Another Case For Gold
Today’s post is an excerpt from What If Stocks Were Priced In Gold? posted at Experience Is Everything. While the post is incredibly interesting it is rather long. The portion I’ve quoted explains why gold will likely outperform the dollar and stocks over the next few years. It follows that you should invest in gold. Even though, I’ve been recommending gold since it was at $495/oz back in December 2005, it’s still not too late. If the below mentioned scenario comes true, you’ll be happy you did!
For much of the last century the dollar was tied to gold, and while the relationship was never perfect — and the U.S. government betrayed the union many times, in many different ways — there was at least some relationship, which helped pull the ratio down. Eventually, excessive inflationary printing caught up with the government in the 1960s, and it became clear it wouldn’t be able to honor redemptions against the dollar at the price it had fixed. Nixon essentially defaulted on the U.S. promise to redeem dollars for gold by taking the U.S. off the standard in the 1970s — and this, more than anything else, allowed inflationary pressure to drive general prices into the stratosphere. This was the moment the Dow-to-gold ratio approached 1:1. To fight rising prices, Paul Volcker, the Fed Chairman at the time, pushed the Fed’s target interest rate past 20% and barely saved the U.S. economy from collapse.
For most of the next 20 years, gold fell and stock prices rose. Meanwhile, the U.S. government capitalized on the lie it had created and printed more and more money. Who really cared? Everyone was making money in the stock market, and prices remained relatively stable. In fact, every time prices failed to act “correctly,” the Fed simply changed the rate at which it would lend to banks. But the illusion of the monetary policy game couldn’t last forever; people used easy money printed by the government to buy assets they couldn’t afford throughout the economy — especially houses. Finally the pressure was just too much, and everything started unraveling in 2007. But the gold market seemed to understand the game couldn’t last, and around 2000 it started a slow, steady rise.
Relative to everything, the number of dollars in the system in early 2009 is almost incomprehensible. Once de-leveraging reaches its nadir — and it’s coming soon — those dollars are going to hit the economy and drive prices much higher.
What have we learned about stocks in such periods of rising prices? Not only do they fail to perform, but adjusted for inflationary price pressures, they actually underperform. General prices and unemployment will continue to rise. The consumer will continue to be unable to consume. Corporate earnings and dividends will continue to collapse as a result. Stocks are going lower — probably much lower.
And what about the price of gold? It will almost certainly continue to increase — not only because people will flock to its long historical stability and consistency, but also because there are simply so many more dollars (and yen, and rubles, and euros) in the world. Remember, the U.S. isn’t the only country printing innumerable sheets of currency. And in that context, remember also that inflationary price increases have almost nothing to do with increased demand, but rather they are the result of currency devaluation and destruction — through printing.
I just want to share two more charts with you. The first should give you a little perspective — it is a historical chart of gold, in both nominal and real dollars. Notice the real price of gold in 1980 (in 2007 dollars) was $2272 per ounce. If I’m correct about inflation and the fate of the dollar — and I’m confident I am — then we are nowhere near the historical high in gold. But I don’t think we’re merely going to re-test that high — I think we’re going to blow through it as the dollar loses value.
In the 1930s, as corporate earnings and dividends disintegrated, the Dow lost nearly 90% of its value from peak to trough. The U.S. was a creditor nation with a huge manufacturing base. The dollar was tied closely to gold. Since its peak in October 2007, the Dow has lost less than 50% of its value. The U.S. is a debtor nation with a relatively small manufacturing base. I can’t say it enough: we borrow profusely, we manufacture very little, and we consume gluttonously. Nonetheless, the consumer has now lost almost all his purchasing power, and corporate earnings and dividends are going to suffer massively as a result.
In 2007, the Dow peaked at about 14,150. To give you some perspective, an 85% drop in the Dow from peak to trough would put it at about 2100.
I know its easy to imagine the Fed has magical powers. I’ve fantasized about such things myself at times of extreme weakness — that maybe the Fed will “somehow” figure out a way to fight and defeat the unprecedented evil specter of inflation it is foisting on its unsuspecting children. Sometimes I do believe that our Lord and Savior Barak Obama will wave his charmed “unicorn horn of change” and all will be well again. Likewise, at times I feel like I could let Uncle Ben Benanke take me just about anywhere in his helicopter of prosperity. My faith in the reverend John Maynard Keynes runs deep, as I hope, and hope, and hope. I find myself gleefully clicking my heels together and repeating, “the dollar is almighty, and the Stars and Stripes will prevail.” And when I am in this wonderful place, I have confidence that someday soon, we’ll all be buying houses with no money down, and with no jobs. Our driveways and backyards will once again overflow with boats, motorcycles, and sports cars.
Then I think about the 1930s. And suddenly I am wide-awake.
Let me ask you a simple question, and I want you to actually think about it. Do you really think we can’t get to the 1930s again? Do you really think that we’re going to return to the exuberant excess of the past few decades? If so, let me disabuse you of the notion: the United States was in much better shape, economically, going into the Great Depression than it is now. Prosperity is not coming back to the U.S. as we know it. We are in a lot of trouble.
Is a Dow-to-gold ratio of 1:1 so incomprehensible? Again, it has happened before — several times. But I’ll even take it a step further: what about a Dow-to-gold ratio of .5? Or less? I promise you, if the Fed fails to soak up all the dollars it’s putting in the system, that’s exactly where we’re going. And what, you may ask, does the Fed use to “soak up dollars?”
I’ll be glad to tell you that too. When the Fed needs to take dollars out of the system, it sells Treasuries (which means it buys dollars). The problem is, the U.S. debt-load is astronomical. Who, exactly, is going to buy that debt from the Fed? And at what interest rate? Remember, if the Fed is desperately trying to take dollars out of the system, there can be only one reason: it is scared of rising prices caused by inflation. But if the Fed floods the market with Treasuries, it will achieve exactly the opposite effect it’s looking for — it will cause rates to rise, probably dramatically. Do you really think the Chinese and the Japanese are going to buy Treasuries at a 2% yield if the Fed is panicking and trying to buy dollars to stop an inflationary price explosion? If so, you’re delusional. Chinese and Japanese people are smart. They’re not going to fund an inflationary dollar at 2%. Ever.
In the past it might have worked. Of course, in the past, the U.S. money supply was much smaller, and our ability to borrow was much stronger. But those days are gone.
As if I haven’t terrified you enough, the last thing I’m going to leave you with is really scary. It is a link to an excellent article by Mark J. Lundeen, whose insight into this economic catastrophe has been stupefying since long before all of this even started. Embedded in the article is a chart that shows historical dollars-in-circulation, relative to U.S. gold.
With that, I think I’ll let you do the rest of the math. Sleep well.
I strongly recommend you subscribe to his blog. And don’t forget to add some gold & silver to your portfolio.
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January 31st, 2009 at 8:59 pm
I picked up some of the Gold ETF last week. The technicals look good and maybe Wall Street is finally buying into the inflation argument.
February 1st, 2009 at 8:55 am
Boy, Nirav, is the author of this piece mixed up. There are parts of it that are correct, but the overall picture is decidedly mixed and confused.
You and I have been in agreement that gold and other precious metals and hard assets will benefit from a period of monetary expansion once the deleveraging is done. I believe that as long as dollars are printed to replace the financial assets lost in write-downs, there is no inflationary pressure created: no extra demand chasing too little supply. (and in fact, we are now entering a period of excessive inventory, whether houses, cars or clothing, which is the source of all deflations).
But once inventory (supply) is back in balance, then all the excess money supply (demand) will probably cause inflation. How much inflation will be determined by how fast the Fed and Treasury can remove the dollars from circulation. One way is as the author described: by selling Treasuries. But this also is the source of one of his misdirections. Here are the errors I saw in his arguments:
1. “if the Fed floods the market with Treasuries, it will achieve exactly the opposite effect it’s looking for — it will cause rates to rise” – POINT: when the Fed uses this policy of selling Treasuries to reduce monetary supply, it is INTENTIONALLY trying to raise interest rates (see Paul Volcker in 1980). Interest rates must go up to attract buyers to Treasuries. That is the whole point, which addresses another of his confused arguments:
2. “Do you really think the Chinese and the Japanese are going to buy Treasuries at a 2% yield if the Fed is panicking and trying to buy dollars to stop an inflationary price explosion?” POINT – NO, of course not. The Fed already knows it will need to raise interest rates to attract capital to Treasuries once de-leveraging (fear) is out of the market. The very low rates of today are a product of global fear of economic failure. I find it very interesting that global wealth is flowing to the US dollar and not to Gold. It really refutes the Gold Bug argument, doesn’t it?
3. “They’re not going to fund an inflationary dollar at 2%. Ever.” POINT – DUH!! Come on, the author of this piece seems smart and well-educated, but this statement makes me wonder. First, the mechanism for issuing debt of any kind, government or corporate, is through auction. The 2% rate is a product of what the market will bear, not some Federal fiat. Interest rates of all types are set by the market, not be some pre-ordained decision. The Fed officials (really, any one educated in economics) understand that when we enter a period of excess money supplY (we can only wish right now), that interest rates will be bid higher.
4. The reason for this is also Economics 101: investors are only concerned with the REAL return of an investment, not the NOMINAL return. The real return is the investment return minus inflation. So, the market will ALWAYS require a return that is positive or in excess of inflation. 2-2.5% is the normal expected REAL return for a riskless investment (Treasury). How do we know this? It is quote every day in the Treasury Inflation Protected Securities (TIPS). When inflation is negative, as it is right now with a contracting GDP, very low interest rates still generate positive Real Returns.
5. “[In the past] the U.S. money supply was much smaller, and our ability to borrow was much stronger. But those days are gone.” POINT – many younger writers, or those not solid students of economic history, forget the context of “the past”. In the 1950s and early 60s, America’s economic nexus, America was the only country with its economic infrastructure left intact after World War 2. America was never bombed or invaded and its manufacturing infrastructure had been built to the sky in support of the Western World’s war machine. Because hard assets were plentiful, soft assets (currency) were not widely needed. People miss this very important point. Currency is just a substitue for real or hard assets. Those assets can be buildings, machinery, coal, oil or gold. American then, like China now, had lots of assets and against those assets, loaned the rest of the world money so they could rebuild theirs. When you loan money, money supply contracts, just as when you borrow money in expands.
6. The author (and most goldbugs) forget that currencies are comparative. If the entire world prints more money in concert, how can any harm be done? The dollar is just a unit of measure that represents economic exchange. Each dollar represents a fractional claim on the national aggregate assets of America. When I was a small boy, $1 meant a lot (could buy 3 loaves of bread). Today, $1 is probably represented by $10 in making purchases (still buys 3 loaves of bread). Does that change my life in any way? NO. Does it change my buying power in any way? NO. As long as my income is 10 times what it was before, it is a wash. No one cares. And as long as the rest of the world follows the same path, it matters not. But, if you hold Real Assets over that time period (gold or real estate, among others), they will hopefully be worth 10 times as much, but probably no more (at least not for long). So, does that ounce of gold today buy any more than it did in 1972? NO. Money is symbolic and comparative, and to try to make some case for a new paradigm for Gold is as hopeless and mindless as those who tried to dismiss it entirely 10 years ago.
February 1st, 2009 at 11:04 am
Good points as usual.
But why does everyone keep saying there’s no inflation?
My tuition is going up 10% next year. As a humongous portion of my spending in 2009, that 10% will outweigh any benefits a drop in oil/gas prices.
My medical insurance has also gone up from last year. So has the rent. Prices of groceries also seem slightly higher than they were 2 years ago.
So where’s the deflation?
Gold is the only thing that’s done well in the past 2 years.Why? Because it’s a store of value. Inflation might be a wash for you since you’re working, but what about retired people who’re invested in CDs and Bonds? Their purchasing power will be totally eroded in an inflationary environment. (I don’t believe TIPS will protect fully against inflation. It’s in the government’s interest to lie about inflation so they pay less interest!) The market has started to demand a higher interest rate on debt. This trend will continue.
The US government is broke. California is broke. It’s issuing IOUs for tax refunds (and maybe even unemployment checks). I believe that excess government spending is a net deadweight loss to society.
Instead of spending hundreds of millions on family planning in developing countries, studying global warming and fixing cemeteries, how about throwing some money at public health, public transportation and college education?
http://www.cato.org/special/stimulus09/cato_stimulus.pdf
February 1st, 2009 at 11:24 am
I think Wall Street has made a passive statement that there is little to no risk of substantial inflation by not bidding up gold prices sooner. But we all know that Wall Street works in dogma-like herd mentalities, so once the feeding frenzy starts, the price of gold could appreciate very quickly.
Give it a few more weeks, and once reporters notice that gold prices have spiked, the news will become more of a “yes, we saw it coming” story instead of a “will it happen” story.
February 1st, 2009 at 2:08 pm
Nirav, first: “So where’s the deflation?” it is everywhere. Do you own real estate (no, since you sold your condos a few years ago, as you told us). You expected real estate deflation and wisely got out. So, how can you deny we have deflation, now? When peoeple (economists) talk about inflation or deflation, they are talking about the national or global aggregate of all prices, not the price of B-school or medical insurance. There are a lot of moving parts to an economy and some can be going up while most of the rest are going down (like right now). Check out the GDP numbers reported last week. The 4th quarter USA economy CONTRACTED by over 3%. GDP measures the sum prices of our gross domestic product. GDP Contraction = National Deflation. It is that simple.
“Gold is the only thing that’s done well in the past 2 years. Why? Because it’s a store of value.” My answer: so is real estate, oil and Treasuries. They are all “stores of value”, as hard assets. So what.
I think my generation has a little different perspective on gold (those of us who have tracked it anyway). I was of “B” school age in 1980 and studying economics. This is the year that Gold hit $850, which is about $2272 in today’s dollars as your guest writer pointed out. Did it store value over the last 25 years? Not unless you consider shrinking from $2272 (in today’s dollars) to $250 (2000) a storage of value.
Here is the truth: gold is an ALTERNATIVE currency, one of many. I don’t deny that right now is a good time for gold. The economic uncertainty and PROSPECT of inflation make it a good short term play. And because of the times, I have some gold (not even 10% of my portfolio, though). But based on my life experience, gold will only be a good INVESTMENT for a short period of time. Gold has the major disadvantage of not growing. It is a form of currency and must represent something other than itself to provide LONG TERM value.
Is $2500 a possibility in the next couple years? Absolutely! Especially if the Feds mis-time monetary tightening once the economy perks up. But unless you believe that “this time its different” (the most dangerous phrase in investing) and we go into a long multi-decade period of inflation (HIGHLY unlikely, as high inflation can’t be sustained), it would be a big mistake to trust gold more than any other currency.
February 1st, 2009 at 2:35 pm
I also wanted to comment on the dooms-day comments: “The US government is broke. California is broke. ”
Again, having been around quite a while, I can tell you I have seen this before, and we all survived. In the mid-1970s, at a time much like this, New York City was broke. It was so bad, that “B” movies were made about the prospects for Manhattan (”Fort Apache, the Bronx”). During this time, NYC came close to defaulting on its debt, before the Feds bailed them out (there were a series of bailouts in the late 1970s as government entities were caught by economic dislocations).
You probably remember Orange County going into technical default on its bonds in 1994 during another currency and debt crisis (when the County Treasurer bet wrong on investments).
But these condition were not a permanent state of existence, and with hard work and time, the problems were solved. It will be the same once again.
We are experiencing a massive “disruption” in the world’s economy. Assets and liabilities are out of balance. There is no doubt about that. This happens every time a period of great prosperity is suddenly disrupted (a bubble is popped) and big institutions with massive inertia, like states and national governments, are caught off-guard. It is hard for a small business to change its financial expectations and obligations in a very short time (less than a year), let alone an entire state or national government. The adjustments will be made and California and the USA will survive.
This is not a nuclear holocaust with the total physical destruction of life as we know it (the one situation that would be long term bullish for gold). We need to all keep this crisis in perspective. Nothing physical is getting destroyed, only imaginary money: fiat currency (which inherently raises the value of the fiat currency remaining, if you think about it). It may be good to buy a little gold (would have been much wiser in 2000, though), but it is an exceptional time to buy corporate stocks that will prosper upon economic recovery. On this saying, Warren Buffet has oft been quoted, but rarely understood: “be greedy when others are fearful and be fearful when others are greedy”. The clamor for gold is starting to sound a little like greed.
February 1st, 2009 at 6:10 pm
To be technically accurate…
Deflation is the contraction of the money supply. A side effect linked to deflation is a fall in prices. However, falling prices does not = deflation. The under-educated media is shouting deflation…but they are wrong. Instead, prices are dropping in consumer goods & real estate because there’s no demand. A fall in demand does not equal deflation.
Instead, the money supply has been growing by enormous amounts. Inflation is the expansion of the money supply. The side effect of inflation is an increase in prices.
Conclusion, the drop in consumer demand is covering up the real inflation (expanding money supply). The money supply has grown so much that we will soon see hyperinflation and Gold/Silver prices Sky-Rocket. The dollar is the next bubble to burst.
February 3rd, 2009 at 7:29 pm
bdcblogs…i think you have it backwards. Monetary contraction is the proximate cause of deflation and a decline in prices is the effect, not the other way around. Housing foreclosures (and the resulting evaporation of assets convertible to money) are a form of monetary contraction, as is a reversal of the “carry trade” and its leveraging effect on the economy, which was very popular among huge hedge funds. The contraction created by those two events, is almost solely responsible for our deflation, which in turn is responsible for our global recession.
Global banking officials have been trying to put the water back in the leaking bathtub by expanding money supply to make up for the “shadow bank” contraction, as PIMCO’s Paul McCulley calls it. So far, they are behind the curve which is why the bathtub continues to empty (prices continue to fall). It is the pricing effect we care about, because it affects our daily lives, not so much the contracting money supply cause.
February 6th, 2009 at 1:13 pm
I have been a reader of this blog for a while and appreciate the intelligent opinions and debate (as compared to say the comments on Marketwatch). As someone without an MBA just trying to navigate through the storm – I find the comments regarding both sides of the inflation debate interesting.
Several have made the point about the printing presses (creation of money) eventually bringing on inflation due to the fact it creates an expansion of the money supply. My question would be, since our money supply (dollar) is a fiat currency (it is not tied to any hard assets anymore)- would one not need to take into account the destructive elements of the bubble bursting on the “money supply”? Meaning – what about all the paper wealth that was disintegrated with the collapsing housing market and then stock market. Yes – much of this wealth was just on paper – but so is our entire monetary supply. Is it possible that as the fed prints money – it is just replacing some of the wealth that evaporated?
I know several people whose net worth two years ago made them millionaires, but who are practically broke today. Despite what “helicopter Ben” has done, their money supply did not expand – but contracted. And they now act accordingly (they are not buying stuff).
I apologize if the question is silly – but just a layperson trying to figure out the best way to protect my family. Should I buy guns and gold or act like Buffet and tread into equities.
February 6th, 2009 at 5:40 pm
Charles,
I have a very intelligent friend who’s buying gold and guns. He’s also buying TIPS. He works for a famous private university here in Southern California and says that when the university is on a hiring freeze, the economy is really in a bad state.
February 6th, 2009 at 9:22 pm
Charles, I apppreciate your point of view and agree with your assumptions. I am acting on a similar thesis. This is also the thesis of those who are experts on the Great Depression. The pure math of what you are saying is true. If paper wealth is destroyed by a change in attitude of the market (fear), then the same fiat currency can just as easily be created to replace the lost paper wealth. The hard assets remain the same. It is only how they are valued that has changed.
Price is all about attitude, or better yet, expectations. In the 1970s, the big challenge was to break the reinforcing cycle of “inflationary expectations”. With unionized labor a large component of end product cost, the more inflation was expected, the more the unions demanded in Cost of Living Adjustments (COLA). Product price was increased to pay for the increase labor costs. The cycle would repeat and inflation accelerated. This went on until Paul Volcker hit the brakes by shutting down the money supply (by aggressively selling Treasuries) and jacking interest rates to 20% in the process. From that point in 1980 until now, the trend in money supply growth and interest rates has been down until we are now at negative money growth or deflation (the Treasury has been aggressively buying bonds until very recently, eliminating 30 year bonds altogether in the process).
The way out is to increase money supply faster than asset deflation is destroying it. Ben Bernanke is doing just this. Deflation will be stopped by 2010 as surely as inflation was stopped in 1980. But it will eventually bring about the opposite problem, which is what worries a lot of readers of this blog.
Just as paper or financial assets were the place to be during the 30 year period of money supply contraction, hard assets, including gold, are the place to be during a period of money supply expansion. It is also prudent to invest away from the dollar which will depreciate against currencies from countries that have a wealth of natural resources, like Canada and Australia, or that run a large trade surplus, like China.
So, I think most of the readers and writers here are correct in their analysis, but inflation is nothing to fear, as long as one is prepared. The doomsday scenarios (requiring guns) are much more likely in an extended period of deflation (like the 1930s), than in a period of inflation, so long as it stays under 10%, which is manageable.
IMHO