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    Default Lessons of the American Lost Decade – Part 1: The gold bugs were right - Eric Janszen

    Lessons of the American Lost Decade – Part I: The gold bugs were right
    Victory is sacrifice, sacrifice is continuity, continuity is tribulation.
    -Jack Kirby
    Imagine you were knocked over the head in 1999 with the December issue of the Red Herring magazine. It weighed in at two pounds, such was the demand for advertising in that west coast technology bubble catalogue at the time. The NASDAQ had climbed over 4000, the S&P500 near 1500, and gold averaged $283 that month.

    You wake up ten years later in the hospital. The nurse left today’s Wall Street Journal by your bed. You pick it up. It’s dated Dec. 31, 2009.

    Holy cow! You’ve been in a coma for ten years. Then you spy the headline “2009: Banner Year For U.S. Stocks” and you smile.

    Whew! You may have been out of it for a decade but at least your portfolio, heavy in tech stocks and the S&P500, kept growing as you slept.

    Then you start to read the story.

    S&P500 1123?

    NASDAQ 2285?

    After ten years?!

    You drop the paper on the floor.

    Banner year? Shit, you think. If they call stocks ending the year lower than ten years ago a “banner year” you’d hate to see what they call a “bad year” these days.

    Slack jawed you look down at the paper now strewn on the floor. Your eye wanders to a small story on page 32: The price of gold is $1095.

    What the hell? Did the world end?

    You crawl out of bed to the window, expecting bomb craters in the street. Instead, zombie shoppers plow the sidewalks with white wires spouting from their ears, pods in their pockets.

    You stagger across the room, climb onto a chair and, from a black metal bracket on the wall, you rip an object that looks like a TV, only flatter. You grab it firmly in your hands and, in one sweep, clobber yourself over the head with it.

    Maybe in another ten years your portfolio will be back to where it was so you’ll have a hope of paying your hospital bill.

    Good decade for gold, bad decade for just about everything else

    In our analysis, the story of the past ten years is told in the price of stocks and gold. We start our journey with a review of articles recently published in Project Syndicate by two economists I respect, Nouriel Roubini and Harvard’s Martin Feldstein. Each weighed in on the topic of gold as an investment in articles. These two fine economists address the question, “Should I buy gold at a historically high price?”

    Feldstein approaches the question from a long-term perspective while Roubini focuses his analysis on the recent past, since 2008. Readers asked for my opinion on these articles. Parts I and II are my response.

    Part III pours over ten years of stock and gold market data to answer the questions:
    • Whether our gold investments are down 10% or up more than 300%, should we buy more, hold, or sell?
    • What’s in store for 2010?
    • Might the year 2010 be the first since the year 2000 that gold finishes the year below its opening price?
    • What might that mean for stock and bond prices?

    Taken together, the review of Feldstein’s and Roubini’s articles, and our review of the past ten years of stocks versus gold, draws us to the inescapable conclusion that for the decade that began in the year 2000 the gold bug hypothesis was the right one: stocks, bonds, and real estate did, net of asset price inflation and deflation, performed worse and with higher volatility than the barbarous relic.

    Part I: “Is Gold a Good Hedge?” by Professor Feldstein reviewed
    Part II: “The Gold Bubble and the Gold Bugs” by Nouriel Roubini reviewed
    Part III: Will the year 2010 be the first in a decade that is worse for gold than for stocks?

    We start with Professor Feldstein’s analysis “Is Gold a Good Hedge?”

    Feldstein follows the script of well-meaning gold investment advice that we have read since 1998 when we began to investigate gold in earnest, and three years before jumping into the gold market in 2001. The script covers five main points to warn potential investors away from gold:

    • Gold does not earn interest or dividends, as do stocks and bonds
    • The gold price does not reflect underlying earnings, as do stocks and bonds
    • The gold price is not determined by supply and demand fundamentals as are other commodities, like copper or silver
    • Gold prices are volatile, compared to stocks and bonds
    • Gold investing is risky, compared to stocks and bonds

    The first point is irrefutable, but the second is only half true—and it’s the untruthful part of it that will get you.

    The gold price does not reflect underlying earnings, but then again since approximately 1995 stock and bond prices have not reflected underlying earnings either, but rather monetary and economic policies intended to produce continuous asset price inflation in stocks, bonds, and real estate. Result: the two largest asset bubbles in world history since 1998. Today stock, bond, and real estate prices are heavily influenced by monetary and government policy aimed at helping the economy recover from the aftermath of these two bubbles, so they are still not driven by fundamentals any more than they were when government policies created the bubbles in the first place. Some day they will be. At that point we will re-enter the stock market.

    As to the third point, that the gold price is not determined by supply and demand fundamentals as are other commodities, this is also true. But if not industrial and other forms of so-called “fundamental” demand, what keeps gold prices above zero? Our conclusion in 2001, and the primary reason we bought gold then, is that the ownership of gold by central banks of more than 20% of all gold ever produced—and no other commodity besides gold—gives gold its unique role as part globally traded commodity, part global currency. The gold price is a function of the value of gold in that unique role.

    The last two assertions are simply incorrect in fact, as we demonstrate.

    To the five main elements of the common gold investment warning script, Feldstein adds two more: gold does not effectively hedge either inflation or a weak dollar, two assertions that are easy to disprove.
    As I walked through the airport in Dubai recently, I was struck by the large number of travelers who were buying gold coins. They were not reacting to Dubai’s financial trouble, but rather were joining the eager rush to own gold before its price rises even further. Such behavior has pushed the price of gold from $400 an ounce in 2005 to more than $1100 an ounce in December 2009.
    Gold prices have risen every year since 2001, so why measure the beginning of the rise in the gold price starting arbitrarily in 2004? The gold price increased from $260 an ounce in May 2001 to more than $1,200 an ounce in December 2009, a factor of four over eight years, not a factor of three over five years. Selecting 2005 as a starting date understates both the duration and the extent of the gold price gain. As we step through Feldstein’s article, we find that the selected time period used in the analysis produces results that support the author’s argument that gold does not hedge inflation or currency depreciation. If the entire period of the free market in gold in the US since 1975 is used, the data lead to the opposite conclusion.

    The author also makes the mistake of expanding personal observations into broad generalizations about the gold market. For example, in his opening paragraph, how does Feldstein know that travelers at the Dubai airport on his recent visit were in fact buying more not less gold than before? If he had been to Dubai several times over the past few years he may be able to estimate that gold purchases had increased or decreased since his previous visits. He then generalizes the motivation of all gold purchasers from that single observation, to “join the rush to own gold” rather than in response to the Dubai debt crisis.

    A google search turned up a dozen articles published between November and December 2009, such as “Debt fears keep Dubai retail gold sales stagnant” in Arab News, that tells us that the debt crisis has in fact affected gold demand locally—by reducing not raising it. Articles in the Dubai business press that we located blamed lower gold sales in recent months on the poor business climate, especially reduced tourism.

    These articles do not distinguish between gold bullion and gold jewelry sales. Gold jewelry and bullion are separate and distinct markets in Dubai, as they are everywhere in the world, the former driven by demand by consumers of gold for ornament and latter of gold by investors to hedge inflation, currency depreciation, and other capital losses.

    Here in the US, the gold jewelry and bullion markets are split between low and high income and net worth groups. As middle class families sell gold jewelry to raise cash to pay the bills in our stagflationary depression (high unemployment, stagnant wages, high and rising goods and services prices, high and rising taxes, and soon to be rising interest rates), wealthy households buy gold bullion to hedge future inflation and a weak currency, two typical long-term problems for nations that run large fiscal deficits combined with a large external debt.

    Building on the speculation that gold bullion demand is up in Dubai and is attributable to irrational herd mentality rather than the rational desire to hedge inflation and currency risk, the author goes on to generalize this irrational behavior as the force that caused the gold price to rise since 2004 in totality.

    The opening paragraph serves to cue the reader that the rest of the article promises to confirm the biases of the author’s target audience, readers who do not own gold and want to be reassured that their decision to not buy gold at a lower price over the past eight years continues to reflect sound judgment even though the price has increased more than ten times the nominal price of the S&P 500 since 2001, stocks being the primary alternative investment proposed by the author.

    As long term gold investors, we favor gold analysis articles that help us decide whether or not to buy more gold, hold it, or sell it over articles that assume that we have accepted the standard arguments against buying gold and have not already experienced significant gains.
    Individual buying of gold goes far beyond the airport shops and other places where gold coins are sold. In addition to buying coins minted by several governments, individuals are buying kilogram gold bars, exchange-traded funds that represent claims on physical gold, gold futures, and shares in gold-mining companies that provide a leveraged position on the future price of gold.

    And gold buyers include not just individuals, but also sophisticated institutions and sovereign wealth funds. Recently, the government of India purchased 200 tons of gold from the International Monetary Fund.
    The recent addition of institutional and government gold purchasers to the gold market signals a significant change in the gold market since 2001. Kudos to Feldstein for mentioning this development, which we rarely see noted in articles of this type, but we wish he’d commented on the possible implications of it because, as gold investors, we want to understand how the gold market is evolving over time from as broad a range of perspectives as possible.
    Many gold buyers want a hedge against the risk of inflation or possible declines in the value of the dollar or other currencies. Both are serious potential risks that are worthy of precautionary hedges. Although inflation is now low in the United States, Europe, and Japan, households and institutional investors have reason to worry that the low interest rates and the extensive creation of bank reserves could lead to inflation when economic recovery takes hold. And the declining value of the dollar – down more than 10% against the euro in the past 12 months – is a legitimate cause of concern for non-US investors who now hold dollars.

    But is gold a good hedge against these two risks? Will gold maintain its purchasing power value if inflation erodes the purchasing power of the dollar or the euro? And will gold hold its value in euros or yen if the dollar continues to decline?
    Feldstein argues that while a weakening dollar and inflation present real risks to investors, gold does not hedge these risks well. He selects the period after 1980 to make his point about the ineffectiveness of gold as an inflation hedge. This date selection guarantees data that show a low correlation between the gold price and inflation.
    Consider first the potential of gold as an inflation hedge. The price of an ounce of gold in 1980 was $400. Ten years later, the US consumer price index (CPI) was up more than 60%, but the price of gold was still $400, having risen to $700 and then fallen back during the intervening years. And by the year 2000, when the US consumer price index was more than twice its level in 1980, the price of gold had fallen to about $300 an ounce. Even when gold jumped to $800 an ounce in 2008, it had failed to keep up with the rise in consumer prices since 1980.
    The US dollar gold market began in 1975, two years after gold was de-linked from the global monetary system and the year that laws forbidding gold ownership by US citizens were repealed. Before 1975, no dollar market in gold existed in the US; governments set the gold price and US citizens could not own it. After 1975, markets not governments set the gold price. An analyses of the dollar gold market that hopes to draw on the history of the entire period of the dollar market for gold starts in 1975, not arbitrarily in 1980 or any other year.

    If we take the gold versus inflation analysis back to 1975, the data contradict Feldstein’s assertion that gold does not rise and fall with inflation, and thus does not hedge inflation.

    In the year before and immediately after gold bullion ownership was legalized in 1975, shown as A in the chart, CPI fell by half from over 10% to under 5% while the gold price fell 40% from $180 to $110 over the same two year period. Then, as inflation picked up again between 1976 and 1980 and peaked at 13% in 1980, shown as B above, the gold price increased nearly eight fold to over $800.

    Then the Federal Reserve raised interest rates to a level considerably higher than the CPI rate starting in 1979. This created positive real interest rates, that is, interest rates that were higher than the prevailing inflation rate. This causes money and credit to contract in the economy.

    To understand why, imagine an interest rate of 10% on a loan to buy a car, versus the average of 6.8% for a five-year new car loan today. Would you buy one? You know inflation today is far less than 10%, because the statistics you read say so and because you observe that prices of the goods and services you buy are not going up that quickly. You believe a 12% loan is expensive. But in 1979 the average person experienced inflation at a rate of more than 13%. An auto loan of 10% was cheap money at the time.

    Now imagine car loans rise to 20% following the short-term rate hikes by the Federal Reserve when inflation was officially 13%. Short-term interest rates would then be seven percent over the rate of inflation. The Fed engineered drastically such high positive interest rates in 1980 to make borrowed money expensive, to reduce borrowing and contract the money supply. As money went from cheap to expensive, credit and money shrank in the economy, and unemployment increased while demand and inflation declined. Gold prices plummeted as shown in C.

    After the 1980 to 1983 period when the Fed attacked high inflation with high interest rates, inflation has remained tame ever since, in the range of 2% to 3% with a brief excursion in the 6% range in the early 1990s.

    Feldstein, by selecting the period after 1980 for his comparison of inflation to gold prices analyzes the portion of the dollar free market era when virtually no inflation existed for gold to correlate to. The observation that gold did not track inflation in the period since 1980 when inflation has been below about 4% leads Feldstein to the erroneous conclusion that gold does not track inflation under any circumstances. In the period before 1980 when inflation reached double-digit levels, gold in fact did correlate to inflation, in both directions, up and down, and owning gold before the inflation occurred protected investors from the effects of inflation.

    Now that we have established that gold indeed hedged dollar price inflation in the past, the question remains, will gold protect investors from inflation again if inflation returns to the US, and are there effective alternatives?

    The relationship between gold prices and inflation throughout history is 100% consistent. The US experience with inflation between 1971 and 1980 is not unique. We cannot find a single instance of inflation increasing in a national currency and gold prices not also rising in that currency. There is no evidence that gold prices will not rise to hedge inflation in the future as effectively gold hedged inflation in the US between 1975 and 1980.

    Is there a better way to hedge inflation in the future than by owning gold? Feldstein, after concluding that gold is a poor inflation hedge based on gold’s performance during a period of low inflation, suggests TIPS are better.
    So gold is a poor inflation hedge. Moreover, the US government provides a very good inflation hedge in the form of Treasury Inflation Protected Securities (TIPS). A 10-year inflation-protected bond will not only provide interest and principal that keep up with the CPI, but also now pays a real interest rate that is now slightly more than 1%. And, if the price level should fall, a newly issued TIPS bond will return the original nominal purchase price, thus providing a hedge against deflation. Of course, investors who don’t want to tie up their funds in low-yielding government bonds can buy explicit inflation hedges as an overlay to their other investments.
    There are two major problems with TIPS as an alternative to gold as an inflation hedge.

    The first problem is that there is no guarantee that the return on inflation-adjusted bonds will reflect the actual rate of inflation. In fact, when an investor needs the most protection from inflation, itself the result of government policy, that government has the greatest incentive to reduce its exposure to costs produced by the inflation.

    One of the ways governments can reduce inflation-related costs, reflected in both the nominal and inflation-adjusted yield on TIPS, is by changing the composition of the inflation index that measures inflation. (I recommend the 1980 paper “Consumer Price Index and the Measurement of Recent Measures of Inflation” by Alan S. Binder in which he explains how the CPI understated inflation in the late 1970s. His paper helps explain why the Fed determined that short term rates above 20% were necessary to create positive real interest rates to tame inflation that was reported as 13% in 1979—because the Fed knew that the bond markets believed that the true rate of inflation was higher than the reported 13%.)

    According to a Treasury Borrowing Advisory Committee report issued September 2008, TIPS have cost taxpayers an extra $30 billion since 1997 when the Treasury began to offer them. By their estimation, TIPS have over-compensated investors for inflation during the period of low inflation between 1997 and 2008. To lower costs in the future, the committee recommended eliminating 5-Year TIPS and reducing TIPS issuance. If these recommendations are followed, this will cause the price of TIPS to rise and yields to fall. This leads to the second problem with TIPS.

    The Committee report reveals the fact that governments are motivated to make TIPS a money-saver for the Treasury—that is the point of TIPS—and conversely a money-loser for investors hoping to hedge inflation. The Treasury wants to reduce the return on TIPS to TIPS-holders, both by adjusting the inflation measure used to index TIPS and reducing supply, and will be most motivated to do so when demand increases as inflation rises.

    If inflation arises again, TIPS investors may receive some compensation for loss of purchasing power but less than is due them because the total return on the bonds may be below the true inflation rate. Gold, in contrast, tracks inflation directly as markets rather than governments decide how much inflation and currency risk actually exists, reflecting these in the gold price. The higher the inflation and currency risk, the higher the gold price. The lower the inflation and currency risk, the lower the gold price.

    While not a substitute for a market-based inflation hedge like gold, TIPS are certainly better than long dated nominal bonds in an inflationary environment. If an investor holds gold and thus is already significantly hedged against inflation and currency risk, the addition of TIPS may make sense. Still, we worry that in a dramatic currency and debt crisis as occurred in many debtor countries throughout history, the performance of TIPS is unknown. Only the UK, Australia, Canada, Sweden, the U.S., France and Italy offer TIPS, and none of these countries has experienced a debt and currency crisis since TIPS became available. Even if a more gradual inflation event occurred without currency volatility, as in the US in the 1970s, there is no way of knowing how TIPS will behave, as they were not introduced in the US until 1997. There is no historical data to guide us.

    Next Feldstein argues that gold is a poor hedge against a declining currency. Again, he picks the period after 1980 for his analysis rather than the entire free market gold period since 1975.
    Gold is also a poor hedge against currency fluctuations. A dollar was worth 200 yen in 1980. Twenty-five years later, the exchange rate had strengthened to 110 yen per dollar. Since gold was $400 an ounce in both years, holding gold did nothing to offset the fall in the value of the dollar. A Japanese investor who held dollar equities or real estate could instead have offset the exchange rate loss by buying yen futures. The same is true for the euro-based investor who would not have gained by holding gold but could have offset the dollar decline by buying euro futures.
    By confining the analysis to the 25 years since 1980, treating the entire 25 years as a single period, and comparing gold to the euro and yen versus a broad basket of currencies, Feldstein repeats the error that he made in his inflation analysis. If we start our analysis of the correlation of gold and the dollar at the time the dollar gold market began in 1975, rather than arbitrarily in 1980, and compare the dollar to a widely used index of currencies rather than confining ourselves to only euro and yen, a very different conclusion than Feldstein’s results.

    Before 1980, gold prices correlated to inflation and not to the exchange rate value of the dollar. During the 1970 to 1980 period, inflation was high and dollar volatility was low. Between 1980 and 1985, the gold price correlated with both falling inflation and the rising dollar as both were driven by radical Federal Reserve anti-inflation policy that produced two severe recessions. After 1985, once the dust from two recessions settled, gold prices correlated to the dollar but not to inflation, because there was no inflation while the dollar exchange rate fluctuated significantly.

    The chart above shows the price of gold since 1973 versus a common dollar index. Six distinct periods, A through F, can be easily identified.
    A: From the beginning of the dollar market in gold in 1975 until 1980, gold prices correlated to inflation but not the dollar as inflation ranged from a low of 4.5% to a high of 13%.
    B: From 1980 to 1985 as the dollar strengthened from 100 to 140, the gold price fell from a monthly price of over $600 to around $300. A long period of low inflation began.
    C: From 1985 to 1988 the dollar weakened from 140 to 90 while gold prices increased from $300 to over $400.
    D: The 1987 to 1995 period was characterized by benign inflation and low dollar volatility. The dollar ranged near 90 and gold near $300.
    E: From 1995 to 2002 the dollar strengthened to 110 and the gold price fell to $260, ending a more than 20 year long period of decline that began in 1980.
    F: Since 2001 when we theorized a long-term decline in the dollar and bought gold, the dollar has fallen to a low of 70 and gold to a peak of $1212.
    The data clearly show a correlation between the gold price and the dollar since 1980. In periods when the dollar weakened, the gold price increased, and when the dollar strengthened gold prices fell.

    The period of the dollar decline since 2001 has been especially good for gold investors. Gold prices increased nearly four fold while the dollar fell by 40%.

    Feldstein asserts that gold does not hedge currency declines. Our analysis shows easily obtained and clear evidence to the contrary, that gold has correlated to the dollar exchange rate in five distinct periods of increases and declines during the extended period of dollar exchange rate fluctuations since 1980.

    If gold does not hedge currency risk, what alternative to gold does Feldstein suggest?
    In short, there are better ways than gold to hedge inflation risk and exchange-rate risk. TIPS, or their equivalent from other governments, provide safe inflation hedges, and explicit currency futures can offset exchange-rate risks.
    Currency futures are not a practical hedge against a declining dollar for most investors. While gold can be held for long periods to hedge a declining dollar, such as between 2001 and today, currency futures contracts have to be purchased with a specific timeframe in mind. This requires investors to time the period of currency weakness. We believe this is impractical for the average investor, and even for professional fund managers.

    Feldstein’s argument that gold does not correlate to the dollar exchange rate leaves him without a way to explain why the gold price has in fact risen coincident with the decline in the dollar since 2001. Instead he suggests that the price rise itself identifies gold as a good investment that provides “diversification in a portfolio of stocks, bonds, and real estate.”
    Nevertheless, although gold is not an appropriate hedge against inflation risk or exchange-rate risk, it may be a very good investment. After all, the dollar value of gold has nearly tripled since 2005. And gold is a liquid asset that provides diversification in a portfolio of stocks, bonds, and real estate.
    Feldstein does not explain how gold provides portfolio diversification. We believe that the data going back to 1975 reveal that gold diversifies a portfolio from inflation and currency depreciation, the very risks he claims gold does not hedge.
    But gold is also a high-risk and highly volatile investment. Unlike common stock, bonds, and real estate, the value of gold does not reflect underlying earnings. Gold is a purely speculative investment. Over the next few years, it may fall to $500 an ounce or rise to $2,000 an ounce. There is no way to know which it will be. Caveat emptor.
    Feldstein asserts in his conclusion that gold is high-risk and volatile investment, but this conclusion does not follow either from his own analysis or from the actual data.

    Risk and volatility are relative. To say gold is risky and volatile is to say that gold is more risky and volatile than the alternatives he suggests: stocks, bonds, and real estate.

    Again, the data tell a different story.

    From 2001 to 2009, during the period of gold’s rise, the gold price has on an annual basis varied far less than the S&P 500, ranging from +20% to -3% while the S&P 500 ranged from +22% to -38%. In every year since 2001, gold has finished higher. The S&P 500 has ended the year lower in three out of the same eight years. Both bonds and real estate have also been more volatile than gold over the period. We are at a loss to understand from Feldman’s analysis how gold can be characterized as risky and volatile when we the alternatives suggested performed far worse and with more volatility than gold.

    Feldstein asserts that gold is a purely speculative investment. But we ask has gold been more speculative than stocks have been during and since the 1996 to 2000 stock market bubble, than real estate during and after the 2002 to 2006 housing bubble, or than bonds since 2008 when the US government, foreign governments, and commercial banks began to purchase trillions of dollars of US Treasury bond issuance in a bid to stimulate the economy in the wake of the collapse of the stock and housing bubbles?

    It is true that the price of gold does not represent underlying earnings as stocks, bonds, and real estate do, at least historically. But this gets to the heart of the matter, one of the reasons why the gold price has risen since 2001 while stocks went nowhere. It is also the primary reason why we invested in gold in 2001 and have stayed out of the stock market since 2000: stocks, bonds, and real estate have not reflected underlying earnings since the sequence of asset bubbles started in the late 1990s. Instead, they reflect government policy of asset price inflation via debt expansion, and politically directed tax subsidies and market deregulation.


    The data are irrefutable. When inflation is high, gold hedges inflation effectively. When the dollar is falling, gold hedges currency risk effectively. Feldstein asserts the opposite, instead recommending TIPS. TIPS, while better than nothing at protecting investors against the kind of inflation that caused gold to shine between 1975 and 1980, a period his analysis ignores, are subject to manipulation by governments who hold all the cards via control of inflation indexes and the bond supply. Currency futures, Feldstein’s recommended alternative to gold as a dollar hedge, are too complicated for the average investor to use effectively.

    In the end Feldstein cannot decide whether gold is more likely to fall to $500 an ounce or rise to $2,000 an ounce and advises “caveat emptor.”

    We asked virtually the same question back in 2001 when gold traded at $270:
    “Gold is now trading near 13% of its inflation-adjusted peak price of US$1,973 whereas U.S. stocks as a class are trading at a premium never before seen, even after recent declines. It's possible that the price of gold will fall the remaining 13% to zero and the DOW to 36,000 in the next few years. But is the collapse of the price of gold the remaining 13% toward zero more or less likely than a return of stock prices to their mean P/E ratios and a counter-cyclical return of the price of gold toward a price ratio closer to one to one from the current ratio of 37 to one?”
    Our answer then was that gold is unlikely to fall further and is likely to rise. Our decision to buy gold in August 2001 when gold traded at $270 was not specifically to hedge either inflation or a weak dollar, although we did expect that either or both to follow directly or indirectly as a consequence of bad economic policy and political leadership that produced the cycles of asset price inflations and deflations, and dependency on asset price inflation for economic “growth.”

    Ever since 2001 we have watched obsessively for reasons to sell gold. Sadly, we are repeatedly confronted with new reasons to either hold or buy even more.

    Since 1998 we have lived through two asset bubbles that grew and collapsed under Democratic and Republican administrations, two recessions after each collapse, two government financed periods of re-inflation that followed each bubble collapse and recession, two wars, a $4500 “Cash for Clunkers” auto purchase subsidy, the $8000 home purchase subsidy, trillions in bank bailouts, billions in bonuses for bankers—the list goes on and on, with no end in sight.

    To us, the first piece of evidence that the US economy was in serious trouble was the emergence of the housing bubble in 2002 following the stock market bubble. The second bubble told us that the first was not an anomaly but a politically motivated development.

    A political system that permits a housing bubble, as we observed at the time, is worse than dysfunctional. No nation has ever escaped the collapse of a housing bubble without a ruined housing market, crashed economy, and trashed banking system, as we noted in March 2006 when we re-opened iTulip to warn readers about what was coming. In the US case, due to the additional error of allowing investment banks into the commercial banking business via the manufacture and sale of securitized mortgage debt, we can add a collapsed financial market to the list of damages caused by the housing bubble.

    The errors compound, with the result an ever-increasing mountain of debt that cannot possibly be repaid out of the nation’s projected economic surplus without continued asset price inflations, which markets determined in 2001 were unsustainable as economic policy. The gold price reflects a gradual loss in ability of global private, and some public investors, in dollar denominated assets to suspend disbelief.

    We have tracked the gold price relative to stocks since 2001, and in Part III we investigate the price relationship between gold and stocks in detail to help us answer the question gold investors ask, “Should we sell, stay put, or buy more?

    Unfortunately, Feldstein’s analysis does not help us answer that question. To the original question, “Is Gold a Good Hedge?” we come to the opposite conclusion: “yes” it has been.

    In sum, not only are Feldstein’s answers to the question “Is Gold a Good Hedge?” wrong, but he asks the wrong question. The data and our own experience point us to a more relevant question, “Will Gold Continue to be a Good Hedge?" as it has during periods of either high inflation or a weak dollar since 1975.

    Roubini comes closer to asking the right question in his article “The Gold Bubble and the Gold Bugs,” reviewed next.

    Lessons of the American Lost Decade - Part II: “The Gold Bubble and the Gold Bugs” by Nouriel Roubini reviewed

    Roubini does not write about the effectiveness of gold as a hedge. Instead he asks if gold is a bubble. His premise, expressed in the title, is that anyone who invests in gold is a gold bug.

    We sympathize partially with Roubini’s antipathy toward gold bugs. We have had our run-ins with them over the years. They imbue gold with magical properties. They refer to gold as natural and honest money. They hate it when we tell them that gold became money when governments made it so, in order to collect taxes in a uniform medium that the subjects of the kingdom could not readily produce themselves—that required the wealth and power of the state to mine and refine—or in many instances, to steal from other governments.

    To gold bugs now is always the right time to own gold.

    To refer to everyone who argues for investing in gold as a gold bug is like calling everyone who eats lettuce a vegan. The kind of mislabeling that Roubini engages in leads to common misunderstandings of the gold market.

    Gold bugs are always in the gold market. The gold market only becomes interesting after non-gold bugs start to get into it. They do so kicking and screaming, one group after another, because the conditions of the political economy that draw non-gold bug gold investors into the gold market are grim and ugly political and economic developments that the average busy wage earner and fund manager wishes would simply go away. These result in two sadly predictable eventualities. Awareness of the risks dawns on gold bugs years before contrarian investors, before contrarian professional money managers, and before traditional investors. Sooner or later they dawn on everyone: bad economic and foreign political policy financed with debt will result in a depreciated currency, inflation, or both.

    The following graph depicts the accumulation of classes of investors in the gold market over time as the price rises. The proximate cause in the rise since 2001 is the dissolution of an economy organized around the interests of the finance, insurance, and real estate industries known as the FIRE Economy, the resulting loss of US global economic and political dominance, the emergence of unsustainable internal and external debt positions, and with these developments the so-far gradual and orderly restructuring of the global monetary system around multi-lateral global political and economic power.
    If all gold investors are gold bugs, did central bankers and pension fund managers now in the gold market suddenly turn into gold bugs?

    Setting aside the dubious premise of Roubini’s argument that only gold bugs are in the gold market, we move on to the rest of his case that gold is a bubble.
    Gold prices have been rising sharply, breaching the $1,000 barrier and in recent weeks rising towards $1,200 an ounce and above. Today’s “gold bugs” argue that the price could top $2,000. But the recent price surge looks suspiciously like a bubble, with the increase only partly justified by economic fundamentals.
    Gold prices rise sharply only in two situations: when inflation is high and rising, gold becomes a hedge against inflation; and when there is a risk of a near depression and investors fear for the security of their bank deposits, gold becomes a safe haven.
    Roubini is half right where Feldstein is 100% wrong. He notes that the gold price does rise with high and rising inflation—high and rising, as in the 1975 to 1980 period, not low and not rising, as during the post 1980 period that Feldstein examines to come to the wrong conclusion about gold and inflation.

    Yet Roubini constrains his time period of examination even more than Feldstein does, to the past two years and misses the lessons learned over the long history of the gold market. He explains the gold price rise over the past two years to the desire of investors to protect the security of their bank deposits. Again, does this group include institutions and central bankers? What about the price rise before and after the banking crisis?
    The last two years fit this pattern. Gold prices started to rise sharply in the first half of 2008, when emerging markets were overheating, commodity prices were rising, and there was concern about rising inflation in high-growth emerging markets. Even that rise was partly a bubble, which collapsed in the second half of 2008, when – after oil reached $145, killing global growth –the world economy fell into recession. As concerns about deflation replaced fear of inflation, gold prices started to fall with the correction in commodity prices.
    Gold prices did rise sharply in early 2008, but they also rose sharply in 2006, and several other times since 2001 if by “sharply” we mean as much and as quickly as in 2008.

    Each time the price rise was dubbed a “bubble” by more than a few commentators, it recovered to rise to new highs.
    The second price spike occurred when Lehman Brothers collapsed, leaving investors scared about the safety of their financial assets – including bank deposits. That scare was contained when the G-7 committed to increase guarantees of bank deposits and to backstop the financial system. With panic subsiding towards the end of 2008, gold prices resumed their downward movement. By that time, with the global economy spinning into near-depression, commercial and industrial gold use, and even luxury demand, took a further dive.
    Again, the data tell the opposite story. At the peak of the panic as evidenced by high market volatility toward the end of 2008, gold prices did not rise on panic buying but fell as leveraged positions in gold were closed along with leveraged positions in all assets. At the peak of market volatility in October 2008, gold prices fell hard along with stocks.

    This was the gold price correction that we were expecting in 2008, although it did exceed our forecast of $780 by 10%, falling to $715.

    On October 23, 2008 Roubini said in an interview, “So all the gold bugs who say gold is going to go to $1,500, $2,000, they’re just speaking nonsense. Without inflation, or without a depression, there’s nowhere for gold to go. Yeah, it can go above $1,000, but it can’t move up 20-30 percent unless we end up in a world of inflation or another depression. I don’t see either of those being likely for the time being. Maybe three or four years from now, yes. But not anytime soon.”

    At the time of his interview, gold traded at $720. Gold defied Roubini’s forecast by rising not 20% or 30% but 40% within 14 months, and without evidence of either “high and rising inflation” or a depression. More than a year later, Roubini asks why.
    So, with no near-term risk of inflation or depression, why have gold prices started to rise sharply again in the last few months?

    There are several reasons why gold prices are rising, but they suggest a gradual rise with significant risks of a downward correction, rather than a rapid rise towards $2,000, as today’s gold bugs claim.

    First, while we are still in a world of global deflation, large, monetized fiscal deficits are fueling concerns over medium-term inflation. Second, a massive wave of liquidity, via easy monetary policy, is chasing assets, including commodities, which may eventually stoke inflation further. Third, dollar-funded carry trades are pushing the US dollar sharply down, and there is an inverse relation between the value of the dollar and the dollar price of commodities: the lower the dollar, the higher the dollar price of oil, energy, and other commodities – including gold.

    Fourth, the global supply of gold – both existing and newly produced – is limited, and demand is rising faster than it can be met. Some of this demand is coming from central banks, such as those of India, China, and South Korea. And some of it is coming from private investors, who are using gold as a hedge against what remain low-probability “tail” risks (high inflation and another near-depression caused by a double-dip recession). Indeed, investors increasingly want to hedge against such risks early on. Given the inelastic supply of gold, even a small shift in the portfolios of central banks and private investors towards gold increases its price significantly.

    Finally, sovereign risk is rising – consider the troubles faced by investors in Dubai, Greece, and other emerging markets and advanced economies. This has revived concerns that governments may be unable to backstop a too-big-to-save financial system.
    Roubini itemizes several plausible yet unverified reasons for the rising price of gold since March 2009, contrary to his October 2008 view. We don’t agree with all of them. For example, the assertion that we are still in “a world of global deflation” is contradicted by the fact of $80 oil and we have yet to see evidence that a dollar-funded carry trade exists, never mind one on a scale that is capable of driving the dollar down. We believe a gross external debt of 94% of GDP, a fiscal deficit in excess of 11% of GDP, and no prospect of growing our way out of debt within the current global monetary and trade structure without a new asset bubble are the relevant factors pressuring the dollar.

    Roubini then returns to the script: gold has no intrinsic value, etc.
    But, since gold has no intrinsic value, there are significant risks of a downward correction. Eventually, central banks will need to exit quantitative easing and zero-interest rates, putting downward pressure on risky assets, including commodities. Or the global recovery may turn out to be fragile and anemic, leading to a rise in bearish sentiment on commodities – and in bullishness about the US dollar.
    If gold has no intrinsic value, then nothing has intrinsic value. Value is determined by market demand, and market demand is a function of economic utility. A commodity with no economic utility has no demand, no value and a price of zero. Sand in the middle of a desert, for example. Obviously gold must have some utility to keep the price above zero. The logical question, then, is what is the utility of gold? It has long been our position that, as the only commodity held by central banks, the utility of gold is as a fallback currency. Its value as a monetary asset rises as the need for gold as a substitute for the US dollar in the global monetary system increases, and we expect it to peak as the dollar-centric monetary system edges toward dissolution, orderly or otherwise.

    Roubini also repeats the common assertion that gold is a “risk asset.” Our one word definition of risk: expensive. To further refine the definition, “risky” means “expensive” in historical measures. By this definition, gold, commodities, stocks, and US Treasury bonds are risky, but not equally risky; further refinement of the definition is needed. Whether an asset is expensive or not also depends on the unique qualities of that asset and its economic value that may be much higher that historical norms indicate, due to unprecedented developments in the macro-environment.

    For example, Microsoft stock at many times in the history of the company appeared to be overpriced, even a bubble. Investors sold the stock when they feared it was too pricey, which it appeared to be many times. Who knew in 1988 that the stock was due to split nine times? In hindsight, if investors foresaw the growing and enduring monopoly pricing power of the MS operating system, and critical business applications built on top of it, they’d have foreseen both extraordinary growth and profit rates as sustainable--at least until Google came along.

    A similar rule applies to gold as the only commodity that central banks possess to diversify dollar risk. Roubini does not appear to understand that gold’s utility, and thus its value, is as the only trusted dollar substitute in the monetary system, and that as the only substitute for the dollar its price is subject to monopoly pricing. The gold price has virtually no upside limit as long as three conditions are met: one, gold remains the only commodity on the balance sheets of central banks; two, global economic and political conditions trend toward a reduced role for the US dollar in global trade; and three, no politically or operationally viable alternative to gold—not SDRs, not euros, not yen—exists.

    Roubini goes on to predict that the next tightening cycle will bring down gold prices. We don’t know why he believes this. Data that reveal the opposite relationship are not hard to obtain or interpret. Consider the impact of the previous cycle of interest rate hikes on the gold price since 1993.

    The gold price increased from under $400 to over $600 as the Fed raised short-term rates from 1% to 5.25% between 2003 and 2006.

    As we have noted in the analysis of Feldstein’s article, gold responds not to increases in interest rates but to real interest rates. Does Roubini believe that the Fed will soon be in a position to engineer an environment of positive real interest rates, while 11.3% of GDP fiscal deficits are needed to maintain unemployment above 9% as the housing market continues to weaken?
    Another downside risk is that the dollar-funded carry trade may unravel, crashing the global asset bubble that it, together with the wave of monetary liquidity, has caused. And, since the carry trade and the wave of liquidity are causing a global asset bubble, some of gold’s recent rise is also bubble-driven, with herding behavior and “momentum trading” by investors pushing gold higher and higher. But all bubbles eventually burst. The bigger the bubble, the greater the collapse.
    Roubini abandons his 2008 argument that only a global depression in 2009 will drive up gold prices more than 20% to 30% in favor of a new theory that a dollar carry trade and resulting asset bubble are raising gold prices. Paul Kasriel of Northern Trust debunked the notion of a dollar carry trade fueling a commodity bubble back in November.
    The recent rise in gold prices is only partially justified by fundamentals. Nor is it clear why investors should stock up on gold if the global economy dips into recession again and concerns about a near depression and rampant deflation rise sharply. If you truly fear a global economic meltdown, you should stock up on guns, canned food, and other commodities that you can actually use in your log cabin.
    Roubini does not provide evidence to support his argument that gold is currently a bubble, never mind one that is large or about to break. He does not establish causality between gold price moves and interest rate changes, or between gold price movements and recent financial market and economic events. He has made several gold price forecasts since 2008 that have failed to materialize.

    The log cabin reference in his conclusion reveals that Roubini has not kept up with developments in the gold market. Early in the market in the late 1990s it was fair to characterize the majority of gold investors as gold bugs who live in fear of global collapse. Do Russian, Indian, and Chinese central banks, the management of Northwestern Mutual Life Insurance Co. that purchased $400 million in gold in June 2009, among government and institutional investors who entered the gold market, fit the characterization of fearful hermits hiding in a cabin with guns and canned food?

    We have established with the analysis of hard data that gold performs well as a hedge against inflation when inflation is high and rising, and as a hedge against a depreciating currency. There is no evidence that gold is a bubble, but in Part III we attempt, as we did in March 2008, to identify a potential price correction target, should a price correction occur.


    The term “bubble” used to have a specific meaning that made it useful. It referred to a multi-year process of asset price appreciation that attracted an ever expanding group of participants into a sphere of influence based on false beliefs, promoted by the industry that manufactures the asset in question, disseminated by the asset manufacturing industry’s trade press, and enabled by government tax, regulatory, and monetary policy. Now it means little more than the instance of the price of an asset rising more rapidly and to a higher level than the observer can explain, which asset the observer very likely did not have the perspicacity to buy at a lower price. A wager that neither Feldstein nor Roubini own any gold is as safe a bet as any one can make, and I can think of no more reliable an indicator to help us time our sales of gold than learning that either Feldstein or Roubini is buying it.

    Gold is insurance against inflation and currency depreciation, but it is more than that. It is a lens through which shifts in the political economy, as they affect sovereign default risk and currency values, can be viewed. Gold is trying to show us something. If we watch carefully and without bias, changes in the gold price reveal profound forces of structural change that started in 2001, and accelerated in 2004.

    Neither Roubini nor Feldstein contribute meaningfully to our understanding of the drivers of gold prices since 2001--or before then, for that matter. They do not help us, as a group of gold investors who are anywhere from down 10% to up 400% on our gold investments, depending on when we purchased, decide whether to buy more, hold, or sell.

    In Part III we forecast gold for 2010, and in the process, the prospects for stocks and bonds as well.

    Lessons of the American Lost Decade - Part III: Better luck in 2010? ($ubscription)

    Will the year 2010 be the first in a decade when gold prices end the year below the year's starting price?

    • Ten years told in stocks versus gold
    • My bad stock market call
    • Stocks, bonds, and gold in 2010

    To the uninitiated, the fortunes of gold investors since 2001 looks like a warm and glorious Caribbean cruise compared to the wild and frigid Atlantic Sea storm whirl in the churn and spray of the stock, bond and housing markets, a near decade-long continuous party where the Champagne flowed like stock trade recommendations from firms that earn fees off stock trading. But for those of us aboard the ship of gold, the past nine years have not been entirely bromidic. High waves punctuated yearlong periods of boredom when the market was becalmed. No days or weeks spent leaning over the rail and puking like on the USS Stock Market, but gold ship passengers spent a few sleepless nights rolling in their bunks.

    Time plays tricks on the mind. We misremember the details. A careful recounting of the past decade of gold and stock prices orients us around the facts, to help us understand what happened, and give us insight into what we may see in the coming year. more... $ubscription

    Photo credits: Remnant of a winter storm outside iTulip offices Dec. 2009, with a minor modification, flowers blooming after the crash in May 2009.

    iTulip Select: The Investment Thesis for the Next Cycle™

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    Last edited by jimmygu3; 01-05-10 at 11:59 AM.

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