All that Glitters…

…is a barbarous relic. In this case, one made out of shiny and precious gold. Gold has been in the headlines a lot in the past months and for good reason: its price has increased well over 30% this year and now stands at or very close to an all time record against the US Dollar (and other currencies as well!)

So just about everyone is saying what a great investment Gold has been or will be in the future. Before you go jump on the bandwagon and exchange your Euros, Swiss Francs or Bolivars for some shiny metal, take some time to read up about gold.

I’ll suggest the wiki page, which isn’t too long and quite informative. LINK.

Here’s my take:

Gold is the ultimate “want” material. Its demand is mainly from “want” and not from “need”. Gold’s limited industrial applications absorb around 300 tons of the stuff a year and it can be readily recycled and usually is, due to its cost. Total demand, however, is closer to 4000 tons a year. Most of that (over 80%) is for jewelry and almost a quarter of that is for India (800 tons). Gold is ideally suited for jewelry since it is attractive and highly malleable. It’s shiny.

However, despite arguments from my wife and Hindu brides-to-be, I think we can reasonably classify jewelry as a discretionary purchase. No one NEEDS jewelry.
Other uses include coins and bars. People buy these and stuff them in safe deposit boxes.

So basically, humans buy gold to hoard it. In jewelry boxes, in safe deposit boxes, in our temples, in our (OMG) central banks or buried under the sand on a tropical island.

An alien visiting our planet would find this behavior amusing (Spock says “illogical but fascinating”), but it’s something our cultures have been doing for centuries. National Geographic estimated that humans in our history have mined 161,000 tons of gold. It sounds like a lot, but since Gold is so dense, that’s only about enough to fill two Olympic sized swimming pools (again wikipedia is the source). It’s all hoarded or hidden somewhere.

Extraction of gold is running about 2500 tons a year, so there is a deficit of about 1500 tons a year, which is satisfied by recycling the gold in those two swimming pools. People (and I mean humans) will pull out their heirlooms, raid someone’s temple, find a buried treasure or simply sell their stash.

These market dynamics make Gold (and its poor cousin Silver), prime material for bubbles. Why? Because humans are greedy. Although the rational behavior of “homo economicus” would be to demand less gold when the relative price of it rises, many times it will be the opposite, the expectation of even higher prices will spur more demand and more hoarding.
Given the need for a voluntary recycling of gold stock to keep demand and supply in balance (and prices in check), small changes in behavior can cause major price swings.
Add in speculation, and you have all the ingredients for a bubble. One thousand tons of gold today are “worth” about $40 billion. A few hedge funds, some changes in allocation recommendation by some global players and you can add that kind of demand easily (or more). Gold futures allow mini-speculators like myself to control thousands of ounces without much collateral, not to mention what the likes of GOLDman Sachs can do.

In those circumstances, there is no upper limitation to price. Put enough players on the buy side of the gold trade and the result could be anything. Two thousand dollars, five thousand dollars. Whatever. Think Dot-Com circa 2000, Housing Circa 2007, Beanie babies, Tulips, etc. or….GOLD itself in 1979-80.

Goldbugs point to the metal as an “inflation hedge”. There is some logic to this rationale. Since the stock of gold is relatively stable, its value relative to other tradable goods (including stuff people actually NEED) should be relatively constant and unaffected by the high-speed currency printing presses flooding the world with their filthy “paper money”. (Here’s a good link about this).

This argument, however, assumes that people are rational in their trading of gold (sell high, buy low). But of course, if humans were totally rational, they wouldn’t hoard this stuff in the first place (or destroy the environment pulling it out of the ground).

Like it or not, Gold is destined for booms and busts.

Now that I have figured that out, the only rational recommendation would be NOT to invest in gold.

So, don’t INVEST in Gold. SPECULATE in Gold.

If humans are going to be irrational, herd-like and emotional, it would only be logical to try to benefit from that behavior. So trade the bubble.

How? First, forget physical gold. No coins, bars or heirlooms. The problem with these is that you won’t sell them when it’s time to do so. It will be stuck in box somewhere, and you’ll say “I’ll sell it when the market rebounds” or “I’ll get it tomorrow” and then you’ll fight with the dealer or jewelry shop guy over a few dollars. You’ll end up hoarding this stuff until the next bubble comes around, or maybe you’ll stuff it in your sarcophagus.

The other thing is that the gold rally didn’t start yesterday. The price has gone from around $300/oz in 2002 to $1200/oz today. Although I don’t think so, we could be nearing a top. But essentially, either it spikes further from here or it stops. If it stops, then why bother?

So, here is how I plan to play the gold bubble. Options. Normally I don’t buy options (I write them), but this is a place where I’d want to use them.

For example, September 2010 140 calls on GLD (a gold ETF aprox 1/10 price of gold), trade for about $5.75. I’ll buy 10 contracts for $5,750.

If all hell breaks loose on the gold market and everyone piles in, let’s say the price shoots up to $2500. I just turned those 10 contracts into 100 grand. If it all fizzles out, well there goes the Jamaican vacation. But that’s it and I won’t have to worry about finding someone to buy my Beanie Baby…er gold bar.
Classic high risk/high return bet. I like the odds better on this than eighteen red on the wheel.

Disclaimer: Caveat, Caveat. This isn’t investment advice and if you aren’t legally able to absorb it, please close your eyes and erase your memory.

Memory lane: you may have the impression that I don’t like gold. Not so. I made my first “killing”, if you will in the 79-80 bubble. At the time, I convinced my dad to buy some gold at $350/oz. in Sep 79 and piggybacked on the trade. A few months later the Russians, bless their souls, invaded Afghanistan and gold spiked. We cashed out in early 1980 at $620/oz, IIRC, after not selling at $800/oz or $720/oz or $680/oz. (ah… greed). I pretty much forgot about gold after that, but Dad lost precious time and money on silver mining companies and the like. (I lost my time and money elsewhere). Bubbles don’t grow again quickly after busting.

This one took 30 years!