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All That Glitters Really Is Gold

Commentators continue to blast gold as a relic, a non-relevant asset class and, quite frankly, on the face of things, it's hard to blame them. Recent run-ups aside, gold has been moribund for over twenty years. Once an $800+ an ounce commodity, it has ranged between roughly $260 and $375 an ounce since the great bull market in equities began in late 1982.

But, has gold really failed in its historical role as a store of value? Not hardly, I think. Ask anyone in Russia during the lava-roast that was their market meltdown if they wished they had bought gold instead of holding soon to be worthless equities, bonds, currency. Ask those folks in Mexico if gold was, in hindsight, the place to be when the peso went from seven to ten plus against the dollar. During the Asian Contagion of 1997/98 when Southeast Asia went through massive devaluation-a time when George Soros flooded Malaysia's central bank with ringgit and broke the currency-did those investors wish they had held gold? Ask them if gold acted as a store of value.

Why then, have pundits ridiculed gold? One significant reason is because gold is a dollar denominated asset in a period of relative dollar and financial asset stability (an understatement since these asset classes had been in the most prolonged bull market in history until the Internet bubble finally burst). As gold ran up from $270 and ounce to a recent high of around $380, it began, finally, to show its metal (pun intended). In other words, it may, even in dollar terms, be performing as it should, even to those wearing dollar-denominated sunglasses. A function it never failed to do for those whose view on the world extended beyond the myopic dollar perspective.

For the past twenty years, there was one other technical trend that frustrated those making the gold case as it applies to its historical role. And that was the propensity of central banks to lend out gold to banks and speculators at 1% interest per year. Now I am not a technical analyst or really an avid proponent of the discipline, but this habit of the banks put a cap on the gold price at $300 per ounce for years and years. How? Simple. Borrowers, expecting gold to always peak at $300 per ounce, hit the central banks up for gold loans at that level. They then sold the gold, en masse, flooding the market with supply. They took the proceeds from these sales and for years invested in Treasuries (some of those with more brass, dare I say, might have bought internet stocks in order to enhance their incomes) yielding several hundred basis points above the 1% the central banks were charging them. A few of these rocket-scientist speculators even bought gold options to hedge against the improbable event of gold breaking through $300 per ounce (I suspect most of them gave up on that after about ten years of wasting their hedge money). In other words, until it didn't work again, the resistance level of $300 became a self-fulfilling prophecy. And that explains also why, once breached, $300 became massive support for the price of gold: those who sold short the borrowed metal at that level, dove in to cover, all at the same time.

At the same time the Central Banks were lending, producers-similarly frustrated by the failure of the metal to rise above $300 -- made forward sales, essentially selling future production at higher prices -- to enhance their returns. The combination of these factors created the technical resistance level that many gold-bugs attributed to a massive, conscious conspiracy.

Gold is a funny market, harder to understand from the dollar investor's point of view because of market trends the last two decades. But, with hindsight, let's recall the August, 1979 cover story in Business Week (as I nearly always do to provide me with historical insight) proclaiming the Death Of Equities. Anybody proclaiming the death of anything should, to an investor, be the clearest buy signal there is.