What’s in a number? Ignoring the day-to-day noise, more than a handful of gold dealers and analysts reckon gold will hit $2,200 an ounce before this bull market is done.

Why? Because that’s the peak of 1980 revisited and re-priced in today’s US dollars.

Simple, right? Too simple by half, in fact.

First, betwixt spreadsheet and napkin, there’s often a slip. Several targets you’ll find out here on the net put the old 1980 top nearer $2,000 in today’s money. One gold dealer puts the figure way up at $2,400 an ounce.

Maybe they got the jump on this month’s Consumer Price data. Maybe $200 to $400 an ounce just won’t matter when the next big gold top arrives. But maybe, we guess here at Bullion Vault, an extra 20% gain (or 20% of missed profits) will always feel crucial when you’re looking to buy, sell or hold. Perhaps that’s the problem.

Either way, having crunched (and re-crunched) the numbers just now, even we can’t help but knock out a target…

To match its inflation-adjusted peak of $850 an ounce – as recorded by the London PM Gold Fix of 21st Jan. 1980 – the price of gold should now stand nearer $2,615.

Two’s up therefore, the lag between current gold prices and that old nominal high scarcely looks a good reason to start buying gold today. “Ask the investor who rushed out to buy gold precisely 29 years ago, at $845 an ounce, about gold as an inflation hedge,” as Jon Nadler – senior analyst at Kitco Inc. of Montreal, the Canadian dealers and smelters – said on the 29th anniversary of gold’s infamous peak last week.

“They could sell it for about $845 today…[but] they would need to sell it for something near $2,200 just to break even, when adjusted for inflation.”

This lag, of course, can be turned any-which-way you like. For several big-name gold investment gurus, including Jim Rogers and Marc Faber, it mean gold has got plenty of room-left-to-soar, compared at least with the last time investors began swapping paper for metal in a bid to defend their savings and wealth.

But for the much bigger anti-gold-buggery camp – that consensual mob of mainstream analysts, op-ed columnists, news-wire hacks and financial advisors – gold’s inflation-adjusted “big top” just as easily stands as a great reason not to buy gold. Ever.

“An investor in gold [buying at the end of 1980] experienced a reduction in purchasing power of 2.4% per annum,” notes Larry Swedroe, a financial services director at BAM Services in Missouri, writing at IndexUniverse.com and recommending Treasury inflation-protected TIPs instead.

“[That was] a cumulative loss of purchasing power of about 55%…Even worse, that does not consider the costs of investing in gold…[and] while gold has provided a slightly positive real return over the very long term, the price movement is far too volatile for gold to act as an effective hedge against inflation.”

Volatility can’t be denied. Indeed, it’s the only thing we ever promise to users of Bullion Vault. (They don’t need to take our word on security, cost-efficiency or convenience.) Traditionally twice as volatile as the US stock market, gold prices have become five times as wild since the financial crisis kicked off.

But price volatility has also leapt everywhere else, not least in the S&P 500 index – now 8 times wilder from the start of 2008. The Euro/Dollar exchange rate is more than four times as volatile as it was back in Aug. ’07…just as the banking meltdown began. Even Treasury bonds have gone crazy, making daily moves in their yield more vicious still than even the gold price or forex!

So putting sleepless nights to one side (if you or your pharmacist can manage it), the key point at issue is in fact the “long term” and inflation.

Why look back to the real purchasing power of gold from 1913 onwards? Besides the fact that its monthly average since – when deflated by the official US consumer price index – comes in at 97.8…pretty much right where it started.

Well, that’s when official Consumer Price data start (hat-tip to Fred at the St.Louis Fed). It’s also when the Federal Reserve was first founded, with the easy-as-pie task of giving the United States an “elastic currency”.

Okay, so it ain’t quite made of rubber just yet. But the Dollar’s own value in gold – by which it used to be backed, pre-1971 – just keeps brickling and bouncing around like it’s being used as a squash ball.

“With the right confluence of economic and geopolitical developments we should see gold break through $1,500 and then $2,000 and then possibly still higher round numbers in the next few years,” said Jeffrey Nichols, M.D. of American Precious Metals Advisors, at the 3rd Annual China Gold & Precious Metals Summit in Shanghai last month – “particularly if we get the type of buying frenzy or mania that often occurs late in the price cycles of financial and commodity markets.

“This is hardly an audacious forecast when looked at relative to the upward march in consumer prices over the past 28 years. After all, the previous high of $875 an ounce in January 1980, when adjusted for inflation since then, is today equivalent to more than $2,200.”

Audacious or not, as Nichols points out, the thing to watch for would be a “buying frenzy” – a true “mania” amongst people now ready to buy gold that sent not only its price but also its purchasing power shooting very much higher.

Because for gold to reach $2,200 an ounce in today’s money (if not $2,615…) would mean something truly remarkable in terms of its real long-run value.

• Inflation-adjusted, that peak gold price of 21 Jan. 1980 saw the metal worth more than 5 times its purchasing power of 1913;
• In March 2008, just as Bear Stearns collapsed and gold touched a new all-time peak of $1,032 in the spot market, the metal stood at its best level – in terms of US consumer purchasing power – since December 1982;
• Touching $2,200 an ounce (without sharply higher inflation undermining that peak), gold would be worth almost 6 times as much as it was before the Federal Reserve was established in real terms of domestic US purchasing power.

“I own some gold,” said Rogers, for instance, in an interview recently, “and if gold goes down I’ll buy some more…and if gold goes up I’ll buy some more.

“Gold during the course of the bull market, which has several more years to go, will go much higher.”

But “much higher” in nominal Dollar terms is not the same as “much higher” in terms of real purchasing power, however. More to the point, that previous peak of $850 an ounce – as recorded at the London PM Gold Fix on 21 Jan. 1980 – lasted hardly two hours.

Defending yourself with gold is one thing, in short. Assuming gold is the perfect inflation hedge is quite another. And taking peak profits in gold – as with any investable asset – is surely impossible for everyone but the single seller to mark that very top price.

That doesn’t diminish gold’s real long-term value to private investors however, as we’ll see in Part II – to follow.

Regards,
Adrian Ash
BullionVault

February 9, 2009

The Real Long-Run Value of Gold, Part I was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Risk Management, OPM, and Volatility

Let’s start with this article by Bernie Schaeffer entitled “Volatility Complacency,” written in reference to the immediate rebound following the terrorist attacks in London. Schaeffer writes:

“The pervasiveness of the ‘buy the terrorism shock dips’ mentality should not be terribly surprising. Buying the dips is what Wall Street does. When stocks tumble, it is in the job description of the so-called ‘financial adviser’ community to ‘hold hands’ with fearful clients so they don’t engage in ‘panic selling.’

“More often than not, the dips do prove to be foolish times to sell. Of course, in those cases where the dips should be sold and not bought, investors suffer huge and often irredeemable losses (think Enron, WorldCom, and the decline off the Nasdaq bubble peak).

Quoting John Succo, a hedge fund manager and writer for Minyanville.com, Schaeffer writes: “We are seeing an acceleration in volatility selling. It is almost a panic.”

John Succo is one of the brightest fund managers I know, especially when it comes to volatility trading. Succo reported on Minyanville that he polled the five largest dealers for option activity in the wake of (and on the day of) the terrorist attacks in London.

Now let’s take a look at the July 6 article “Option Plays to Kick the Range-Bound Blues.” Bernie Schaeffer, this time writing for Forbes magazine, has this to say:

“The S&P 500 has been mired for the past 18 months in an excruciatingly narrow trading range, but I believe the coming expansion in volatility will blow away those who have been selling option premium to achieve ‘income.’ In fact, I would not be at all surprised if we were to see a 1,500-point Dow move in either direction before the year is out.”

“The whole concept of ‘income’ as a driver for equity investments, which moved to the forefront during the low-volatility environment, is becoming questionable at best. Selling call options against stock you own becomes a downright foolish strategy ahead of a major market move. If the move is to the upside, you’ve sold away all the big capital appreciation, and if it’s to the downside, you were inadequately compensated by the paltry call premiums for the risk you assumed.”

Bernie Schaeffer: Strange Recommendations

So what does the article suggest?

* Sell the Abercrombie & Fitch August $60 put (ANFTL)
* Sell the Toll Brothers August $85 put (TOLTQ)

Those sure seem to be strange recommendations for an article knocking income as a driver for equity investments and advising people that “selling call options against stock you own becomes a downright foolish strategy ahead of a major market move,” especially when one believes “the coming expansion in volatility will blow away those who have been selling option premium to achieve ‘income.’”

However, the article might have mentioned that given the expense of buying options that far out (October), it will likely take a pretty big move to fight not one, but two option premiums for the strategy to work.

Those not familiar with options should note that the risk profile of selling puts for income is identical to that of the buy/write covered-call strategy (“selling call options against stock you own”) that Schaeffer was knocking in this statement.

At Friday’s close, two days after the Forbes article came out, you could sell three TOL puts, collecting $120 minus commissions for the trade. One would then have to pray that if we did see a mammoth move, it would be to the upside. This does not seem like a viable strategy if one is expecting a huge uptick in volatility, regardless of what support there might be for a stock with high, short interest.

Assuming a potential 1,500-point Dow swing in either direction, does one really want to be selling puts on TOL for a lousy $40 premium? Perhaps one could collect $65 or so at the time the Forbes article was published, but articles like this are going to get the average person in deep trouble if there is one misstep.

Furthermore, odds are substantial that one would indeed pocket that $120 or whatever in premium (assuming the short puts were held to expiry).

Bernie Schaeffer: Decreased Volatility, Not Increased

Also, note that some people will not be satisfied collecting that $120 for three puts and will instead sell 60 of them in an attempt to pocket $2,400. That strategy works fine, until it doesn’t.

All it takes is a bombing in the United States; TOL to unexpectedly warn (the odds are not zero on this); or, for some reason, investor sentiment to suddenly change.

All of a sudden, there is a big gap down in homebuilders, and the person trying to get an extra $2,400 in income is suddenly $30,000 in the hole from selling puts.

Given the time delays between Schaeffer writing the recommendations and when they were published, Schaeffer might already have recommended to his clients to take substantial profits on the latest surge in TOL.

Please note the above statement was not meant to be a reflection on the service that Schaeffer provides to his clients. Bernie Schaeffer is one of the more respected names in the business. Instead, consider it as a warning that magazines might have space or other considerations, and some key details of a trade may have been left out.

As I pointed out, there are time considerations as well. Those time considerations are even more crucial with options. I am quite confident that Schaeffer has stop-loss and profit-taking points, as well as initial risk profiles on how much premium needs to be collected to justify risk. Unfortunately, those factors are not present in the article.

There are all kinds of general advice floating around about selling puts for income, and in fact, there are even some new mutual funds out there using this construct as their “business model.”

Multiply the above example by the amount of people, hedge funds, and mutual funds opting for this strategy, and you have a recipe for a huge disaster.

Bernie Schaeffer: Other People’s Money

Another point in regard to volatility and risk is that when you use “other people’s money” (OPM), you can do or say whatever you want without consequences. Mutual funds collect their fees whether stocks go up or down.

The fact is, however, that in order to keep the money coming in, Wall Street has a vested interest in keeping all the news positive 100% of the time. It seems to help ad revenue as well as fund inflows. If there is any chance for a positive spin, news will be spun positive.

Take the June employment numbers, for example. Although the numbers were way light versus expectations, unemployment dropped because the participation rate dropped. A falling participation rate in a “recovery” is hardly a sign of strength.

Of course, the headline “5% Jobless Rate Lowest Since September 2001″ touted the drop in unemployment, rather than the numbers miss.

If mutual funds did not have a mentality of 100% long 100% of the time with no regard for risk, perhaps we would see some real analysis coming out of Wall Street. That is a moral hazard when dealing with OPM in a 100% bullish climate.

I suspect that somewhere near the bottom of the bear market, when it will be time to go long and buy and hold for the duration, no one will believe it, having been burnt too many times in the process.

Make a mental note that when we start to see huge inflows into “long and short/market neutral” mutual funds, the bear market likely will be nearly over.

In a related OPM story, I received a cold call yesterday from an options broker touting oil and natural gas. Sometimes, I listen to these pitches just for fun. His line was, “Don’t you want to make money?” I asked him how many oil and gas futures he had. His answer was “None. It would be a conflict of interest to have any.”

My commodities account is at Alaron. The head metals broker I deal with trades his own recommendations both long and short, as does the head grains trader. There is no conflict of interest for them to do so.

In fact, I want people to have their own money on the line when they make a recommendation — as long as they are not purposely front running it. (Just in case anyone is wondering, no, I will not receive any benefit from this plug for Alaron.)

I can’t confirm this, but I am told by another source I highly respect that put selling was very popular right before the 1987 crash.

Bernie Schaeffer: Notes to Bernie Schaeffer

1. I am not trying to knock any of the recommendations in your Forbes article per se. I do not know the circumstances at the time of your recommendations or any other conditions or restrictions you placed on those recommendations.

2. I have tremendous respect for your knowledge about options and options trading. You know more about options than I will probably ever learn. I enjoyed both of your articles mentioned in this blog, and I regularly read your work. Hopefully, the public is now better educated about the volatility risks you mentioned.

3. I do have problems with the article as presented by Forbes. Specifically, I question recommendations to short puts in an article supposedly written to stress taking advantage of increased volatility. I have my doubts the public will get the basic idea of the article, at least in conjunction with the recommendations listed. Hopefully, no one follows those recommendations without understanding what they are doing and why. I assume that in actual practice, your recommendations give advice on how much premium to collect for the risk and stop-loss targets. If so, the article missed critical points on risk management. I am only using this opportunity to point out the risks of blindly following magazine recommendations, especially short volatility recommendations, that may have “undefined” and/or huge risks.

4. I have a sneaky suspicion you were not the one picking those recommendations to go with that article.

5. Got any volatility plays for us that are better representative of going long volatility, instead of shorting it?

Best Regards,

Mike Shedlock – “Mish”
July 12, 2005

Bernie Schaeffer: Risk Management, OPM, and Volatility was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.