The Big Picture

“He who has the gold makes the rules”

Of all the gold quotes, this one is my favorite.

About a decade ago, in the throes of the financial crisis, gold was roughly in the last third of a long secular bull market that began in roughly 2000. Admittedly I was not a fan of gold, from a traditional investment standpoint. Gold didn’t fit well into the accepted definitions of portfolio construction. I understood that some investors buy physical gold and hold it for the very long-term, in many cases intergenerational. Also that gold is a store of value. However, when I looked at gold I found that it could be just as perilous as any other asset class. At the time, I really didn’t have a strong thesis as to what made the yellow metal tick. I of course heard the numerous outcry’s on how “gold would solve all of our investment problems!” Which of course it did not; as those kinds of statements do not age well.

Today, I have a much clearer understanding of the precious yellow metal. Is gold insurance against the stock market? Is it a hedge on inflation? Is gold money? There are many beliefs and debates.

Have a Plan and a Process!

From the Trenches

“Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.” – Warren Buffet

Not all famous investors are keen on gold. The Oracle is one of them. Disagreements make a market…  Furthermore, speaking of outer space. Did you know NASA is looking to mine gold from a nearby, relatively speaking, asteroid? It’s a thing…

In thinking about Warren’s quote, why is it that we have all this gold in the ground? Apparently the U.S. has a hole in the ground near Louisville, Kentucky. So while the Martian’s may find this silly, gold has a long history as a sought after item of value. In 643 B.C. the Lydians (modern day Turkey) were the first known to use gold as money (Wiki).

Is gold money?

A sizable group of people will make the argument that it is. From the definition of money, however, gold only serves two of the criteria well (see my post Money from June 2017).  Gold is a unit of account (fairly simple to measure against). However, gold is not a great medium of exchange. It is not so simple to carry around and exchange for goods and services. Gold does meet one criteria very well; it is an excellent store of value (with an asterisk).

* Like many asset classes, gold has demonstrated periods of material valuation shifts! 

So as with any investment, the price paid as well as the prevailing market environment determined the investor’s results. 

All asset classes share this unfortunate attribute, and gold is no different. The last secular cycle in gold took place from 1971 through 2000. Gold was in a bull run from 1971 through 1980, followed by a bear run from 1980 through 2000. A 29 year cycle! Before 1971, dollars were backed by gold and gold was exchanged between central banks at a set price. This system was abolished in 1971 by the Nixon administration. Gold appreciated materially in the 1970’s as a result. (As a side note, this is a long “rabbit-hole” subject with more aspects than this decision alone!) Bottom line is gold increased nearly 1800% through 1980. The party ended, as party’s inevitably do, when a new economic policy was enacted. Interest rates began to decline as well as inflation, and a long period of real growth ensued. Gold fell nearly 70% through 2000.

The point?

If you were stuck “holding your bag of gold” it took over 25 years for gold to reattain it’s 1980 value! That is not a fun ride…

Gold price 1974 to the present. Notice the 1980 peak and the long wait to break-even. Currently, we are in year 8 of the wait for gold to reattain its 2011 price.

The most recent secular run in gold began not long after the turn of the Millennia. It coincided with the bursting of one of the most damaging bubbles in history, Dot-coms. We can likely point to policy decisions yet again that kicked off this “gold-rush”. Interest rates were lowered to 1%, causing the value of the dollar, as well as confidence in the dollar, to decline significantly and gold to rise. The most recent peak in price was in 2011, which also happened to coincide with the bottoming of the current-cycle dollar value. Coincidence? No, it is not…

The 3 primary factors why we see gold appreciate?

  1. When the dollar is declining in value (relative valuation changes). 
  2. When real interest rates are negative (interest earned minus inflation is below zero.)
  3. When confidence in the monetary system or monetary policy weakens. Confidence always plays a critical role!
Bottom Line: No offense to the Martians, but regardless of how silly burying gold in the ground and guarding it may seem. It serves as one of the most critical aspects of a monetary system. CONFIDENCE.

The Weeds

“In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value.” – Alan Greenspan

The above quote from Alan Greenspan in an article he wrote in 1966, “Gold and Economic Freedom”. Ironic from the man who would later become a Fed Chairman and is directly responsible for depreciating the value of the dollar during his tenure! He must have had a change in beliefs?…

Furthermore, the statement is just plain false! There are a few generally accepted hedges on inflation. Stocks, Real Estate, and real assets, such as gold! Dollars, not so much. The powers that be do not want you hoarding your dollars. That provides no benefit to the economic system. So dollar hoarders are punished with inflation.

This leads to the age-old argument on the Gold Standard…

“We need to go back on the gold standard!” Really? Are you sure? The gold standard wasn’t exactly a picnic either. As David Frum points out, it is a choice of the lesser of evils:

“The modern currency float has its problems. There is no magical monetary cure, monetary policy is a policy area almost uniquely crowded with trade-offs and lesser evils. If you want classical gold standard, you get chronic deflation punctuated by depressions, as the U.S. did between 1873 and 1934. If you want a regime of managed currencies tethered to gold, you get regulations and controls, as the U.S. got from 1934-1971. If you let the currency float, you get chronic inflation punctuated by bubbles, the American lot since 1971. System one is incompatible with democracy, because voters won’t accept the pain inherent in a gold standard. System two is incompatible with free markets, that leaves system three, as the worst option except for the others!”

Well said.

Last point. For the first time in 8 years we see a strong thesis developing for the price of gold to rise. Please contact me if you would like to discuss further. 
Bottom Line: The gold standard primarily revolved around the idea of backing paper currency with physical gold. Should the desire arise, what is to stop anyone from exchanging said paper for physical gold?

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