Fashionable Financial Advice
Gold - September 2001
Note: gold prices are shown in this essay as both a nominal value with a real 1999 inflation adjusted value in parentheses, e.g., $400 in 1980 ($890.70).
Questioning Fashionable Financial Advice
In testimony before the Committee on Banking, Housing, and Urban Affairs February 23, 1999, Greenspan said, "Monetary policy certainly has played a role in constraining the rise in the general level of prices and damping inflation expectations over the 1980s and 1990s. But our current discretionary monetary policy has difficulty anchoring the price level over time in the same way that the gold standard did in the last century." In testimony before the Committee on Banking and Financial Services, September 16, 1998, he said "Losses, however, in an environment where gold standard rules were tight and liquidity constrained, were quickly reflected in rapid increases in interest rates and the cost of capital generally. This tended to delimit the misuse of capital and its consequences" and "In the late twentieth century... fiat currency regimes have replaced the rigid automaticity of the gold standard in its heyday. More elastic currencies and markets, arguably, are now less sensitive to and, hence, slower to contain the misallocation of capital."
Gold is not a good long term investment but it has functioned well earlier this century to allow governments to rescue major currencies and more recently to help individuals to defend themselves against the ravages of runaway inflation. In the next section, I look at how private ownership of gold may help individuals to hedge inflation and currency risk in our time. The risk arises because the world's reserve currency, the U.S. dollar, is issued by the world's largest net debtor nation. The British Pound Sterling was once the world's reserve currency. At the end of world dominance of British empire, Great Britain also became a net debtor. The shock of The Great Depression caused creditors to suddenly demand that Britain meet its obligations. Unable to do so, Great Britain defaulted, resulting in the end of the Pound Sterling as the world's reserve currency. A similar fate may await the U.S. dollar, to a greater or lesser extent, with serious consequences for anyone who does not hedge this risk.
Gold's performance relative to stocks since 1984 explains why gold is now popularly viewed as dead as an investment. An entire generation of investors and financial advisors have seen the DOW increase 750% while gold has fallen 55%.
Disappointment has greeted gold investors since the early 1980s who purchased gold in the hope of owning an appreciating asset. However, this trend is less damning for gold when viewed in a long-term historical context. One way to get such a view is to examine the ratio of the DOW to the price of gold over a long period. Historically, the price of gold and the stock market are counter-cyclical. The graph below shows gold and equities investor sentiment during peaks and troughs in the cycle.
In a recent interview on the topic of his new book The Power of Gold, author Peter L. Bernstein says, "In 1980, the value of all the gold in the world, the monetary gold in the world, was more than the value of the New York Stock Exchange. So if you had taken just a small position in gold in the 1960s and the early 1970s, it would have exploded into an enormous amount when everything was hitting the fan, so you don't have to have a big position as a hedge against an extreme outcome like that for it to pay off."The ratio of the DOW to the price of gold approaches one to one toward the end of periods of financial insecurity brought on by excessive and prolonged inflation or deflation during which owners of capital have sold equities and bonds and purchase gold as a means of capital preservation. During the previous two peaks in the equities markets in the 1920s and 1960s, the ratio was 19 to one and 27 to one respectively. The current top in the equities markets marks a new peak in the gold/DOW ratio, now 37 to one.
There is an obvious price relationship between the DOW and the price of gold, but is there causation between equities and the yellow metal? The answer is yes. During extended periods of disinflation that are conducive to rising stocks prices, investors are focused on asset appreciation. The good times for equities are periods of falling, not just low, inflation and interest rates. On the other side of the disinflation/inflation cycle is a period when stocks fall as inflation or deflation and rising real interest rates reduce corporate profitability and innovation. Then investor focus shifts from capital appreciation to capital preservation, especially the purchasing power of accumulated wealth. Why does demand for gold as a means of capital preservation work in both the inflationary and deflationary case? Because in both circumstances investors are faced with a loss of principle, the the first instance via a loss of purchasing power of the currency in which assets are priced and in the second case via default by security issuers. By "extended period" I mean the kind of bear market in stocks that characterizes a market that is repricing assets to account for previously non-discounted structural deficiencies in the underlying economy. The most recent example is the fall of the Nikkei from 40,000 at the end of 1989 as the market discounted the worldwide popular fantasy that was the "Japanese Miracle" to take into account the Japanese economic reality that is now derided as "Crony Capitalism."
The current popular fantasy that is keeping U.S. stock prices and the dollar high is that the U.S. economy is strong.
Strong U.S. Economy?
Nonetheless, the U.S. continues to draw in extraordinary amounts of foreign investment. This is largely because the fantasy of the "strong" U.S. economy has been self-fulfilling. Foreign investment, chasing sexy U.S. equities and relatively high interest rates on U.S. government debt, supported rising imports as the dollar gained strength. The increased imports fostered competition from cheap imports. This helped keep prices low and created demand for new technologies to improve corporate productivity and profitability, not to mention a technology company stock bubble. These economic forces created the ideal environment for rising stock prices for the past 20 years. Once the U.S. economy turns down, extraordinary private debt will cause the U.S. economy to contract rapidly (see "Living on Borrowed Time" above), the trend of foreign investment will reverse, the dollar will fall sharply, perhaps very sharply, creating a self-fulfilling dynamic in the other direction. As the dollar falls, imports become more expensive, dollars return from overseas, and domestic inflation and interest rates rise, even as the recession deepens. Further, unemployment rises, demand for imports falls, foreign demand for dollars falls and demand for U.S. exports rises. Exchange rates will adjust so that foreign demand eventually offsets the fall in domestic demand for domestic goods. But while capital flows can change in Internet time, increases in domestic manufacturing capacity required to fill increasing foreign demand takes time to build. In the mean time, the economy slows and goes into reverse. The U.S. will experience rising inflation and a contracting economy... stagflation. At the same time, the effects of debt deflation, as described in the Economist article, will reduce overall economic activity. (Falling prices are commonly associated with deflation, but that's a misconception created by the U.S. experience of the 1930s when the U.S. operated under a gold standard and the buying power of the dollar was not determined by floating exchange rates as it is today. The modern U.S. future case is more likely to approximate the experience of Thailand during the currency crisis of 1997 when the baht fell more than 40% against the dollar, import prices skyrocketed and economic activity slowed to a crawl.) Coping with the impact of this structural change is the Fed's challenge for the current decade.
At the early crisis stage of this structural re-adjustment of the U.S. economy and markets, the immediate reaction of most U.S. and foreign investors alike will be to buy short-term U.S. treasury securities. This will help support the dollar through the initial crisis, to some degree countering the fall in demand for other dollar denominated assets, especially equities. As the U.S. economy contracts, however, a weakening dollar trend will begin as foreign investment in U.S. debt subsides, and this decline will tend to be self-sustaining. At this point the yield curve becomes deeply inverted, as demand for short term debt outpaces demand for long term debt by a large measure, due to fears of a growing recession and rising interest rates. Rising short-term interest rates will compensate purchasers of U.S. treasuries for the rise in inflation. A convenient way for investors to participate is to set up a Treasury Direct account, buy 91 day T-bills and have Treasury Direct services re-invest them -- all of which can be done online. One can request that T-bills be re-invested up to ten times automatically. The advantage of this over inflation indexed treasuries is that one isn't counting on the U.S. Labor Department to set the actual level of inflation that the Treasury is using to index interest rates on the notes. If you re-invest 91 day T-bills, the market sets rates for you, not the government. Still, the biggest bargain in inflation-indexed government debt these days is the I Series Savings Bond. These are currently paying a risk-free rate of 7.49%. This compares well to the not at all risk-free -17% annualized rate of return on the DOW over the past 12 months. The bad news is that individuals are limited to only $30,000 of purchases a year, but that's only a problem if you're in the top 10% income bracket.
this scenario, at the same time that stocks are falling and interest
rates, unemployment and inflation are rising, the dollar price of gold
is skyrocketing. How much? No one knows, of course, but
tools are available for adventuresome guestimates. My personal
returns us to the ratio of the DOW to the price of gold. Over
periods of time, regardless of whether gold is officially part of the
system or not, the dollar price of gold and the DOW meet at a more or
one-to-one ratio at the apex of each structural re-adjustment to the
If you buy the idea that the DOW and gold will meet again some day, by
guessing at the degree of the fall in the DOW, you can get a fair range
of possible future values for gold. The 90% fall in the DOW in
1930s is not the right comparison to use. Monetary tools are more
effective now than then. For one thing, taxes are so much higher
now than in the 1930s. The government cut taxes by 50% following
the crash in 1929. This didn't help much then but now that taxes
represent a substantial portion of income, even a 10% reduction will
a positive impact on the economy. This is why Greenspan is
trying to talk Congress out of tax cuts. In the current
they are inflationary. He wants this monetary powder kept dry,
the day when deflation is the enemy. The Nikkei is a more
yardstick for the degree of likely fallback of the DOW.
After peaking around 40,000 at the end of 1989, the Nikkei corrected to its 1986 pre-bubble level, around 15,000. More than ten years later, the Nikkei is still stumbling around in the 16,000 - 20,000 range -- a fact that ought to instruct U.S. stock investors that investing in the stock market for the "long term" doesn't mean the year or two it has taken the stock market to rise 40% in the past few years. It means sometimes waiting a decade or two to get back to where you were when you got in. (By the way, commercial real estate prices in Japan have recently returned to their 1984 pre-bubble levels.)
I trace the start of the U.S. bubble to 1994, the year that Greenspan started to refer to it as such in Federal Open Market Committee meetings (see Full text of March 22, 1994 FOCM meeting transcript 3.7MB PDF file). A return of the DOW to pre-bubble levels puts that index in the 4000 - 5000 range at the bottom of the cycle. The fall of the DOW to 4000 - 5000 and the rise of gold to $4000 - $5000 where they meet at a more or less one-to-one ratio may take two years or more. This is the range for selling gold and buying stocks -- although you will by then be told by every financial reporter, pundit, analyst and advisor that equities are dead: invest in gold.
I know, I know. How can gold possibly rise to $4000 or $5000? Let's go back to my father's experience. He purchased gold at $50 ($196) in Mexico in 1972. Gold averaged $612 ($1,363) in 1980. The gold price rose by a factor of 12, or 1200%. Let's say the dollar falls 40% during the dollar correction, a number proposed in certain non-hysterical circles (see Banks Warn of Currency Threat - BBC 8/23/2000 and Restating Our Bear Case for the Dollar - Morgan Stanley Dean Witter July 2000). In that case, gold in nominal terms rises to $382. Unless you truly believe that gold is the buggy whip of investments, as was commonly believed in the early 1970s, gold will then at least rise to its previous bull market peak price. To equal the 1980 average inflation-adjusted price, the last year of the previous bull market in gold, gold needs to rise to $1,363. If gold is to then rise to reflect demand for capital preservation in depreciated dollars in line with previous bull markets which were the counter-cycles of previous stock bull markets, gold will rise by another factor of ten or more. That puts gold over $13,000. That may happen, but even I have a hard time imagining such an event. It's so unintuitive, I can't bring myself to suggest this possibility. But it does imply a more palatable way for the DOW and the gold price to once again reach parity.*
The usual argument is that this will never happen because no one buys gold. But that's like saying in 1980 that no one will buy stocks again, as the famous Business Week article "The Death of Equities" stated. No one was buying gold in the early 1970s. Not only didn't anyone buy gold, nobody could. Private gold ownership in the U.S. was illegal. What made gold interesting to previously uninterested investors in the 1970s is the same event that has made stocks interesting to investors in the 1980s: rising prices. In the case of gold, a perception of financial risk increases demand for gold for capital preservation. Do investors buy gold when they perceive financial risk?
Sales of American Gold eagle one ounce gold bullion coins increased 736% from the time before Y2K publicity started and the peak of public anxiety about Y2K in late 1999. And that's without any increase in the price. In fact, due to the Asia crisis, coincidentally the price of gold fell during the entire Y2K gold buying period as Asians sold gold and the dollar benefited from capital flows into the U.S. from Asia. It's specious to argue that the public doesn't buy gold in times of financial uncertainty.
Put these two primary factors together, rising prices due to a falling dollar and perceived financial risk due to rising inflation and falling stock prices, and you have a bull market in gold. A few years into this bull market the financial services industry will get involved to make money on the rise in gold prices. You will begin to see financial products marketed by the financial services industry and a proliferation of positive articles in the financial press about gold. But once you begin to see the "Equities are Dead" articles again, that will signal the time to sell gold and switch those assets back into stocks.
The details of gold derivatives are wildly complicated to the lay person. Bottom line is that gold market players on the both the demand and supply side (including bullion banks, gold mining companies, central banks and hedge funds) as well as intermediaries have, each by independently acting on self interest, engaged in market activities that have created a large short position in the gold market. You might wonder how gold producers and major holders of gold, such as central banks, benefit from a short position in the product they either produce or hold, or both, especially when the systemic effect is to suppress the price of gold. The reason is simple: they can make the asset perform better at lower risk that way in an environment where gold prices are falling. As for central banks, without these activities the asset isn't performing at all. The net effect of this enormous short position is not known, but safe to say that any price movements that would have happened in the gold price without derivatives will eventually come to bear on the shorts, and this will some day create a sudden spike in the gold price. The trick will be to figure out where the price goes from there. Under these circumstances the anti-gold crowd has a point: how is gold a "safe" investment when the price may behave more like a dot com stock -- exploding up and down -- due to market forces other than supply and demand for gold for "safety" purposes. My sense is that the volatility that derivatives will create for the gold price will be short lived. Subsequent to the eventual collapse of over-extended short positions, gold will in the long run behave like a traditional store of value.
Is gold insurance against dollar devaluation or other unforeseen financial risks? I conclude with the following quotation taken from the International Monetary Fund, "the second-largest official holder of gold in the world, with about 10 percent of total official gold stocks of member countries" in its current pamphlet titled The Role of Gold in the IMF: "Gold provides a fundamental strength to the IMF's balance sheet, giving it operational maneuverability and adding credibility to the level of its precautionary balances."
One can buy physical gold now for around $270 and have gold provide the same "fundamental strength" to one's personal balance sheet as it providesthe IMF's. As a long term investment I conclude that it's value is far more doubtful. The environment for capital appreciation is more likely to persist long term than not. Progress marches on. One is best off owning an index of stocks that will tend to grow in line with world economy, an inevitability in spite of occasional setbacks. Still, it's hard to go wrong with a small gold bullion position. Gold is now trading near 13% of its inflation-adjusted peak price of $1973 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?
gold indeed falls another 50% to $135 you have paid a small risk
premium for owning the world's oldest and most widely held financial
insurance, and a lot less than the 84% you'd have lost investing
in the widely touted New Economy stocks represented in the iTulip.com
when we first warned you to not buy them back in January 1999.
* There is a scenario for a $13,000 gold price and it's not pretty. The low price of gold is due largely to the success of international monetary authorities fo maintain a steady exchange dollar rate. What might happen to the price of gold if world geopolitics changed to cause monetary authorities to fail to cooperate with each other to support stable exchange rates?
June 24, 1997, during the peak of the Asian financial crisis, Japanese
Prime Minister Ryutaro Hashimoto told a luncheon meeting at Columbia
"I hope the U.S. will engage in efforts and in cooperation maintain
stability so we will not succumb to the temptation to sell off treasury
bills and switch our funds to gold." A year later the resolve of
the U.S. to support the dollar was tested during the financial crisis
1998 when the dollar fell 14% against the yen in one week, from 135.33
yen on October 5 to 116.4 yen on October 10. Gold during that
reflected the view widely held by market participants that the U.S.
intervention was virtually guaranteed, and the gold price hardly
Yet, might some event occur to motivate the kind of extreme
response from a foreign central bank alluded to by Hashimoto?
unimaginable after the last 20 years of increasing monetary
Such a reversal in the progress achieved to date is indeed unlikely,
not impossible. See The
1. Can the government confiscate gold from U.S. citizens again? Of course. In addition, the government can, in times of emergency, re-classify your short term Treasuries notes into long term bonds. If you believe Gillespie Research's Shadow Government Stats, the government has been understating the rate of inflation used to set the inflation component of the interest paid on TIPs and Series I savings bonds, thus underpaying holders for the actual loss of purchasing power of the principle on the bonds. And the government can confiscate whatever kind of gold they need in times of emergency, whether old gold coins or new.
Disclaimer: Did you pay anything to read this report? No. And "no" is exactly the liability iTulip.com assumes if you make an investment decision based on this report and it doesn't work out for you. The harsh reality of investing is that you have to think for yourself and make your own decisions. Everyone writer has an interest, an angle, a prejudice. The primary source of predjudice is one's own interest. For example, if the author holds a lot of equities or has taken a public position in favor of holding equities he or she is going to tend to seek out reasons why equities are good to own and tend to askew arguments against holding equities. Never make an investment decision based on a single article you read. Read opposing views, try to understand the motives of the authors. Think. Then make a decision. End of free advice.