This article originally appeared in Marc Faber's Gloom, Boom, & Doom Report. Reprinted with George Karahalios' permission.
The discipline of successful investing includes not only the courage and patience to lay stakes near bear market bottoms when assets can linger far below their intrinsic value, but also the preparedness and conviction necessary to sell assets when they surpass fair worth, often at climatic tops. Far too many investors are one-dimensional, committing themselves to just a single asset class which they cannot rationally analyze because they've become too emotionally attached. Logical investors realize that dreams rarely materialize as scripted and are often derailed by unforeseen circumstances.
In the gold bug’s dream, the perfect time to sell gold will be easy to spot: while humanity is starving itself to death through its own ineptness, society will have righteously dedicated a vast amount of its resources to procuring every viable ounce of gold and silver from beneath the earth's surface. In relation to gold, everything would be astoundingly cheap. Gold would be recognized as the ultimate currency, providing gold bugs with both an easy exit from gold and a closure to a lifelong pursuit of justice—a justice that would be administered against a corrupt fiat monetary system that painstakingly punishes frugal savers in favor of free-spending debtors, hard-working producers in favor of lavish consumers, and honest laborers in favor of crony capitalists, elitist politicians, and sundry special interests sporting their agendas.
Theoretically Thinking
While today’s dogmatic political, economic, and monetary leaders might yet deliver to gold bugs their ultimate fantasy, investors would be better served by considering precisely what drives capitalists to own gold and by charting a reasoned exit strategy for when those circumstances might change. Before making a gold investment, it is paramount to embrace the belief that gold is a store of value, as evidenced by thousands of years of history in which gold has been used as money. To believe otherwise would suggest that gold is just another speculative gamble which can randomly boom and bust, as Fed Chairman Bernanke recently implied in an exchange with Congressman Ron Paul.
Congressman Paul retorted that it is curious that it is central bankers, who are in the business of money, that have historically been among the greatest hoarders of gold. Fed Chairman Bernanke coyly dismissed this peculiar stock-piling behavior as mere “tradition,” perhaps like something that might be found in a superstitious ritual. Yet social scientists sometimes recognize tradition as a source of knowledge—wisdom handed down from generation to generation as a survival technique. It is no coincidence that gold has been recognized as money over time because it demonstrates the inherent qualities of an ideal currency: classically this has been defined as any good that serves as a unit of account which is easily identifiable, is a good store of value in the sense that it is not easily replicated, and is a generally accepted medium of exchange in transactions.
While intermittently central bankers appear to be Houdini-like in their ability to deceive the public into embracing a particular fiat money as that medium, it is other goods that function as better inter-temporal stores of value. When the fraud of an easily created fiat money is finally exposed, nothing has restored public confidence to the banking system better than gold and silver for these are the time-tested monies of the free market. This fact has not been lost on money-peddling central bankers who engage in the “tradition” of hoarding gold to insure the ultimate survival of their trade.
When might the relative value of a “stable” money dramatically increase? The answer is self evident--during times in which everything else proves unstable! Many disruptive actions or conditions can induce unrest in the world: war, natural disaster, plague, famine, or even mass psychosis (some religions). Also, money can gain appeal when politicians meddle with the free market through excessive taxation, massive regulation, and invoke special purpose subsidies. Most of these shenanigans are hard to hide; though sometimes they do occur in conjunction with exogenous events.
It is only when resource misallocation occurs on a monumental scale, usually through perpetual money printing, that the value of money can become totally mispriced. This is because capitalists cannot clearly decipher between healthy, real demand for a product or service and the illusory demand induced by money printing episodes. A money-printing escapade becomes particularly dangerous when a macro circumstance evolves and masks the resource misallocation—something like today’s currency wars.
If a debt bubble is allowed to form as a consequence, the stage is then set for additional money printing designed to alleviate the unsustainable debt burden. Further, this weakens the morale of the population and makes people extremely susceptible to the disruptive actions cited above because a weakened culture is less prepared to handle exogenous events and may resort to desperate actions such as laying the blame elsewhere, persecuting specific peoples, or even to going to war against foreign competition. Anything is tried in order to alleviate the immense pain brought about by excessive mal-investment. Such a virtual cycle only works to further reinforce the allure of truly stable money—traditionally that money has been gold.
This is not to say that a fiat-based monetary system like Bretton Woods cannot succeed. In theory, a tightly regulated environment in which the money supply grows at a controlled rate might replicate the advantages of a gold standard yet retain the flexibility necessary to employ national trade strategies against competing nations who might attempt to tweak free market forces. As long as the money supply grows at a rate commensurate with true economic growth, incomes should increase at a rate proportionate to the growth in debt, and consequently, the level of debt will be very serviceable. Unregulated fractional reserve banking offers temptations to lenders, rulers, politicians, and cronies which the human animal simply cannot resist—especially when the chief regulator (the Fed) becomes derelict in its duties by either miscalculating or turning a blind eye. In the end, poorly regulated fiat monetary systems can spin out of control, spawning debt-pyramids that result in a chaotic series of asset bubbles and busts that torment the average household.
Today’s Economic and Political Realities
Debt is now the cornerstone of every relationship—relations among family members, vocational groups, local citizenry, equity and bond and commodity markets, and now even relations among nations! In the western world the problem is now very clear: there is simply not enough income to service the debt burden. In the US in particular, the debt-to-GDP ratio will soon approach 400%, and that’s excluding tens of trillions of dollars of potential entitlements owed. In lieu of tackling the problem, the US government has chosen to prop up bad debt, run huge deficits, and redirect valuable capital to itself at a time when the country desperately needs effective investments. As a consequence, things more like money (M1) are in short supply relative to things that foster debt (John Williams’ reconstructed M3), and in response the Fed feels compelled to intervene with an arsenal of monetary weapons (things that make you ask, “WTF?”). Fed Chief Bernanke denies that he is monetizing the debt and promises to shrink the Fed’s balance sheet at an “appropriate time” (apparently sometime after mid 2013). By refusing to purge the debt, he is left with no other option but to print because it’s all about the debt, stupid!
Currently, the debt pyramid is cracking throughout the EU where the banking system is on the verge of collapse. The bank balance sheets are laden with questionable sovereign obligations from fellow EU members like Portugal, Ireland, Spain, Greece, and now Italy—all of whom are overleveraged and unable to repay. Unlike the US where there is both a complete political, economic, and monetary union, the EU is made of disparate members who are united only by a common currency. So while the US Fed is usually quick to print, sometimes the ECB dithers as economically responsible members such as Germany contemplate the cost/benefit analysis of bailing out its profligate monetary allies. As sovereign risks increase, the interest rates demanded of these nations by the marketplace increase too. The situation is further complicated now that the credit agencies are under pressure to address deteriorating ratings a priori, rather than to dishonestly rubber stamp AAA as had been the practice.
These bond market flare-ups have not gone unnoticed by the equity markets where many indices have corrected by 15-20%. This is particularly a threat to US economic growth because an asset-dependent economy made up of paper shufflers is likely to falter if the equity markets swoon too much. Eventually, the ECB caved and now believes it has forcefully responded to stem the crises with the equivalent of a sovereign-bond sinking fund of nearly 450 billion Euros (the US version of a TARP), while the US Fed has pledged near-zero interest rates for at least two more years. If the ECB has underestimated the size of the sovereign bailout or is slow to act, markets could swoon yet again—not a comfortable political position for a Fed pressured by Tea Party types who push austerity and create dissent among Fed members!
Mr. Bernanke does not find himself to be alone in his difficulty of restraining free market forces which, if unleashed, could potentially annihilate, in a domino-like collapse, the highly integrated global banking system. Today’s circumstance was brought about by a global, top-down intervention into the free market by eastern governments that pegged their currencies to create jobs, western politicians who foolishly expanded the size of the welfare state and allowed debt to pile up, and a remiss or corrupt chief regulator in the Fed who routinely printed. To keep the peace, eastern governments remain committed to a strategy of overproducing and stockpiling their products in spite of a waning demand, while westerners must constantly inject liquidity to stave off burdensome debt obligations.
Sadly, the debt pyramid was foreseeable. Thomas Hoenig, president of the Kansas City Fed, warned in a 1996 speech in Davos, Switzerland about the dangers of deregulating and expanding the federal safety net to include too-big-to-fail institutions that were trading highly leveraged derivatives and structured finance vehicles. While former Fed Chief Alan Greenspan was busy accepting the accolades associated with the early benefits of an inflation, Ben Bernanke was studying the Great Depression and expanding his interventionist’s bag of tricks. Free market purists insist that the jig is up, thanks mostly to the bond vigilantes who are now demanding world austerity. Studied historians know that a determined monetary magician will not stop printing until he is physically removed from the stage.
If necessary, the Fed can engage in what Bernanke has described as “interest rate targeting,” meaning that bond rates will be suppressed by any means necessary. This would be a nameless QE which is potentially unlimited should it require the Fed to purchase bonds from a market fraught with active vigilantes who are sure to pressure rates higher in response to deteriorating credit quality or looming inflation. If, in spite of the Fed’s money printing, economic activity remains weak, Bernanke has warned us that he can increase the velocity of the money pool by charging interest on deposits held at the Fed. A true Keynesian might believe that this would work to stir economic activity by encouraging the banks to lend out their reserves to consumers and businesses instead of hoarding them at the Fed. As the economy picked up, ideally wages would increase faster than the debt burden. What better way to create wage inflation than to actually force it upon the marketplace? At first, expansionary monetary policies are sure to be a gold bug’s best friend. But what if something changes, like if interest rates were to rise in earnest—then what?
Investors who haven’t any macro-economic knowledge are ill-prepared to properly value assets in today’s complicated world. US equities look to be a relative bargain when valued by traditional metrics that do not account for the prevalent macro risks (in nominal dollars everything may be cheap). Delta-neutral traders mistakenly believe themselves to be hedged, but their problems emerge when bailouts are slow to materialize and counter-party contracts fail. Under this circumstance, gold could spike, perhaps temporarily as a safe-haven asset, but would rebound once the inevitable bailouts proliferated throughout the system, stoking inflationary fears. Unimpeded, the final act of these central banks might be to collapse not only their respective economies but also their respective currencies. Care to guess the future price of gold?
Things Change: Identifying a Gold Top
At the peak of a typical bull market rational thinking is a rarity among the participants. Investors often judge the future by extrapolating a past trend when in fact what the future brings is “change.” Gold is particularly difficult to value because—if it is truly money in the sense that it preserves purchasing power—it is worth the most during frantic times. Chaos precipitates the change necessary to end gold’s fortunes, but it can also elicit wacky policy responses that can further propel the gold price. Thus, gold investors can be torn between trying to distinguish whether their emotions are symptomatic of a normal top that eventually occurs in most markets or, instead, are indicative of a sustainable gold advance.
Gold die-hards salivate at the prospect of a disintegrated world. Admittedly, if central bankers are given carte blanche, all of the prerequisites to a gold bug’s dream could be in place. Nonetheless, gold investors would be well-served to monitor the conditions that routinely define bear market bottoms and bull market tops—a combination of both price and circumstance. Extremely low valuations and improving fundamentals can mark bear lows, while absurd valuations and deteriorating conditions often characterize bull highs. Markets turn on a dime for good reason—because s*** happens!
If gold is not considered to be money because it is not regularly used as a medium of exchange, then at least it can be considered the rich man’s store of value—portfolio insurance—a hedge against depreciating currency and general instability. The price of financial insurance can explode when disequilibrium occurs in a market. Today’s macro policy of “financial repression” (negative real interest rates) works to misallocate resources by diverting monies to failed business models, starving the economy of its future growth potential. In addition, governments find themselves constantly intervening in all markets in hopes of preventing the collapse of the very disequilibrium fostered by their misguided policies.
A government that reversed course by adopting more laissez-faire policies would empower the private sector, shrink itself, and build a strong foundation for future growth. This could be accomplished by a combination of tax cuts, removal of regulatory burdens, tort reform, the minimization of transfer payments, and the privatization of government services. Society could agree to limit government expenditures to some mutually acceptable percentage of GDP. Further, such a government would find it unnecessary to perpetually tinker with the money supply in order to juice the private sector. This would be a true threat to instability and therefore the gold price! Thus, if I were to sense a change in the political winds likely to embrace such proactive policies, I would posthaste position one foot next to the nearest gold exit in anticipation.
This doesn’t mean that more socialism necessarily fuels a higher gold price. In fact, as we have recently learned, a crony-capitalist nation whose policies only reward the wealthy and those connected to the government indeed are a boon to gold. For this reason, some socialist nations tend to have stronger currencies than money-printing capitalists run amuck. A more productive socialism that redirects funds from entitlement programs to infrastructure projects might actually mitigate some economic pain, restore some stability, and perhaps even slow the gold bull market. The danger is that infrastructure-socialism can escalate into a more permanent centrally-planned economy which generally results in slower growth and is bad for the relative value of fiat currencies.
Another threat to gold comes not from the adoption of sane economic policies, but rather from oppressive governments that might confiscate gold. For the first time in modern history, governments hold less gold than the private sector and could institute a high gold tax to capture lost gains. Note that this may not end the gold bull market per se as more competitive countries might not punitively tax gold, but depending on a person’s country of citizenship, a threatened high tax rate on gold might call for a premature exit.
A world in which production and consumption are more balanced by region might reduce tensions and lessen the possibilities for war. In an idealistic environment, productive economies create peaceful solutions to resource scarcity. On the other hand, if the developing world continues its rapid growth and squeezes the price of natural resources while the still powerful west clings to backwards economic and monetary policies, war tensions might escalate, and gold as a store of value might become even more appreciated.
Contrary to what Mr. Bernanke might insinuate, gold is not just another collectible such as baseball cards or tulips but a stable store of value over very long periods of time. The problem is that it is difficult to define what constitutes a fair relative price for gold since many of the world’s other assets have short shelf-lives: cities decay and often are superseded by other power centers; businesses regularly come and go as evidenced by the revolving components of equity indices; and fiat currencies rarely survive for more than a few hundred years. Nevertheless, it is easy to define gold not by analyzing its nominal value but by judging its worth relative to other potential opportunities. If other markets offer ample value, then by definition, gold is potentially expensive (overpriced).
Tomorrow’s Opportunities
Lost in all of the confusion generated by today’s debt crises is the progress made by man through his accumulation of knowledge and his ability to innovate. Modern man spends much less time procuring food and shelter and therefore is better prepared to endure mal-investment than his predecessors. Paradoxically, this cushion diminishes the necessity for gold as catastrophe insurance but also enables poor macro policies to manifest themselves (which pressures gold higher).
When at least part of the world recognizes the danger of participating in a debt pyramid scheme and weans itself from its reliance on money printing and other forms of intervention, the great gold trade will likely subside, and other options should be considered. This does not mean that gold will necessarily fall in nominal terms, but better global opportunities would present themselves. Since I accept that today’s highly unusual macro imbalances will gradually resolve themselves, I have identified future opportunities in the order in which I believe they will emerge.
Whereas physical gold is an investment with no counterparty liability, gold mining companies are businesses that generally profit from an increased gold price. In today’s chaotic world, gold in the ground trades at a steep discount to the intrinsic value of gold in hand. If enough calm and rationality persists long enough to allow gold miners to execute on their business strategies, gold equities should greatly appreciate relative to gold itself. When temporary stopgap measures are instituted—such as additional QE—gold shares often shoot up in price, but then vacillate back and forth if these measures create additional systemic instability that causes all equities to suffer. Thus, it is not unusual for gold shares to spike twice--both before and long after the metal ends its run.
Many potential gold equity investors fear that these companies are controlled by hucksters, which is always a concern, but their most pressing challenge is that many gold companies are run by engineers with little financial background and who sometimes make poor choices. Gold mining is a capital intensive business, and when the marginal cost of mining increases in conjunction with the gold price, both banks and equity underwriters demand high risk premiums. Eventually, though, a rising market usually creates its own liquidity. As the price of gold escalates more than enough to offset the mounting costs of removing it from the ground, the miners’ potential cash flow increases and liquidity should find its way to the mining stocks. Eventually, companies will opt for better debt terms from the banks or else issue corporate debt directly to bond investors rather than to serially dilute their own shares. History tells us that there are various conditions when gold shares can trade at fire-sale prices relative to the metal—just prior to the onset of a new gold bull market when share discounts linger from the memory of the previous gold bear (2000), when disruptions to global equity markets suppress all share prices (2008), and sometimes well into a gold bull market when the economic viability of the mining business strongly improves (late 2011?).
It has been difficult to identify with precision how, when, or even which part of the world will emerge the least scathed from the grand resource misallocation caused by our interactive central planners. Regardless, any resumption in the strength of world growth most certainly would lead to an increased commodity demand. In particular, the markets for oil and uranium are very supply constrained due to declining reserves or man’s refusal to permit production. Natural gas is likely to see increased demand as the substitution effect out of expensive oil gains momentum. Agricultural and base commodities also will offer compelling value, particularly if bought during crises when the relative price of gold spikes. The beauty of investing in commodities over general equities is that they are generally negatively correlated to financial assets because rising commodity prices are an important cost component of corporate profitability. More importantly, commodities can thrive in a fractured, yet advancing world.
Once global growth achieves a more healthy footing, any remaining gold holdings can then safely be converted into equities, especially companies that are poised to gain from the demand generated by vibrant emerging markets, though early on the commodity sector might offer better risk-adjusted reward. Aside from commodity stocks, global tech companies, whose costs are often not affected by rising commodity price, might prove the most beneficial equity investments. When the locations of emerging power centers become more clearly defined, supply constrained real estate investments in these areas should offer reasonable value. Finally, if and when money printing subsides as a strategy to deal with excessive debt, investment grade bonds in reliable companies should be enticing as their values will probably not yet reflect the stability offered by economies wise enough to make the tough decisions.
Over the next 12-18 months I expect the global debt crisis to perpetually re-erupt unless massive bailouts ensue. Either way, I expect the gold price to exceed $3000 US. At that point gold will have achieved close to fair value relative to the future prospects of other assets if the world were to have righted itself. (I know gold enthusiasts claim that gold is under-valued by multiples relative to the total level of existing credit in the system, but, then again, what asset class isn’t?). More likely, I believe that the adjustment process will take additional years, perhaps even many, and gold could ultimately spike to absurd levels against all fiat currencies before finally settling back. If I happen to sense an inflection point at which some part of the world is about to adopt more rational policies that could benefit alternative assets, or that governments are on the verge of taking steps that could limit gold’s potential, I will convert my gold into the better opportunities that I have identified, perhaps in the order discussed.
Until the debt has dwindled to a manageable level, I certainly would rather camp in these investments than to risk putting a dime’s worth of my gold into reproducible fiat money! However, just in case it is the gold bugs who realize their righteous dream of a humanity starved for gold and it is I who miscalculates, I shall preserve just enough of the physical metal to last me the rest of my life. It wouldn’t take much.
