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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.
Robert Blumen
Robert Blumen is
an independent software developer based in San Francisco, California
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