Bingham on Gold

November 28, 2001

It seems only yesterday, we were hearing a lot about a new era, but now we are actually living in one, not because of Sept. 11th, which is not an occasion to be used to promote self interest. The extirpation of the terrorists is not likely to weaken the productive capacity of the U.S., neither is it likely to undermine the country's monetary and financial well being. Long term and widespread profligate private and public financial practices suffice.

Therefore, today I am going back to basics to discuss gold and gold shares both as money and as alternative investments.

The trick to alternative investing is to know what is truly an alternative. The best would be one, which has a negative correlation with the rest of the portfolio but provides a high enough return in difficult times to reduce long term volatility and to preserve or increase the overall return over the investment cycle. As I see it, gold and gold shares are that alternative because they are not dependent on the business cycle for their value. Others such as oil, natural gas, timber, venture capital, and real estate may all be fine investments, but may not be the best alternatives during financial stress because they are all heavily used in the production of goods and services.

The combination of its physical properties and historical use has made gold and gold mining shares particularly suitable to serve as a hedge against inflation and general economic instability. The uniqueness of gold's characteristics means that gold's valuation often moves independent of fluctuations in the business cycle. These characteristics include:

1) Gold has been used as money for thousands of years, and is also a monetary reserve asset. The United States holds 70% of its reserves in gold and major European Nations also hold large gold positions.

2) Gold is scarce but durable. Virtually all of the 140,000 tonnes produced throughout history are still in existence. Most are held because of gold's monetary and wealth identifying characteristics.

3) Gold has few industrial uses, and those it has do not destroy the gold.

These characteristics have led to gold's distinctive distribution pattern.

Gold's Distribution Pattern

Unlike commodities, gold is produced for accumulation.

No commodity in the world has a distribution pattern remotely resembling gold's. Commodities are produced for consumption. Gold is produced for accumulation.

Additions to above ground gold supplies rarely exceed 2% a year, similar to productivity improvement. Therefore, gold's value has been stable over long periods of time. Periodic fluctuations in gold's price primarily have reflected changing perceptions in the value of paper money and confidence in financial instruments. That is why gold's value has increased during periods of recession and deflation, as well as during rapid inflation.

During the deflation of the early 1930's fears of devaluation and the safety of securities and deposits led to rising demand for gold. In 1934, under a fixed gold price system, the United States Government succumbed to the market and raised the gold price 69% despite a 20% drop in consumer prices. Gold mining shares soared and paid high and rising dividends throughout the depression. During the great inflation of the1970s, gold rose in two great waves from $35 to $850 an ounce. Gold mining shares soared and by the early 1980s many were paying dividends equal to their prices a few years earlier.

Confidence was once defined by Benjamin Disraeli, as "suspicion asleep." And the most glaring example of "suspicion asleep" is Marco Polo's description of paper money, which he first saw in China in 1271 A.D. He wrote:

" All these pieces of paper are issued with as much solemnity and authority as if they were pure gold. A variety of officials write their names and put their seals on the paper. The chief officer smears the seal with vermilion and impresses it on the paper so that the seal remains printed upon it in red. The money is now authentic. The Kahn each year creates a vast quantity of the money which he exchanges for gold and silver so that the great Kahn, in fact, has more treasure than all the kings of Europe."

Twenty years later these "notes" became totally worthless. The Chinese had been Kahned. They learned the hard way that paper money is a note, a form of credit, and that gold is money.

This is the product of gold's 6000-year history. Fifty years ago, central banks held 70% of the world's gold. Even then, they were unable to suppress gold's price indefinitely. Today, they hold less than 25%. But despite the growing monetary feebleness of central bankers, the market hangs on their every utterance.

This is a two part, three decades history of credit growth in the United States.

Credit growth appears to have been slightly slower in the 1990s than during the 1970s. In reality it has been faster when the leverage effect of derivatives is included. Derivatives barely existed in the 1970s, but since as recently as 1994 have more than quintupled to $100 trillion according to the Bank for International Settlements. These derivatives added heavily to general economic risk. Falling dominoes soon may become more than a game.

This is evidence of a bubble in the markets, excessive debt being absorbed by a seemingly endless bull market rather than by seemingly endless inflation. Sadly for most, it is at the peak of a credit induced speculative bubble that confidence in the paper money system is highest because at that point the recent returns on paper assets have been spectacular. In 1929, only a few Cassandra's warned of the impending doom and in the broad 1966-1972 top formerly conservative pension funds proudly proclaimed their 100% commitment to common stocks.

This is one reason the purchasing power of gold, which is stable over long periods, is not constant. In 1934 an ounce of gold could buy a good suit. By 1970, with the government in control of the market an ounce could buy only the vest. By 1980, with confidence in paper at its nadir, the same ounce could buy two suits. Today I guess it's worth a jacket.

By the same token the purchasing power of the Dow Jones also fluctuates. It was not until 1966 that the Dow regained its 1929 purchasing power, and then not until 1995 that it could buy what it bought in 1966.

Today, the focus of the gold market on central bank activity may be misplaced and may even be the forerunner of a change in sentiment because:

First, over the long term central bank gold sales are irrelevant to the value of gold. Central bank holdings amount to little more than 30 days trading volume. The gold price, like stocks and bond quotations, depends on perceived value, which changes with perceived economic conditions. Nevertheless, the attitude of a major holder of any investment may affect public sentiment. If the world's largest mutual funds were to announce that they intended to reduce their common stock holdings, the Dow would be in trouble-until the fund managers were proved wrong. That is about what central banks have done from time to time. During the late 1920s, Britain exchanged gold for its own paper only to see gold double by 1934 against a devalued pound. During the 1960s, central banks disposed of gold at $35 an ounce and were proved wrong when gold rose to almost $200 in 1974. They were proved wrong again in the late 1970s when they sold gold at $200 on its way to $850 an ounce.

Suspicion may lurk, but confidence in paper money and financial instruments remains high, as illustrated by:

1) The continuing high valuation of many Dow Jones type stocks, 6 to 7 times book value and 1.5 % dividend yields are unprecedented even at the peak of any previous bull market.

2) The assumption that the business downturn will be mild and limited to a final inventory correction. So far, sales have been falling as fast as inventories.

More important, Alan Greenspan, an early proponent of the inventory correction theory, said in July, "the demand for capital equipment, particularly in the near term, could pose a continuing problem." Later in his testimony he said, "A deterioration in sales, profitability, and cash flow has exacerbated the weakness in capital spending. He also noted that weakness was not limited to high tech, but was "evident across the board".

Capital spending propelled the economy up and is now propelling it down.

Standard and Poor's has announced sharp drops in corporate earnings for three consecutive quarters with casualties stretching across the economic spectrum.

3) The high flying and highly leveraged real estate market still survives the credit-financed bubble despite rumblings of office vacancies and the apparent cooling of the residential market. The cancellation of government thirty-year bond sales look like a thinly disguised tactic to bolster real estate prices and to save financially wobbly corporations.

4) The expectation that there will be no serious financial fall out from the slowdown despite banks' rising non-performing loans and heavy involvement in real estate. Bank stocks continue to sell at reasonably good prices. Fannie Mae and Freddie Mac shares are at spectacular prices despite financial leverage in real estate lending that would make even the banks flinch.

5) The dollar so far has defied a massive current account deficit, by attracting a huge flow of foreign capital. Recently the risks have grown as both direct foreign corporate investment and highly mobile portfolio inflows have shrunk. Treasury Secretary Paul O'Neil may yet regret saying he is not worried about the current account deficit, and that a strong dollar is a side effect of a strong economy. However, any weakness of the dollar, should not be mistaken for Euro or Yen strength. The Yen suffers from continuing economic malaise and a central bank that is monetizing government deficits. The impediments of the Euro include no sovereign control, uncertain continuity, and a plethora of weak currency nations knocking on the Euro's door.

Then there is Argentina and other emerging markets, as well as Japan, all of which are in financial straits. One wonders when the hot money in these nations will follow Secretary O'Neil's dictum "to take a bath".

And here are statements by two people in the know, which could make one think twice. Last spring, testifying about economic conditions, Alan Greenspan said. "One big risk is that consumer confidence could crumble like a dam being breached. The torrent carries with it most of the remnants of certainty and euphoria that built up in earlier periods." Soon thereafter the Japanese Finance Minister warned, " Government finances are on the verge of collapse."

And here are two more from respected economists just in late October. One said, "monetary policy doesn't have the potency it did prior to the bubble in business investment". The other " with zero real short term interest rates, 10 and 30 year bond yields remaining steeply higher than overnight rates and a ballooning money supply, along with the huge increase in government purchases, the risk of inflation pressures over the long term have clearly risen."

If any or all of these gentlemen are proved correct, the gold pit may soon be rumbling and the watchword for paper money may be "Look out below! ", and the golden rule that " he who has the gold, makes the rules" may be invoked.

Gold is impervious to rust.