Who’s Right on Gold: Buffett or Dalio?

07/21/2011 11:13 am EST

Focus: COMMODITIES

Igor Greenwald

Chief Investment Strategist, MLP Profits

The Oracle of Omaha has pooh-poohed bullion as an investment, while the star hedge-fund manager plainly disagrees. For now, the latter has the better case, writes MoneyShow.com senior editor Igor Greenwald.

Nine months ago, Ben Stein asked Warren Buffett whether gold was in a bubble, and the Oracle of Omaha responded with a rhetorical question.

Would you rather have a 67-foot gold cube made of all the bullion in the world, or all the farmland in the US, ten Exxon Mobils (XOM), and $1 trillion in walking around money? Because the price is about the same, he pointed out.

Buffett’s point was simple: Gold is not a productive asset. It just sits. Its value is entirely dependent on the whims of buyers.

Buffett, of course, is one of the world’s richest men, and its most respected investor. His track record speaks for itself.

But then so does gold’s, which has risen 500% over the last decade. When Buffett dusted off his gold cube visualization back in October, gold sold for less than $1,400 an ounce. Now it’s at $1,600, just off a record high in nominal terms.

Why is that? It’s not as if someone has discovered a productive use for gold that wasn’t apparent last year. Farmland prices have soared too, alongside Exxon shares. But gold has certainly kept up, and outperformed spectacularly over the last decade.

It turns out that 67-foot-high cube has a use after all—as the high ground people seek to escape the torrent of paper currencies all around them.

Another billionaire famed for his investing prowess has apparently translated this concept into an equation. The New Yorker’s excellent profile of Ray Dalio, the star hedge-fund operator behind Bridgewater Associates, lists one of the “decision rules” compiled by Dalio to guide the firm’s trades as follows:

“…over the long run, the price of gold approximates the total amount of money in circulation divided by the size of the gold stock.”

That makes a lot of sense. Because gold has minimal industrial applications and near-universal acceptance as a store of value, it should appreciate in proportion to monetary expansion, and depreciate when the supply of paper money contracts.

What does Dalio’s equation tell us about the price of gold today? To be honest, not much.

Does he mean that we should divide the price of gold by some broad measure of dollars in circulation? Or by the nominal value of all the paper currencies around the world? And what’s a long run, anyway?

But as for the price tomorrow, the trend is clear. Here’s a chart showing, in one broad measure, the growth of US money supply:

chart
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And here’s the percentage increase in US money supply over last five years (green lines) vs. growth in Chinese money supply (orange line) over the same timeframe, courtesy of Bloomberg:

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Click to Enlarge

In contrast, gold production seems to have leveled off at around 2,600 tons in 2010, roughly 1.5% of global stockpiles.

In the race between a printing press and picks and shovels, bet on the printing press.

From The New Yorker:

Dalio believes that some heavily indebted countries, including the United States, will eventually opt for printing money as a way to deal with their debts, which will lead to a collapse in their currency and in their bond markets.

“There hasn’t been a case in history where they haven’t eventually printed money and devalued their currency,” he said.

I must be in the minority that believes nothing nearly so dire needs to happen for gold to do well. It’s simply a measuring stick for the adjustments the West is having to make to cope with an influx of cheap labor from Asia, and of the equalization of wealth between those cheap laborers and the (for now) much wealthier Westerners.

This wealth transfer from rich countries to poor ones is going to be measured in thousands of dollars an ounce. Given the overhang of debt and the gulf in levels of consumption, this sea change should be accompanied by money printing well in excess of growth in real demand.

Nothing particularly tragic or apocalyptic about that. The Chinese—who have few better investment options than precious metals—would say it’s about time.

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