for a decade never changed their minds, not even when it went up almost 1,000%, and the gold bulls (myself included) are still pounding the table after a very large and painful correction.

No White Flags in Sight

It will be interesting to see how long this correction lasts, because corrections usually last until nearly everyone capitulates and sells. But with gold, nobody is capitulating anytime soon. There is a lot of gold that people are unwilling to sell at any price.

One of my clients told me that he has owned the Market Vectors Gold Miners ETF (GDX) since $57/share and still owns it (presently about $18). Then you have all the physical buyers—what, are they going to take their gold out of the safe and put it in a box and ship it off to the bullion dealer so they can realize a capital loss? Never. They would rather die and just bequeath it to their children.

So it’s going to be interesting to see what constitutes capitulation in precious metals. All the hedge funds that were screwing around with it are already out of the trade and have been for a while.

It’s funny—not only do people not sell on the way down, they actually buy more. The US Mint recently ran out of silver Eagles, because at $16 an ounce, people are stocking up. And every time gold has broken some level of technical support, the physical buyers have come in and have vacuumed up all the coins until the premiums blew out and the mints screamed, “uncle.”

This is either going to end very badly, or it’s going to end… great. It does kind of remind me of equities in the ‘90s. If you recall, stocks were a religion back then. Just buy the index fund and dollar-cost average. Stocks go up forever. And if it goes down, buy even more. A pretty nasty bear market in gold has not disabused people of these habits.

Besides. Go back to the ‘70s—you had a 50% correction on the way to $800 an ounce. We could easily have another 50% correction and still be in a bull market. And what if we do get inflation? Pandemonium.

It’s funny, because as you look around the stock market for bargains, there are none. Newmont Mining, one of the largest gold producers in the world, has a smaller market cap than travel review website TripAdvisor. I take this as a sign.

(Disclosure: I’m long the gold and silver ETFs GLD, SLV, GDX, SIL, and I own both physical gold and silver, and I’m also short TRIP.)
Jared Dillian