Questioning Fashionable Financial Advice
Gold - September 2001


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?

If 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 catastrophe insurance, and a lot less than the 84% you'd have lost investing (speculating) in the widely touted New Economy stocks represented in the Index when we first warned you to not buy them back in January 1999.
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

Gold has been in use as money for thousands of years, as those partial to viewing gold as the only "real money" point out.  But the longevity of gold as money does little to clarify an understanding of gold's current role as a monetary asset, as a personal investment, or as personal financial disaster insurance.  As J.K. Galbraith said, "There can be few fields of human endeavor in which history counts for so little as in the world of finance."  Attempts to relate gold's financial history to the present is fraught with opportunities for errors of deduction and leads down many paths of political diatribe.  I try avoid the political issues here and leave that to the many web sites and discussion groups available to the intellectually inquisitive (for a comprehensive list of related links, see Sharefin).  Instead my aim is to offer my view on whether gold is worth owning now and why.

This piece has taken me a long time to write.  The more I looked into gold the less I felt I understood.  Plus I have a history with gold that I wanted to make sure I was properly discounting. More on that later.

Many highly informed opinions on gold contradict each other utterly and the personal interests and biases of those opinions are not always easy to glean.  Understanding gold was a far more ambitious project than I imagined at the onset, and I'm still not done.  I consider this piece a work in progress because reaching any kind of intellectual resolution on the topic of gold in our time is lost in a sea of historical momentum, religious belief, opposing economic principles and monetary theory, mysticism, financial fashion and the complexities of modern financial market instruments and operations.   It's obvious why conspiracy theories about persistently low gold prices abound. These provide much needed intellectual relief from the challenges of dealing with a lot of complexity and ambiguity.  But one has to make decisions in life without all the facts, so I attempt to reach the best conclusions I can at this point.

The piece is long, so to show mercy I broke it up into two sections.  

Gold: Section I - What is it?

Writing this piece required some soul searching.  I question my objectivity because gold and I, we go way back.  My interest in gold developed at age 17 in 1975 when I was introduced to gold by my father and my uncle Herb.  Do I have an emotional and sentimental attachment to gold that inclines me to make the case for it?  Can I remain objective?

Here's the scene in 1975.  The world's central banks eliminate direct ties of their currencies to gold March 15, 1968.  Three years later, thanks to Richard Nixon, holders of dollars are no longer able to redeem them for gold held by the U.S. Treasury.  Private gold ownership by U.S. citizens is legalized less than two years later, on the last day of the year 1974.  For those of you who are entirely new to this, it may be difficult to imagine now but for 41 years Americans were not allowed to own a certain metal as bullion, and I don't mean plutonium.  On April 5, 1933, President Franklin Delano Roosevelt issued Presidential Executive Order 6102 calling in gold owned for the purpose of "hoarding."  Private citizens were paid for the gold in dollars at a going rate of $20.67 per ounce.  The Treasury then set the price of gold to $35 per ounce, thus devaluing the dollar and boosting the gold-backed dollar money supply in order to stop the persistent deflation that was crippling the economy. Forty one years later, on December 31, 1974, with Executive Order 11825, President Gerald Ford repealed the Executive Order that Roosevelt used to call in gold in 1933.  Then, in 1977 Congress removed the president's authority to regulate gold transactions during a period of national emergency other than war.1  In the three years between the U.S. de-linking of gold from the dollar and the legalization of private gold ownership, my father and uncle anticipated the coming change in gold ownership law and discussed the merits of buying gold.

I remember my father's phone calls back and forth with my uncle.  They concluded that the Fed was likely to succumb to political pressure to over-extend the money supply.  I should probably mention that my father was a Harvard trained physicist with a contrarian streak two miles wide.  He and my uncle hypothesized that pressure on politicians to fund everything voters and special interests wanted, and somethings they didn't want such as the Vietnam War, was likely to induce them to use their new ability to create money freely without the constraints imposed by either a gold standard or settlement of foreign debts from Treasury gold reserves.  Monetization of debt and price inflation were likely to follow.  They seemed especially certain that the Fed might print money to fund the war in Vietnam rather than engage in the more fiscally responsible yet politically difficult act of raising taxes.  Or maybe some other crisis might occur to cause the money supply to grow in an uncontrolled fashion, without the discipline of gold.  He and my uncle bought gold in early 1975 to hedge these risks.

The decision was as contrarian as any you can imagine.  Gold as an investment was dead as a road kill in 1975, just as today.  The consensus among pundits and economists then was that gold had no future at all as a personal financial asset.  The chairman of the Bank for International Settlements (BIS), for example, proclaimed in 1972 that gold without demand from central banks as a monetary asset was free to fall from its then fixed price of $35 ($140) to its true market value as an industrial commodity, "around $7.50 ($30) per ounce."

Dead Again

This was not the first time gold passed from favor.  The first attempt at a money system without gold backing, called fiat money, was the application of a new theory of money created by Scottish monetary reformer John Law in 1716 (for details see Janet Gleeson's excellent book John Law - The Philanderer, Gambler, and Killer Who Invented Modern Finance). After several rejections by various European governments, Law received permission in 1716 to try his plan in France. The French government was heavily in debt as a result of  extensive wars of Louis XIV, who died in 1715.  Law's program promised to reduce the public debt. This held obvious benefits that outweighed the risks that had caused every other government to reject the idea. With Law, however, lowering the public debt was incidental. He shared with his mercantilist contemporaries a belief that money is a creative force in economic development and that an increase in its quantity would stimulate a larger national product and would increase national power. He differed from other mercantilists in looking upon a central bank as an agency for manufacturing money in the form of bank notes that would circulate in place of gold and silver, which were scarce. At first, Law's system worked very well.  But in the end, the system failed and France sank into a depression far more severe than the one from which Law's fiat money regime had temporarily ended. France returned to a gold standard for more than a century. To this day, France maintains a disproportionately large reserve of gold relative to its European neighbors.

The latest attempt at a fiat money regime, and by far the most successful, is the current one. But it had teething problems. At its start, the world's central bankers and economists were confident in the new system of free floating, non gold backed currencies and saw the rapid demise of gold as a monetary asset. The following excerpt from "How to Invest In Gold Coins" 1970, by Donald J. Hoppe.

"...we in what the French like to call the "Anglo-Saxon camp" have been told for a considerable time now, through our press and by the pronouncements of even some of our highest Treasury and banking officials, that gold, like the Deity in the eyes of some modern theologians, is dead; that the use of gold for monetary purposes or as a store of value is, in that already well worn cliché, a "barbarous relic." Furthermore, it is said that the sooner we are able to abandon it completely, the better it will be for us.

"But perhaps the demise of gold as the center of the monetary universe has been reported, as was the death of Mark Twain, somewhat prematurely."

As it turns out, Mr. Hoppe -- and my father -- were mostly right.  Correct in their assessment that central bankers were to lose control of the money supply for political reasons (see Burns, Baby, Burn!) and that the dollar price of gold was to rise as a result.  But they were wrong about the main cause.  The cost of the war in Vietnam contributed but the more significant source of runaway inflation was unexpected and external -- the oil crises of 1973 and 1979 -- that caused sudden price inflation and wrecked havoc in the newly minted monetary system based on floating exchange rates.  Not only didn't gold fall to $7.50 as predicted by the BIS but it peaked at $870 ($1937) on January 21, 1980.

At that time gold worked very well as a hedge against inflation, that is, depreciation of the dollar.  Alas, my father didn't sell his gold at $870 ($1973) or even $600 ($1336) and passed away in 1991 when the price averaged $376 ($465), his gold still locked in a safe deposit box at the bank.  A stock market believer in 1991, I sold nearly all of the gold I inherited.  For sentimental reasons, I did keep a single Mexican 50 peso gold coin (1.38 ounce) still in it's original paper and plastic coin case with the purchase price penned on it: $79.   Actually, that price is theoretically impossible.  By the time gold became legal to own in 1975, the price was over $100.   My theory is that he bought it in Mexico on one of his occasional trips there and brought it back -- my Dad the gold smuggler.  In any case, the bullion value of this coin is $375 at this writing, up 475% from the sticker price in 27 years.  Not as good as an S&P 500 stock index fund, but not too shabby for a dead financial instrument.

That's my personal experience.  How relevant is it in today's world?

The Problem with Gold

Gold fails as a long term investment for one primary reason: gold earns no dividends or interest.  Any investment that earns 7% annual interest compounded over ten years will yield a nominal return of 100%.  If you invested $100,000 in instruments yielding 7% in 1990, you'd have $196,715 today (see Compound Interest Calculator).  Of course, inflation has to be taken into account.   Your $196,715 in 2000 dollars is $143,936 in 1990 dollars (see CPI Inflation Calculator) so your real (inflation adjusted) return is closer to 70%.  This assumes you are believer in the CPI as an accurate accounting of inflation.  Many argue that removing housing, energy and food from the U.S. inflation measure causes the index to under report the level of inflation experienced by average Americans.  This same complaint is repeated by the citizens of other nations where inflationary pressures are evident in the prices of housing, energy and food, items which comprise the majority of household expenses.  European friends tell me they don't believe their governments' inflation measures, either.  Conversely, in a country where the economy is suffering deflationary rather than inflationary pressures, such as in Japan, housing, energy and food are included in the official price index.  This lack of a standard for measuring inflation that persists over time and that is shared by all of the governments of the worlds' leading economies leads to suspicion that inflation measures are manipulated for political purposes.  This may account for unexpectedly poor sales of CPI Inflation Indexed Securities by the U.S. and other governments.  Still, gold purchased and held for almost any twenty year period in history offered worse returns than any other investment.

What is Gold Now?

Is gold now solely a commodity, like copper, that will fall in value in a deflationary (debt) collapse?  No.  Gold is not a only commodity. Unlike any other metal, gold has commodity applications but monetary applications as well.  However, its monetary role has changed in significant ways that have created a lot of confusion.

Do you know of any commodity that the world's central banks hold in such large amounts?  The world's central banks have had over 30 years since gold was disconnected from currencies to sell their gold.  But they haven't.   According to the International Monetary Fund, "Total official holdings have been reduced by 3,000 tons, or less than 10%, over the past 30 years." (Source -- World Gold Council)  The question is, if they don't think they need it, why haven't they sold it?  The standard answer is that they have too much of it to sell without negatively impacting the price of the remaining gold they possess and hurting economically allied nations that produce gold.  The problem with this argument is that the world's central banks have had 30 years since the demise of the Breton Woods system to sell their gold.   Methods for selling gold without significantly impacting price or hurting gold producing countries are well documented (see Can Government Gold Be Put to Better Use?  Qualitative and Quantitative Effects of Alternative Policies).  It's hard to imagine that sales of an average of 3.3% of holdings per year over 30 years, an amount that represents a small percentage of annual gold mining output, will have had a significant impact on the gold price.

The intentions of the world's central banks were demystified on September 26, 1999, when a group of European central banks announced the Washington Agreement:

Oesterreichische Nationalbank Banque Nationale de Belgique Suomen Pankki
Banca dÌItalia Banque centrale du Luxembourg De Nederlandsche Bank
Banque de France Deutsche Bundesbank Central Bank of Ireland
Banco do Portugal Banco de España Sveriges Riksbank
Schweizerische Nationalbank Bank of England European Central Bank

In the interest of clarifying their intentions with respect to their gold holdings, the above institutions make the following statement:

1.Gold will remain an important element of global monetary reserves.
2.The above institutions will not enter the market as sellers, with the exception of already decided sales.
3.The gold sales already decided will be achieved through a concerted programme of sales over the next five years. Annual sales will not exceed approximately 400 tonnes and total sales over this period will not exceed 2,000 tonnes.
4.The signatories to this agreement have agreed not to expand their gold leasings and their use of gold futures and options over this period.
5.This agreement will be reviewed after five years.

This may strike many as simplistic, but I am inclined to believe that central banks continue to hang onto most of their gold for the reason mentioned at the start of this piece: all past fiat money regimes have failed.  Although unlikely, this one might, too.

Gold and the Master of the Universe

You might be surprised to hear that the world's most well know central banker thinks a return to a gold standard now is, for some reason, a good idea.  This is a more radical position that I'd take.  But then what do I know?  I'm sure he has his reasons.

Senator Paul Sarbanes: "... is it your intention that the report of this hearing should be that Greenspan recommends a return to the gold standard?" 

Greenspan: "I've been recommending that for years, there's nothing new about that.  It would probably mean there is only one vote in the FOMC [Federal Open Market Committee] for that, but it is mine." 

- Senate Committee Hearing, September 1997
    Greenspan appears to be a defender of gold as monetary insurance, in contradiction to younger economists who are more firmly attached to this generation's orthodoxy and contemptuous of the previous generation's economic orthodoxy.  I suspect he laments the lack of a gold standard because this makes his job much harder.

    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 - Section II - Gold Sucks

    Financial planners and other experts are not so sure it belongs in a portfolio at all. "If somebody is super-wealthy and wants to be super-safe, owning some gold is fine for them," said Don Boegel, a certified financial planner in the Minneapolis suburb of Plymouth, Minn. But for normal people, he doesn't see the use. Even for the super-cautious, "I personally don't think they'll see a significant rate of return on it," he said. 

    Holding gold (CNNfn March 2, 2000)

    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%.

    Gold vs Stocks

    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.

    Gold vs Dow
    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.

    Chart by sharefin

    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."

    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?   

      The biggest risk (in the US) is that high levels of debt and falling asset prices might trigger debt deflation, a concept first developed by Irving Fisher in 1933. Fisher placed much of the blame for the Great Depression on the excessive levels of debt taken on during the boom years of the 1920s. Debt deflation -- a spiral of falling asset prices, rising debt-to-asset ratios, forced asset sales, an increase in bad debts, and a decline in bank lending -- can seriously amplify a downturn. And lower interest rates do little to stimulate the economy, because the overhang of debt discourages people from borrowing more. In the early 1990s the deepest recessions were in countries that had seen big increases in private-sector debt in the late 1980s, most notably Britain.

      The Economist
      Living on borrowed time - November 6, 1999

Growth in the private-sector financial deficit (firms' and households' savings minus total investment) surged to a record 5% of GDP in 1999 from a surplus of almost 4% in the early 1990.  (At the time of the last great crash in 1987, the private sector had a modest financial deficit of only 0.8% of GDP).  In the late 1980s, Japan, Britain and Sweden all experienced a similar deterioration in private-sector net saving as property and share prices soared. When these economic bubbles burst, all three economies saw a sharp increase in net savings as firms and households were forced to repair their balance sheets, triggering deep recessions.  By 1995 nearly 62 percent of all US households had liquid savings of less than $5,000.  By 1999, total household debt has risen to a record 102% of personal disposable income, up from 85% in 1992.

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.

In 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 several tools are available for adventuresome guestimates.  My personal favorite returns us to the ratio of the DOW to the price of gold.  Over long periods of time, regardless of whether gold is officially part of the monetary system or not, the dollar price of gold and the DOW meet at a more or less one-to-one ratio at the apex of each structural re-adjustment to the economy.  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 the 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 have a positive impact on the economy.  This is why Greenspan is constantly trying to talk Congress out of tax cuts.   In the current environment they are inflationary.  He wants this monetary powder kept dry, for the day when deflation is the enemy.  The Nikkei is a more reasonable 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?

American Eagle 1 Oz Coin Sales
Year Quantity Price
2000  35,000 $273 Y2K selling starts
1999 2,023,000 $279 Y2K buying ends
1998 1,839,500 $294
1997  771,250 $331 Y2K buying starts
1996  275,000 $388
1995  297,750 $384
1994  310,000 $384
1993  514,000 $360
1992  385,800 $344
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.

Gold Derivatives

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.


"Gold still represents the ultimate form of payment in the world. Fiat money in extremis is accepted by nobody.  Gold is always accepted." 
- Alan Greenspan - May 20, 1999

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?

If 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 catastrophe insurance, and a lot less than the 84% you'd have lost investing (speculating) in the widely touted New Economy stocks represented in the Index 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?

On June 24, 1997, during the peak of the Asian financial crisis, Japanese Prime Minister Ryutaro Hashimoto told a luncheon meeting at Columbia University, "I hope the U.S. will engage in efforts and in cooperation maintain exchange 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 of 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 week reflected the view widely held by market participants that the U.S. Treasury intervention was virtually guaranteed, and the gold price hardly moved.  Yet, might some event occur to motivate the kind of extreme self-protective response from a foreign central bank alluded to by Hashimoto?  Seems unimaginable after the last 20 years of increasing monetary cooperation.  Such a reversal in the progress achieved to date is indeed unlikely, but not impossible.  See The specters
of Bretton Woods - Hugo Salinas Price December 23, 1997 - for the point if view of a Mexican on the losing side of the dollar reserve currency regime.

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.

Private, Industry, Government
Industry Data
Gold Rush? - Research Magazine Understanding the Gold Price - Global Resource Investments Ltd. Gold Statistics - Amerigroup
Principles of Money - Dr. Roger A. McCain, Professor of Economics Facts About Gold - Gold Institute Annual Gold Supply/Demand - Chamber of Mines Online Statistical Tables
Role of Gold in the IMF - International Monetary Fund
Gold Price Charts - Kitco
Is the Gold Market Sitting on a Time Bomb? - MoneyWeb USA October 3, 2000 F.A.M.E. - Foundation for the Advancement of Monetary Education

Gold market "time bomb" theory blasted by South African - The Mining Web October 6, 2000
AMI - American Monetary Institute

Holding Gold - CNNfn March 2, 2000

World Central Bank Gold Holdings - World Gold Council

Good as Gold? - Fortune March 18, 1996

The spectres of Bretton Woods - Hugo Salinas Price December 23, 1997

Burned by Gold - Fortune March 16, 1998 Why the US dollar has the gold price on a tight leash - November 12, 2000

Wisely Investing in an Era of Greed - Fortune October 2, 2000

If Down Is Up and Bad Is Good, Gold Stocks Must Be Hot - The July 17, 2000

The Power of Gold by Peter L. Bernstein - Interview, The September 29, 2000

Wall Street Rediscovers Gravity - Safehaven October 2000


Con-Gold Arguments Pro-Gold Arguments
Gold is not money, legal paper is money Gold is Money, Fiat "Money" is a Fraud
Brief Description of the Federal Reserve System A Criticism of the Federal Reserve System
Central Banks Can Sell all of their Gold A Criticism of Government Manipulation of Money and Markets - 1939
Central Banks Should Sell all of their Gold The War on Gold

Disclaimer: Did you pay anything to read this report?  No.  And "no" is exactly the liability 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.