The following article is pretty indicative of the bullish argument for gold. While I certainly have no faith in any paper currencies, I’d much rather invest in assets that are likely to grow and that have some level of pricing power. One time Warren Buffett was asked by a student how they could protect themselves from extremely high inflation. His answer made a great deal of sense as he mentioned that as a town Doctor or Lawyer, or something serving a substantial need in society, the student would have pricing power regardless of the status of the currency.
Investing is no different in that companies such as Pepsi or Philip Morris have pricing power as people are willing to pay a certain percentage of their income to enjoy their products. Owning businesses such as these that have the ability to grow and produce cash flows regardless of the status of the currency, is a safer way to brace for inflation than just buying gold, as long as you are paying a reasonable price. The problem with just buying gold outright is that it is extremely difficult to value it. The below article represents Buffett’s comparison to the “Tulip Mania” as a one off event, but the truth of the matter is that these types of bubbles have happened repeatedly, throughout the history of speculation in markets. For those of you that haven’t read it I’d certainly recommend Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay.
The book describes several manias in different asset classes but the common theme was speculator psychology where people avoid all rational valuation techniques, on the belief that something just has to go higher, and that they can get out before it turns around. Twelve years ago when stocks had experienced a bull market for the better part of two decades, far fewer pundits were advocating the merits of gold as a diversification tool, as its performance lagged substantially. Modern Portfolio Theory utilizes simulations based on past performance to predict future behavior, so the merits of buying gold weren’t any more clear than it would have been to buy Apple stock below $10 per share. Now when an Advisor performs a Monte Carlo Simluation, alternative assets like gold and silver, counter the dismal performance of stocks over the last decade. Those same models that are reliant on past performance also advocate bonds as a far larger percentage of a portfolio based on their excellent performance over the last twenty years which have been marked by declining interest rates. These models don’t take into consideration that the 10 year treasury is hovering around 2%, and that increases in interest rates are likely to decimate the purchasing power of the buyer of bonds. Gold and Silver’s primary uses are no longer jewelry or photography, but instead are as an asset class for investors. ETF’s buying these commodities have allocated hundreds of billions of dollars boosting prices drastically beyond what previously would have been sensible based on the actual utilization of the assets. These funds have generally performed well causing more people to pile in, but because these assets don’t generate cash flows they require someone constantly being willing to pay more. As soon as the psychology changes gold is likely to drop and there is no margin of safety from pricing power or cash flows to protect the speculator with the wrong timing. Whether you view gold as a higher quality asset than tulips is really irrelevant as the common thread in both investment theses is that someone will pay more than you are paying for it.