The Gold Bugs Were Right
Commodities / Gold & Silver 2009 Jan 04, 2010 - 05:24 AM GMTBy: LewRockwell
Eric Janszen writes: 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.
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