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Grantham "Guarantees" that Gold Will Crash

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05/18/2010

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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