Respected value investor Jeremy Grantham “guarantees” that gold will crash. He is quoted, “I hate gold. It does not pay a dividend, it has no value, and you can’t work out what it should or shouldn’t be worth…It is the last refuge of the desperate.”
Grantham has achieved great success over a long investing career by applying the concepts of value investing. This methodology uses quantitative methods to estimate a plausible market value of a security based on either conservative market prices of assets held within the capital structure of the security or the cash yield of the security under conservative assumptions. Value investors buy assets when they are selling at prices significantly below their plausible market values. Grantham was one of the notable critics of the recent stock market and housing bubbles, basing his forecasts on valuation models showing that both assets were significantly overpriced in the market.
Grantham’s valuation models do not provide a meaningful number for gold. Gold doesn’t have any assets on its balance sheet, so it can’t be valued on its assets, and it doesn’t pay a yield, so it can’t be valued on cash flow. Grantham’s argument is in essence that if his model doesn’t produce a valuation for gold, then it has no value at all. I think that the correct conclusion for Grantham to reach concerning its price would be agnosticism, not that it is over-priced (for an asset to be over-priced requires that it have a meaningful valuation to which its price can be compared).
Some value investors, such as James Grant, like gold but agree that it can’t be valued using value investment principles. Grant calls it “the value investor’s guilty pleasure”, meaning that value investors cannot analyze it using valuation models but choose to buy it anyway.
Of course a model that uses yield is not going to give you any meaningful value for gold: that’s because it’s the wrong model. I think the Grantham’s error is comparing gold to other risk assets. Risk assets are created when investors transfer purchasing power from consumption into the creation of more capital goods. A stock or a bond is someone else’s liability. Cash is something that you hold in order to provide purchasing power at some future point. In the world of assets, gold is more like cash or liquidity than a risk asset. It’s not exactly money, but I think of it as an alternative monetary asset. Gold should be compared to other cash or liquidity assets.
Value investors such as Grantham tend to hold larger amounts of cash than other investors. In normal times, they want to have the ability to purchase an asset should it suddenly become cheap. During a bubble, value investors tend to hold a lot of cash because they don’t see many opportunities to buy assets below the prices produced by their valuation models. Value investors tend to to hold more of cash exactly when it is worth the least.
During the 90s tech bubble and the housing bubble: the value of cash “crashed” relative to equities and homes. During the tech bubble, investors would park their short-term funds in the stock market because cash was losing value relative to stocks on an almost daily basis. Did Grantham write a bearish piece in the mid-90s “guaranteeing” that his cash would crash? Of course not. In the early 90s, if he had known that his cash was going to crash, would he have sold it and bought stocks? Doubtful. During the entire bubble he stood firm in his conviction that cash would bounce back against equities and provide better opportunities — and he was right.
There is a real chance that the cash will crash again in the next few years, but this time relative to consumption goods and gold, not stocks and houses. Investment professionals include among cash-like assets money-market funds, short-term government debt and bank accounts. (I always found it a little weird that government debt is considered cash but that’s the subject of another blog post). It is a near-certainty that government debt will default because debt levels everywhere have risen too far in relation to government funding. There is also a decent chance that cash will “crash” if we get a lot of inflation. If either or both of those scenarios come to pass, gold would most likely appreciate against other cash-like assets.
I think that the problems with Grantham’s argument is its reliance on the assumption that fiat money will remain stable and a lack of understanding of the role of gold in the monetary system. Even without government debt defaults or hyper-inflation, gold has some value as a alternative monetary asset that people hold as a form of purchasing power that will maintain some value over time. It’s impossible to calculate this value using value investor models, but Paul van Eeden has done some interesting work based on purchasing power parity relative to the era of the gold standard. I’m not sure that van Eeden’s model is accurate but at least he is analyzing it as a holding rather than trying to analyze it as if it were a stock or a bond.
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41 Responses
In my judgement, value investing works best when the country is not commiting financial suicide with geometrically increasing spending and borrowing. My 100% gold portfolio far outperformed buffet in the last few years, though obviously when a country is on a sounder footing, he is the far superior investor.
Gold is doing well now, but it really shines, so to speak, when the hyper-inflation kicks in.
I like this post, but I have to disagree with the statement that “It is a near-certainty that government debt will default because debt levels everywhere have risen too far in relation to funding.”
This makes absolutely no sense when it comes to a sovereign fiat currency. They do not “default”, and there is no such thing as “funding”. There is only possible future inflation if the government spends too much or if foreign holders of US dollars decide to spend inside the US.
@George, maybe that paragraph was a bit unclear. I was trying to make a parallel argument for two kinds of assets that are both considered cash but are different in terms of how they would go to zero. Government debt and money itself. Government debt is funded by taxes and it can default.
“Government debt is funded by taxes and it can default.”No, debt is not funded by taxes. When you pay taxes, the money is destroyed. This serves to redistribute the wealth between and among the private and public sectors, but it has nothing to do with repayment of the debt. That is as easy as changing a few 0s in a computer and could be done even if there were no taxes whatsoever (with inflation being a consequence, of course).
Taxes serve to drive demand for the currency (since you must use that currency to pay taxes), and they serve to remove money from the system and therefore redistribute real resources, but they are not used to pay down the debt. There is no connection there. The government doesn’t have a “store of wealth” from which taxes are received and debt is paid; sovereign fiat does not work like that.
You might be thinking of Greece, which is a different situation because it does not have a sovereign fiat currency and can actually default on its obligations.
PT Bull, you are right that gold has had a great bull run since the early 2000s, but over the long run, stocks are better. Someone investing every year since the mid 1970s is still ahead of a gold investor. Gold is a good currency and a good hedge when confidence in paper is faltering, and I don’t dispute that, but it should not be considered an investment in the same sense that stocks, bond, and RE are investments.
@Geoge – Governments collect lots of revenue in terms of taxes. They spend the tax revenue on lots of things, including interest on debt. They also create money to pay off the gap between what they spend and what they can borrow at the rate of interest that they want to pay. If you add it all up, the net effect is as you say, redistribution, but that redistribution takes place using montetary transfers. Taxes do not drive demand for currency, the need to obtains goods and services drives the demand for currency.
This article leaves out an important fact: Grantham recently added a position in gold!!! That says a lot considering he hates it, can’t value it, and it’s the “last refuge for the desperate.” To me that means he understands that fiat money goes down. He might like stocks more, but he recognizes that the “cash” he wants to be in should include gold not just fiats.
@George
http://www.archive.org/details/ModernMoneyMechanics
“Government debt is funded by taxes”.
Don’t you mean that Government debt is serviced by taxes? They can borrow the actual money from China or Japan, and, indirectly, through the Federal Reserve. (The Fed is not allowed to directly purchase the Treasuries at Auction. However, there is nothing to stop a Member Bank from purchasing the treasuries at auction and then depositing the treasuries as collateral with the Fed. In this way the Fed is not dependent on China or Japan to clear the treasuries at auction. I suspect this is why the Fed does not want to audited.)
Yes, but if it weren’t for the power of taxation, then fiat currency would already have a value of 0. The money first enters the economy through govt. spending, and then comes back by taxation. It’s either pay taxes or go to jail, so the currency has value because it takes real work to generate the income needed to pay those taxes.
Ok, will take a look.
Since I can’t place a trade today, using mid-1970s prices, I am primarily interested in investment results in the here and now, and into the future. Arbitrarily chosing a time frame that happens to contain historical data that is more favorable to one’s argument than that of another time period is often used by investment advisors explaining how their strategy was and continues to be sound despite apparently bad results in the here and now.
Maybe he just wants to make money…
Does he take book value into account in his formula? I’m no accountant, but I think that gold assets would be considered to have a rather solid chunk of book value if not exactly a barnburner on revenues and earnings.
Not sure who this guy is, but if he a Really Big Player like Soros et al. then I would assume he’s talking down gold so that he can buy some.
Hey, I’m holding some gold myself
I wasn’t even around in the mid 1970s… but I think it holds that if you look at any long-enough portion of time, the stocks will win out, no matter which year you start at. It just depends on your time horizon. This assumes regular investments and not a one-time buy.
The problem is the model and the problem is losing track of what a model represents. Will Grantham ever consider the fact that models go obsolete when they no longer model what they are supposed to model? His model rests upon a fiat currency base. When that base evaporates the model is meaningless.
Since his model cannot explain the value of gold it is already obsolete and soon to be categorized as meaningless.
in real terms, the seventies bear market saw the sp500 lose essentially as much value as during the great depression.
“A stock or a bond is someone else’s liability.”
What is this supposed to mean? It’s as though it’s supposed to make gold sound special. Gold is no else’s liability if you mean you own a coin or bar outright thus is an instrument of equity. Of course it isn’t someone’s liability because it’s not a claim to a debt. It could be considered someone’s else liability if you sell your gold for a profit and someone else buys that gold and the gold price tanks – then the gold becomes their liability. However when you own anything outright then it’s “no one’s liability” regardless of what it is.
i didn’t find anything objectionable about “last refuge for the desperate”. if you can’t value it, then calling for a crash is groundless.
Tell me you are not saying that the higher the tax rate in the country, thus the more income that is needed to to pay the taxes, then the greater the value of the currency?
If taxation is how we derive the value of the currency, then higher taxes must mean that the high tax country has a higher value placed on its currency?
Or are you discounting the future potential to tax and the greater the wealth of the country means the greater propensity to tax it thus increasing the value of the currency?
Please elaborate.
“A stock or a bond is someone else’s liability.”
A stock or a bond is is a claim on some future cash flow. It is someone else’s liability to actually produce that cash flow in the future. If that liability is defaulted upon, that is, if the future cash flow does not materialize, the stock or bond turns out to be worthless.
Gold on the other hand is a commodity. It can be used for instance to produce a nice piece of jewelery which one could give as a gift to one’s wife on a special occasion. Clearly, the happiness of women receiving a gold jewelery is independent of cuts of dividends or debtors defaulting on their bond payments.
Viewing gold as a financial asset only, there is no distinction between stocks, bonds and gold. Their monetary (cash) value is always someone else’s liability. Indeed, in order to convert these financial assets into cash, one needs to find someone who is willing to buy these assets. In that sense, the value represented by any financial asset different from cash is always someone else’s liability. Liability in this context means the ability to deliver cash in exchange for the assets offered.
Grantham is wrong in claiming that gold does not pay dividends. Gold does indeed pay dividends. Since gold maintains its purchasing power over long periods of time (but not necessary in the short term) the nominal gain in the price of gold can be viewed as a capitalized dividend payment.
This is very similar to stocks which do not pay any dividends. Very often, the price increase of such stocks over time is simply the result of monetary inflation. In other words, adjusted for inflation, the value of such stocks is constant over time.
There is one characteristic of gold which is not met by any other financial asset. Except for gold, all financial assets have a finite life span, that is, they all become worthless in a rather short period of time. Gold is the only financial asset maintaining its value over centuries and millennia.
For me the attraction of gold is not primarily the return on investment, but that it allows me somewhat to withdraw from a system that I view as organized crime.
For example, if I had to pay a protection racket in order to run a successful business, my response would be to dump the business. This moral dimension should be kept in mind even when it does not immediately enter into economic calculations.
no mate.there is no such final truth to the ‘equities will always win in the long run’ cliche.it is used by those who peddle equities to make their own profession seem to be superior.
black swans etc can destroy all that long term earnings in a flash. life is random.invest in yourself if you can
I peddle equities for a living and it is a fact that the value of every equity will at some point decline to zero. All businesses eventually succumb. The only apparent reason that equity indexes appear to rise, on average, is because those component equities which are beginning to die are always removed.
Of course gold does not produce a return. It is a present good. It is liquidity.
“Grantham’s valuation models do not provide a meaningful number for gold. Gold doesn’t have any assets on its balance sheet, so it can’t be valued on its assets, and it doesn’t pay a yield, so it can’t be valued on cash flow.”
I hope this is an oversimplifcation of Grantham’s intellect. Gold doesn’t have “assets on its balance sheet” because it is the asset. How does Grantham value the assets on the balance sheet of a company? He uses either the past purchase price of the asset or the current market value. He doesn’t go into infinite regressions trying to use cash flow or the assets on the books of the assets ad infinitum. So he needs to do the same with gold. It is the asset. It does not derive its value from any asset or cash flow. It is the fundamental asset. It’s value is its market value, nothing more, nothing less.
Gold is not an investment. Gold is money. It is a commodity. When people buy gold, they don’t invest in anything. They exchange a form of money that loses value for one that doesn’t. Money doesn’t earn interest and doesn’t produce anything. It is a commodity used as a medium of exchange. Gold only appears to appreciate in value. The US dollar is not the measure of all things monetary. Gold is that measure. When gold appears to appreaciate in value, it’s really the US dollar that is depreciating in value.
Investors should think of gold as cash that doesn’t depreciate. If you want a return on your investment, you need to invest in something with a good return. Gold is cash for short term holding to meet expenses and unexpected circumstances. You should hold gold long term only if you expect high inflation or the collapse of the whole system of paper money and credit.
Nice comment… I would add a few points though. Gold isn’t just cash that doesn’t depreciate, it is also a fear and greed sink. In times of fear, it can command a price premium beyond what currency depreciation alone would tell yo . It is also subject to significant short term volatility and pullbacks. Do prices of housing and other real goods stay stable in relation to gold? No, they can fluctuate significantly. This shows that there is more to it than just currency depreciation, and holding it for the short term must be mentioned with this caveat.
Check out billy blog, he goes into more detail on how modern fiat works and i believe he has a few posts on this very topic. Not saying i endorse it morally or as an ideal way of doing things, but it is how things operate in a sovereign fiat world.
Gold and dollars are not directly correlated like that. By such reasoning if you were to take a look at the price of gold in real terms then the price should be practically flat. But it isn’t.
“I hate gold. It does not pay a dividend….”
This is a classic. Buffet keeps telling this line as well.
Gold doesn’t pay any dividends because gold is cash, ie money.
Did you ever hear some financial guru argue “money” has no value because it pays no dividends?
But lets say gold is not money but just a commodity.
Also in the said newsletter, Grantham says he likes timber. Did anyone hear timber, or any commodity for that matter, paying dividends?
The underlying reason for the hatred against especially gold, by these contemporary financial gurus is, because “gold as money” represents another time, another version of capitalism that they are not familiar with. They are so much accustomed to making money in fiat money system where there is institutionalized and constant inflation of the money supply they are literally scared shitless of the possible end of this unsustainable system.
Blumen,
“During the 90s tech bubble and the housing bubble: the value of cash “crashed” relative to equities and homes”
That is not a crash of cash, but only a missed opportunity.
A crash means the value of cash would fall against almost all goods an services, which would only be possible as a result of inflation. Since supply of gold can not be inflated arbitrarily a crash of cash in gold is impossible.
The dollar price of gold can crash, but that would mean gold losing its money functions, while retaining its good functions and becomes a commodity only.
This could happen short term and I think it already did and it is behind us.
There was a time when people had faith in fiat money, especially after late eighties and the nineties where gold fell as low as 250 dollars an ounce, but I don’t think we will ever see that kind of abandoning the notion of “gold as money” in the future.
Only if you make the same “legal tender notes have valuation benchmark facilities” mistake that Grantham makes. How have stocks done when priced in terms of actual money (i.e. gold)?
People like Grantham have staked their fortunes on the perpetuation of the paper “money” swindle. That particular socialist crime spree, however, is as good as finished.
Just thought of something, if he is “buying” cash when it is at its lowest value, then that would be a smart move.
During the boom buy some cash (it’s cheap then) during the bust buy some capital (at that point capital is cheap). Assuming, of course, the cash currency does not “go under”
The whole gold thing comes down to familiarity, most value investors of the Graham/Dodd school only stick to what they know. You have to read between the lines when they talk about gold and other precious metals, they typically mean “I don’t know”
I heard 2000 years ago, someone else said the same thing.
Darn gold investors investing in worthless metals!
The author wrights
It is a near-certainty that government debt will default because debt levels everywhere have risen too far in relation to government funding.
If he is talking about the federal government then one has to say that the only way the federal government would default is if it (they) wanted to. Since they have a monopoly over money, they can simply write a check for any amount be it 1,000,000,000,000 or 100X that amount. People think the government has to get the money from somewhere they don’t money only exists in peoples imaginations and the government has total control over that illusion. Taxes simply control, dominate, and hold down inflation and are not needed to pay the governments bills.
It seems that gold has not gained any value, its simply a reflection of a loss in the dollar of today and to come. It leaves you to believe that it has no real demand in the long run. Commodities we need and use actually look much better.
My Old Man, who didn’t own any gold, liked to say, “An ounce of gold buys a good man’s suit.” That was true for a hundred or so years. Is it still true? I buy cheap suits.
The more you think about it, the more you find it a little funny. If I bought 10 dollars of gas at $1.60 gal before 2008 when gold was hovering around $600, I would pump 16 gallons. If I bought 10 dollars of gold at that same time and more than doubled my profits in gold as of today, I could cash in for about 21 or 22 dollars and I could only buy maybe 6 gallons @ $3.46 a gallon. I just lost out on 10 gallons of gas – conservatively. By the time the added expense reaches the consumer, they lost money in buying the gold. I am starting to believe – if the bottom dropped out, what does anyone want with gold?
Sent from my iPhone
What do you think the Gold price per ounce will be in January 2012?