In what follows, we turn our eyes again to gold, that curious inert metal with the monetary heritage. The topic comes with baggage. It’s hard as an investor to look at it objectively. Many investors make a case for gold laden with ideological fury over the government’s printing press. These investors are always saying buy gold. Their arguments are timeless, but not timely.

Of course, buying gold all the time is not really an investment strategy. If you bought gold in the 1980s and 1990s, your return was abysmal. So, as with all assets, there are times when gold is a really good buy and there are times when it is not. Sounds obvious, but many people seem to want to think that gold is an exception to the order of things. It isn’t.

But how do you know if gold is cheap? Well, intelligent people usually advance a couple of arguments:

1) On an inflation-adjusted basis, gold is 30% less than its all-time high in 1980. Okay, that’s true, but it’s not particularly timely because by that measure gold has been cheap for three decades. And who’s to say that the 1980 gold price is a benchmark we should pay attention to, anyway? By that way of thinking, the NASDAQ is a bargain, too, because it trades at a big gap from its 2000 high. But is it? I think not.

2) The other point often advanced by the “gold is cheap” crowd is the old monetary base argument — that gold’s price tends to track the monetary base over long periods. The monetary base is essentially bank deposits and currency. It’s like the seedlings of inflation.

This second argument is a little more interesting. Yet, as the government has added huge piles to the monetary base in the last year or so, the gold price has responded in a muted way. This next chart shows what the gold price would have to be to “catch up” to the monetary base.

The hedge fund QB Partners really likes this argument. QB writes: 

“True capital has already begun to flow where it is being treated best — to capital-producing economies and to global stores of wealth, from paper money and financial assets to hard money and hard assets…

“The graph shows visually how much U.S. dollar purchasing power has been lost. We think gold is cheap by a factor of almost 7 times.”

If a gold price of $7,000 an ounce doesn’t strike you as implausible or absurd, QB’s next comment might. QB says the chart “does not necessarily imply a target price for spot gold. The gold price could move higher than that if it experiences a blow off top, like all other bull markets tend to do before exhausting themselves.” So, $7,000 an ounce, you see, is just some kind of base case.

Maybe it’s not so implausible. Strange stuff happens all the time in markets. If I had told you on May 6 that Accenture — a $40 stock with a $29 billion market cap — would trade for a penny a share the next day, you would have thought I was nuts. Yet, on May 7 it did just that, if only for a second.

As investors, we tend to think too narrowly within the confines of what seems probable. Yet, the really big money lies in the outlying events. As QB puts it:

Most investors allocate to the markets by playing the odds, which by definition gravitates capital to the middle of a bell curve of possible outcomes. This fools the investor into thinking that the probability of future events is somewhat predictable. Of course, history is rife with startling social, economic and political tail events. Stuff happens — things like earthquakes, the bombing of Pearl Harbor, the 1980 U.S. Olympic hockey team, the demotion of Pluto, dot-com bubbles, liar loans and even periodic global economic failures and the re-assertion of gold as money.

This is essentially the familiar “black swan” argument made popular by Nassim Taleb. This is really the best argument for gold in my view. It is a hedge against really bad stuff happening. And when really bad stuff happens, gold holds up.

Of course, over the last decade, it has more than held up. Gold has been the best-performing asset class from December 1999 to December 2010.

People often invest by looking in the rearview mirror. They feel better investing in stuff that has done well. Even professionals feel this way. It’s easier to recommend gold to your clients; all you do is show its price chart. Money follows performance, which is why so many investors get mediocre results. They hop into the hot fund or sign up for the hot newsletter just as it is about to go cold. They abandon apparent losing strategies and sell poor-performing stocks just as they are about to turn up.

But the gold market is different because it’s so small. Even a small amount of interest in gold will send it up a lot. Just imagine if people decide a small sliver of that tall bar of financial assets should be in gold. We’re talking about some serious pressure on the gold price.

Frankly, the gold market is set up perfectly these days. You couldn’t design it better. Bad stuff is happening — see the crisis in Europe. And you can surely bet more bad stuff will happen, given all the debt and leverage that still remains in the system. Even if you don’t know exactly what will happen or when it will happen, you know a monetary crisis is good for gold.

As an added bonus, gold has a track record, which will attract fans soon enough. And when it does, it can’t really accommodate many buyers because the market is small. This means the chance of the gold price spiking upwards are pretty good. It’s like being in the lifeboat business on the Titanic. No price will seem too high!

Regards,
Chris Mayer
Whiskey & Gunpowder

May 28, 2010

Monetary Crisis Could Lead to Wild Gold Spike was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

These assets — bonds backed by U.S. homebuyers with low (or no) incomes — had become utterly illiquid. No one would buy or lend against them, not at any price. And an asset you can’t sell or borrow against is worth precisely nothing.

The resulting mayhem? It would have sounded frivolous two years ago. But the subprime crisis caused the first run on a British bank in 130 years, a forced collapse in U.S. interest rates, and the fire sale of Wall Street’s fifth largest investment bank for just 16 cents on the dollar.

“[Now] it seems that the financial system is slowly working its way through this subprime shock,” writes Gillian Tett in the Financial Times. “The largest banks and institutions have written off almost $200 billion and raised more than $100bn-odd of capital to plug this gap.

“Indeed, the write-downs have been so vast that some analysts expect to see some write ups in the next set of results.”

Crisis over? That key marker of investor anxiety, the gold price, fell 15 percent from its top of mid-March to the end of April. The preceding surge had taken gold bullion up from $650 per ounce in August to above $1,030 the day after Bear Stearns was sold to J.P. Morgan.

The proximate cause for gold’s jump — and then setback — was the Federal Reserve’s decision to slash U.S. interest rates. Gold turned sharply higher as the Fed began cutting rates in Aug. ‘07. It only flagged when Fed policy-makers implied a pause in their war against the Dollar (albeit it temporary) seven months later.

That’s why a significant portion of new gold investment since last summer has gone into physical metal — owned outright — rather than simply into paper promises or credit arrangements.

What makes physical bullion stand out for the growing number of private investors choosing outright ownership instead? Gold futures or options would, after all, give them leverage to the gold price, super-charging their gains if they call the short-term direction correctly.

Repeated studies also prove gold’s safe-haven appeal on the basis of its “non-correlation” with securitized assets, such as equities and bonds. Gold prices move independently of the broader financial markets — neither together, nor in opposition. This lack of correlation makes gold a crucial component of any diversified portfolio.

Owning the metal outright — whether as gold coins in your pocket or large bars held securely in market-approved storage — takes you “off risk” with regards to the solvency of banks and brokerages. And it leaves you holding a highly liquid physical asset that’s instantly valued just by checking the gold spot price online.

“While the subprime shock may be ebbing,” continues Gillian Tett in the Financial Times, “the problem is that…as the U.S. economy slows, there is a good chance defaults will soon emanate from the corporate and consumer debt world.

“And the more that banks are forced to tighten credit as a result of the subprime mess or other losses, the greater the risk that this second wave of defaults will emerge — creating the risk of a vicious spiral.”

The current lull in the gold price says fewer investors are worried today. But only this week, Moody’s Investors Service — one of the three credit-ratings agencies now blamed for letting investment banks issue toxic subprime bonds as “triple-A” bonds — warned of a sharp rise in U.S. corporate-bond failures. It sees the default rate on low-rated junk bonds quadrupling to four percent by the end of this year.

Wherever the subprime shock has hit hardest, municipal debt also looks weak. Council members in Vallejo, California voted on Tuesday to file for bankruptcy, thanks in no small part to “house prices in Vallejo and the surrounding area falling some 26 percent on a year ago,” reports The Independent here in London. “The city is expecting $1.6 million less in property sales taxes.”

And all this while — 12 months on from the first trouble at UBS and Bear Stearns — the final cost of the subprime shock itself is still pending. Chairman of the Federal Reserve, Ben Bernanke originally put a $100 billion forecast. The International Monetary Fund (IMF) has since set the ceiling at $945bn.

But there are hidden costs too, as Bloomberg reports this week. Now State Street, the world’s biggest institutional fund manager, faces more than $625 million in lawsuit damages, for instance, after being sued by four insurance companies for putting their cash into subprime bonds without their approval.

Let’s imagine all of your wealth is sitting safely outside the next subprime-style blow up. A loss of confidence in one sector can still become a system-wide crisis. And the failure of subprime bonds to pay up should have reminded us all that counterparty risk remains very real, no matter how clever derivatives salesmen become.

A growing number of private investors, in contrast, would rather hold at least some of their wealth in a liquid, tradable asset, entirely free from the risk of default. What price they pay should depend on what they think will happen to interest rates.

But the value of gold as a portfolio back-stop remains hard to beat, even 15 percent below the last all-time high of mid-March.

Regards,
Adrian Ash
BullionVault
May 13, 2008

Hedging Risk with Gold was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Beached whales may have nothing to do with the world’s exhaustible supply of crude oil…or inexhaustible supply of dollars. But I see a connection…an ominous connection.

It is difficult to say how old she may have been, but certainly north of 50 years is a safe bet. Apparently, this whale was migrating along the coast of Southern California when a massive object, probably a cargo vessel, struck her.

The impact crushed numerous bones, including ribs and vertebrae, damaged her nervous system and caused significant internal hemorrhaging. There is evidence that the vessel dragged the whale through the water for some distance. Eventually, the whale succumbed to the injuries, died and washed ashore near Ventura, Calif., just northwest of Los Angeles.

The death of this particular whale brought the financial world into my consciousness with a certain shocking level of reality. There is actually an old school of thought, for example, that regards the discovery of a beached whale as a sinister portent…and so it may be.

In the 17th century, the English writer Thomas Hobbes (1588-1679) published numerous works that laid out much of the template for modern political philosophy. Among the most famous works by Hobbes was Leviathan (a fancy word for whale) — doctrine for the foundation of societies and legitimate forms of government, in which the state is portrayed as a whale-like monster.

In Leviathan, Hobbes articulates the necessity of a strong central authority to avoid the evil of discord and civil war. According to Hobbes, any abuses of power by this authority are acceptable as the price of peace. The sovereign must control civil, military, judicial and ecclesiastical powers. Hobbes argues that the sovereign has the authority to assert power over matters of faith and doctrine, and that if he does not do so he invites discord.

The use of the term “leviathan” by Hobbes was no mere random choice of words. Whales are large, beastly creatures that were reputed to swallow men whole (Jonah comes to mind). And according to Leviathan, life in the raw state of nature is “solitary, poor, nasty, brutish and short.”

So let’s play a little game. Let’s imagine that beached whales actually portend some kind of bad luck or grim event. What grim event, therefore, might the beached whale in Ventura County, Calif., portend? Allow us to suggest a couple of possibilities: Oil higher; dollar lower.

Oil and Energy

Oil has climbed to a record-high $92 per barrel. Why is the price rising?

The Peak Oil paradigm is beginning to gain traction. I have discussed Peak Oil extensively and often in my investment letter, Outstanding Investments. America’s Secretary of Energy and former Director of Central Intelligence James Schlesinger recently noted at an international conference on the subject of energy, “The battle is over, Peak Oil is now accepted as inevitable, and the debate only becomes as to when.”

This is a remarkable statement, coming from one of the most “inside” of U.S. political insiders. One of the long-term trends you can expect to see is that oil prices will remain high. Oil supplies will be precarious and subject to disruption by weather events, natural disasters, and fourth-generation warfare aimed at “systemic disruption.” Also, new discoveries will trail consumption. The global oil industry will extract at least three barrels of oil equivalent for every “new” barrel it finds via discovery of reserve growth.

So looking ahead, oil and natural gas in the ground, as booked reserves or realistic and exploitable resources, is more and more valuable. It also means that oil service companies with a lock on technology and the operational skills to create technological systems for extracting hydrocarbons are also more and more valuable.

The Feeble Dollar

Recently, the gold price jumped to a new high as the dollar flirted with new all-time lows. Gold’s strength highlights the ongoing decline in the value of the U.S. dollar via chronic, gross and ought-to-be-criminal monetary mismanagement. For example, on Tuesday, Sept. 18, the U.S. Federal Reserve cut its key federal funds interest rate by 0.5%, as if the big problem of the U.S. economy in recent years has been not enough cheap credit.

The Fed rate cut, as expected, made many Wall Street traders happy and goosed the stock market indexes. According to the Fed, “Developments in financial markets since the committee’s last regular meeting have increased the uncertainty surrounding the economic outlook.”

But the Fed action also caused an immediate spike in the prices for gold, silver and oil futures. So evidently, some savvy players understand that temporarily cheaper dollars are not necessarily good for the long-term health of the U.S. currency or economy, and this understanding is reflected in things with intrinsic value like precious metals and energy fuels. Even former Fed Chairman Alan Greenspan has stated that he believes that we will see double-digit interest rates at some time in the future in order to salvage the long-term value of the dollar.

Back to That Whale

So let’s get back to the beach in Ventura County. Within a few days of the whale’s discovery, the wildlife biologists had examined it and learned whatever they could discern from the necropsy. And for reasons of public health, the authorities had towed the carcass to an isolated spot on a different beach for as respectable a burial as is possible when using bulldozers. RIP, blue whale. The omen came, the omen passed.

But we know an omen when we see one. Do not let this whale perish in vain, dear investor.

Beware the false prophets of the conventional media who tell you that everything is fine and that there is plenty of oil (”if only we would drill in such-and-such locale,” goes the refrain), or that the dollar is sound. You need to understand that the energy supply of the U.S. — and the rest of the developed world — is in a precarious state.

We cannot just drill our way out of it. And you need to know that the situation with the U.S. dollar, the world’s reserve currency, is quite tenuous. We cannot just borrow and spend our way out of it. The government and monetary authorities, the “leviathan” of Thomas Hobbes, have overplayed their hands, abused their powers and are slowly but surely wrecking the long-term value of the dollar.

Sure, things may just drift along for a while like a dying cetacean hit by a cargo ship on the high seas. But sooner or later, the trends will manifest themselves and you will be glad that you have a portfolio filled with energy stocks and precious metals. As the old whalers used to say, “Thar she blows.”

Until we meet again…
Byron W. King

October 29, 2007

Beached Whales and Economic Omens was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.