Disclaimer: Your capital is at risk. This is not investment advice.
Utility drives value
How does a long-term fall in supply impact price? I raise this because on 12th May, gold’s digital friend will undergo its third “halving”. That means the newly mined supply of bitcoins will fall by 50% to approximately 6,300 per week compared to the current 12,600.
The idea is that rising scarcity will send the price higher. With 18.3 million bitcoins in circulation and only 2.7 million left to mine, the world is running out of bitcoins. Quick, buy while you still can!
This popular narrative is that a lower supply leads to a higher price, courtesy of stock to flow models. These focus on the new supply, known as the flow, which is a small number that tends towards zero over time. The stock, on the other hand, is a very large number which nudges higher, ever so slowly. When you have 18.3 million bitcoins, does it really matter if you add 12,600 or 6,300 coins to the stock? Should you focus on the small number or the elephant in the room?
The father of value investing, Benjamin Graham, said that in the short run, the market behaves like a voting machine, but in the long run, the market behaves like a weighing machine. Flow factors are technical and will only impact the market over the short term, as in the long term, prices will eventually find their fundamental true price. Graham would focus on the intrinsic value of the stock and ignore the noise from the flow.
As it happens, the stock to flow situation in the gold market is remarkably similar to bitcoin. That should come as no surprise as bitcoin’s supply characteristics were modelled on gold. According to GoldHub, 3,463.7 tonnes of gold were mined last year, bringing the total above ground supply to 197,576, which is a 1.7% rise. After May’s halving, bitcoin’s inflation rate will be similar to gold’s, and for the remainder of the 21st century, both gold and bitcoin will see the growth in their stock fall. GoldHub states there are just 54,000 tonnes of gold left to be mined, which made me wonder what the impact on the gold price would be if it was left in the ground.
In trying to find the answers to some difficult questions, I put out a survey to the London Bullion Metals Association (LBMA) members, and I thank those who took the time to respond. If the gold mining industry was suddenly shut down, for whatever reason, most members felt the price would move between 50% and 100%. Yet, when asked if the gold mining industry was shut down over a longer period, respondents felt the price would rise, but to a lesser degree. By implication, and after a brief consultation with Benjamin Graham, the voting machine would trigger a shock move, but the weighing machine would see things settle down. Ross Norman from Metals Focus told me:
“An imposed constraint on fresh metal coming to market would likely see market prices more than double, in my view, as scarcity fuels the demand”
Be sure; I am not suggesting gold mining will be shut down. It would be impossible as the industry is so fragmented and is spread across so many geographies. Furthermore, the precarious state of public finances will see any new supply find a good home. Gold is not just a luxury good or a toy for the rich; it is an essential part of the financial system, albeit on an informal basis. But I’m sure there is no shortage of people that believe gold will once again enjoy a more formal role, as the fiat experiment is stress-tested to the extreme. The hypothetical scenario of no new gold helps us to better understand supply dynamics. Less gold supply may positively impact the price, but perhaps any super spike will be short-lived.
Lessons from other markets should remind us that less supply doesn’t necessarily lead to value creation. To illustrate this, look no further than company buybacks. According to super strategist Ed Yardeni, S&P 500 companies bought back $726bn of equity last year. That reduced the number of shares in issue and boosted prices. It boosted prices for technical reasons, as there was more demand for the shares and less supply.
Buybacks boost earnings per share as the company’s earnings are spread across fewer shares. That sounds great, but if you overpay for those shares, it ends up being capital destructive, as the value was transferred from the buyer to the seller. Buybacks are only accretive if you pay less than intrinsic value, in which case the value goes from the seller to the buyer. Given US shares prices were high in 2019 and generally above intrinsic value, buybacks were collectively capital destructive. If you are still in doubt, ask why the S&P 500 buyback ETFs have underperformed the S&P 500 this year by 10%. The market crash swapped the voting machine for the weighing machine. The flow factors suddenly became irrelevant. When the tide goes out, the market values the stock and ignores the flow, something market watchers have seen time and again.
While lower supply doesn’t create value, it might damage market liquidity. GoldHub data puts gold volumes at $145bn per day, which is not far off the S&P 500. New gold supply is a lesser $500m per trading day. I suspect the ebbs and flows of new supply impact the market technicals, but as we know, it’s only a matter of time before the weightlifters come out and squash the voters. The fundamentals remain unchanged.
Yet LBMA members believe lower supply has its benefits. When asked if less supply would boost gold’s appeal as a long-term investment, they agreed and even went a step further. Lower supply would make gold even more attractive to the central banks. The jewellers were also comfortable with less supply as they felt gold would be perceived to be “more precious” if there was less of it. Bron Suchecki from Pallion said:
“an increasing gold price will damage jewellery sales, but restricted supply would be perceived by the average person as making gold jewellery more precious.”
Regardless of the actual impact on price, investors find the idea of scarcity to be attractive. Alastair Macleod from GoldMoney reminded me that as the price goes up, you create more demand. Gold is a Veblen good, like the fancy ties worn by the suave dudes in private equity. The more you charge, the more they want them, despite their “value” credentials. Yet deep down, we all know that everything will face the weighing machine in the end. Those old enough to recall the recession from the early 1990s saw the likes of Gucci come close to bankruptcy.
Yet supply is important. If the quantity of gold were to increase rapidly, investors would rightly lose confidence. According to The Sun Newspaper (it must be true), NASA has identified an asteroid with enough gold to make everyone a billionaire. If it landed on earth, it might collapse the gold price, or alternatively, it might lead to million-dollar loaves of bread. But a significant increase in supply is only devastating if the item has no utility. More supply doesn’t make gold less dense, less beautiful or less inert. It still has the amazing properties it always did. Perhaps the voting machine would see the gold price collapse as everyone got their billion-dollar share. But when the weighing machine returned, a substantial rally would begin. Some people wouldn’t be satisfied with a billion in gold and would want ten.
Imagine you were fortunate enough to own a few dozen Monets or Van Goghs. Would you burn a couple each year to boost the scarcity of the rest of your collection? To think that would create value is ridiculous. While I’m no expert on art, I would think that great artists should paint as much as possible.
In valuing gold, bitcoin, or any other asset, the focus must be on the asset itself as market influences will only ever be temporary. What purpose does the asset serve, and is it long lasting? I would argue that bitcoin represents a powerful digital network that will thrive, a sort of technology stock without profits or a CEO, but with near perfect security and distribution. Gold, on the other hand, is the ultimate and timeless store of value that that the financial system will turn to whenever there’s a storm, just as it always has in the past. It all comes down to the asset, and I suspect the supply side is far less relevant than many people think.