THE CASE FOR GOLD TODAY

The One-handed Economist
December 27, 2010

The establishment argument against gold comes down to the statement that it is a collectable that earns no yield. Art, rare coins, stamps and gold and silver bullion do not earn a yield. Stocks, bonds and real estate earn yields, so the prudent investor should focus on these assets rather than gold or precious metals.

First, let us examine a hole in this argument. Let us look at bonds and other fixed income investments. The best instrument here is T-bills because they are virtually risk-free (not counting the risk from the depreciation of the currency). A study of the yield on T-bills going back to 1933 (which is the beginning of the modern monetary system) shows that the yield paid on T-bills bought at almost any time over the past 75 years has been completely eaten up by the depreciation of the currency.

For example, right now you can buy a T-bill yielding 1%. But the (official) Consumer Price Index is rising by 4% per year. So at the end of 12 months time, you receive $1,010 (from your original $1,000 investment) and can buy goods which at the start of the 12 month period had cost $970. In reality, your money has shrunk in value and you have received negative interest. It hasn't been this bad all the time, but the average over the past 75 years shows a return of (very close to) 0% real interest.

This eliminates T-bills as an establishment investment, and it pretty much eliminates any riskier fixed income investment as well. Because all you are receiving beyond the T-bill rate is a small risk premium. Yes, you get some extra return, but you have to take extra risk.

The game is not worth the candle. And if you try so-called inflation protected Treasury securities, they are only protected against the "inflation" reported in the official Consumer Price Index. Interestingly, it was right at the time that these were introduced that the Bureau of Labor Statistics began to introduce fraudulent statistics into the CPI so that it no longer truly measures the rate of price increase in our society.

What is needed during this period when the U.S. currency is depreciating (as measured against goods) is an economic good which protects you against currency depreciation and which also has a yield. Stocks have yields because (most of) the companies have earnings. Real estate usually has a yield (unless it is raw land). In both of these cases, it is possible to protect yourself against the depreciation of the currency and still earn a return on your capital.

So far the establishment argument is looking good. Both stocks and real estate, like gold, can protect you against the depreciation of the currency. But unlike gold they pay a yield. The problem with this argument, however, is that it is true only for the long term.

Starting with the Kennedy tax cut of 1963, budget deficits and the creation of money became the operating policy for both political parties. Indeed, the (official) Consumer Price Index has risen every year since that date. However, different goods react differently to the easing of credit and the printing of money. The result of this has been the development of what I call the commodity pendulum.

First, commodities lag behind the rise in other prices and become undervalued. Then they play catch up and rise rapidly. When they go too high the cycle starts again. For example, commodities were undervalued in 1971 and dramatically outperformed stocks through the decade of the '70s. In the '80s and '90s, the situation was reversed; commodities declined, and stocks rose. Starting early in the new century commodities were once again undervalued and began another rise, and this will soon lead to large scale declines in bonds and stocks. That is, the first part of this century will be a repeat of the 1970s.

So although the establishment point is correct for the very long term, it is too long for practical trading. Yes, stocks can give you protection against the depreciation of the currency as well as yield. But that did not help the stock investor from 1966 to 1982 because he lost 70% of his capital in real terms.

The argument for gold now is the same as it was in the early 1970s. Gold, and other commodities, are coming off a giant oversold condition. Over the '70s, gold multiplied by a factor of 25 times. What will happen during this swing of the pendulum cannot, as yet, be predicted. But it is likely to be quite similar.

Take the establishment supporter who bought stocks in 1966. It was the recognized "wisdom" of that day to buy "good, sound stocks for the long pull." They laughed at the foolish gold bugs buying gold stocks with the price of the metal at $35/oz. Gold, after all, was a collectable. This situation is repeating in our day. The same forces which pushed gold upward then are pushing it upward now. The ethanol bill plays the role of the Russian wheat deal. The establishment type who buys "good, sound stocks for the long pull" today is quite likely to sit through a 70% decline in real terms over the next dozen or so years.

We all know what the establishment did in the 1970s. When gold raced over $800 in January 1980, they said, "We will pretend that this whole affair never happened. It is too embarrassing to admit that we were wrong and the gold bugs were right." Those who do not learn from history are condemned to repeat it. And repeat it (the seventies) they are.

But when the commodity pendulum is finally over (and that will be quite some time in the future), and the cycle is ready to switch back in the other direction, when the day comes that gold is overvalued and stocks undervalued (similar to 1980-1982), I will be perfectly happy to get out of gold and buy stocks again.

But as I remember the advice of the economic establishment over the past generation, they were as bullish as they could possibly be on stocks in 1966. And then they turned as bearish as the gloom of night in 1982. I am confident that they will do the same thing on this second swing of the commodity pendulum.