Preserving Wealth with Gold Shares

March 22, 1999

One of the great risks investors face now that we are at the peak of greatest bull market in stocks the world has ever seen, arises from a widespread ignorance and bias against gold as an investment. Investors are constantly steered away from gold investments by Republican and Democrat Administration alike as well as Wall Street spin-doctors. Why? Because by relegating gold to the status of "just another commodity" in the minds of the public, the power to run the printing presses in order to pay for political favors and bail out corporate friends remains unchallenged. Moreover, a panic out of paper into gold, which has been superior to all other forms of money for thousands of years, would accelerate the demise of the U.S. Dollar and hence U.S. global economic supremacy. From the government's viewpoint as well as Wall Street's, investors must be kept believing paper money is better than gold so our promiscuous financial orgy can continue. Propaganda titles like "Gold has lost its luster" may shape opinion in the short run, but history is not on the side of paper vs. gold longer term.

One does not need to look beyond the international bailouts of the past decade to see how the establishment protects its own. Large banks and most recently a huge hedge fund have been rescued by using "printing press" money to help them retain strong balance sheets when they would otherwise need to write off huge loans resulting from economic disasters like Mexico, Brazil, Russia and a host of Asian countries. International banking concerns like Citicorp, Chase Manhattan, Morgan Stanley and Goldman Sachs can confidently enter markets offering enormous rates of return without needing to face high levels of risk commensurate with those high returns. Firms deemed "too large to fail" are confident government will come to their aid, thanks to the ease of printing money. What a deal for the elite! The Clinton Administration has demonstrated time and time again that a flood of printing press money will be made available as needed to keep the balance sheets of the big banks healthy and thus avoid painful business cycles. We can't argue against such a noble goal but the problem with that "solution" is that each successive bailout worsens the global imbalance between supply and demand, not to mention the misallocation of resources. Rather than allowing the invisible hand of the market to establish balance between supply and demand in the global markets, the stock market and economic bubbles are pumped up to even greater levels of the absurd. Accordingly, the eventual day of reckoning is likely to be all the more devastating when it arrives.

Regular readers of this letter are quite aware of my belief that we are entrapped in a global self perpetuating downward spiral of economic activity that is feeding on itself. This notion appears absurd to most Americans, who have not only managed to avoid the economic misery common throughout the world, but in fact have benefited from it. But globally, the detachment of gold from currency has over the past sixty years, removed all discipline from the creation of money and credit. The explosion of money and credit, which is tied to the exponential growth in federal debt pictured on the following page, fueled the greatest bull market in stocks the world has ever seen. It was this creation of excess liquidity that has been largely responsible for inflated stock prices. The trouble is that always in the past, periods of excessive credit and money creation have led to economic collapse. Also at every cyclical top, the most educated, in-the-know "hot shots" assured the populace that "this time it is different". The experts have always been wrong!

Relationship between the Dow Jones Industrials & Gross Federal Debt This graphic is available in the March 10, 1999 issue of J Taylor's Gold Resource & Environmental Stocks newsletter.

The explosive creation of money and credit pictured above, combined with supply side economics, the demise of communism, and huge technology gains have resulted in enormous oversupplies of almost every good and service imaginable. Instead of price inflation, we have "supply inflation". Massive supplies would not be problematic if effective demand in the global economy were in balance with those supplies. But, demand continues to fall behind the expansion of supplies that are being pumped out at a furious rate by developing countries with excessive capacity, in an attempt to meet their huge and growing debt obligations. Despite their noble efforts, the ability to service debt is declining because profits and cash flows are falling due to slumping demand and profit margins. This, my friends, is a recipe for disaster. It is the same recipe that led to the Great Depression of the 1930's. Only this time the credit expansion is much bigger, which leads this writer to believe the ultimate correction could be akin to or even greater than the devastation following the Crash of 1929.

To keep American consumers spending and American banks lending, the Fed and the Clinton Administration have been pumping up the stock market and bailing out banks with easy credit. But these policies simply make a bad problem worse in the long run by adding to excessive macroeconomic supplies. What is truly needed if we are to escape an eventual global economic meltdown are policies to stimulate global demand, most notably through more egalitarian income distribution in the developing countries. Those kinds of changes almost never take place peacefully, except by divine intervention. Such intervention has taken place in western culture where Judeo-Christian faith led to values that paved the way for economic freedom and a relatively egalitarian income distribution. As a believing Christian I always hope for a global revival of Christian faith. Such a revival could be expected to bring with it a continuation of peace, prosperity and freedom. But the relevancy of faith to economic prosperity is a notion increasingly viewed by westerners as lunacy. Trusting in our own wit rather than submitting to God's laws is more the direction of western culture than it has been for 220 years of American history. The religion of Humanism will bring disaster. You can count on it!

Having adopted Humanism as their god, our power brokers assume there is no economic problem a proper monetary policy cannot fix. Apparently, they have forgotten that monetary policy failed to reverse the downward spiral of economic activity during the 1930's, for a host of reasons, including excessive debt loads and shrinking profit margins - the same problems that afflicts the global economy now. In fact, easy monetary policy even now simply pumps up "Wall Street", not "Main Street", thus leading to even greater stimulation of the supply side of the economy. Thanks to the absence of a gold standard, the narcotic of easy money has allowed us to avoid economic pain in the short run by pumping money into the our economic veins. But like drug addiction, the final outcome of this economic addiction can also be violent so that a devastating conclusion to the existing credit bubble may also lie ahead of us, perhaps sooner than we imagine.

Preparing for the Decline with Gold Shares

The $64 question is what can we do to prepare ourselves for the carnage that is most likely to visit us when the day of reckoning arrives? Aside from placing faith in our God, there are certain things we can do as mere mortals to prudently prepare for financial adversity, such as allocating some exposure to gold. A study of history suggests that an allocation of at least 10% of one's investment portfolio to gold shares may be able to provide a considerable amount of insurance against financial devastation.

A Homestake Mining "Portfolio Insurance Policy"

There have been times, as during the past 18 years, when owning gold shares would not have been beneficial. However, during times of significant economic and political adversity, owning gold has been an enormously effective way to retain portfolio value. The case can be made that over the long term, investment portfolios containing gold mining shares do much better than those without equity exposure to the yellow metal.

It is not easy to find gold mining companies with long histories that can be used to prove this point. One company though that has been around for quite some time is Homestake Mining. I am indebted to Mary Magnani, from Investor Relations at Homestake Mining for providing me with extensive share price data on Homestake that dates back to 1888. To determine whether or not owning gold shares could enhance portfolio value over the longer term, I constructed a series of portfolios including: I) 100% allocated to the Dow Jones 30 Industrials; II) 100% allocated to Homestake Mining; and III) a series of portfolios comprised of various weight combinations between Homestake and the DJIA. The model I constructed assumed that $1,000 was initially invested in January 1903 and that "x" percent of an allocation to Homestake was made on the first business day of each year. What my number crunching exercise revealed was:

  1. The performance of a portfolio of DJI stocks could be significantly enhanced by allocating a percentage up to 31% of that portfolio to Homestake and,
     
  2. The optimum allocation to Homestake Mining was 15% (See Chart II).
     

Portfolios choosing the DJIA and the one with DJIA + Homestake were started in 1903 with an assumed $1,000 initial investment.

The advantage of allocating the optimum 15% to Homestake on a decade-by-decade basis plus the year ending 12/31/31 and the 8-year period ending 12/31/98 can be seen from Chart III.

Decade Ending DJIA Only DJIA + Homestake Difference
1910
1920
1930
1931
1940
1950
1960
1970
1980
1990
1998
$1,820
$1,540
$5,130
$2,830
$2,780
$5,020
$13,150
$17,680
$20,590
$56,210
$195,160
$1,820
$1,520
$4,730
$3,350
$4,640
$7,460
$18,110
$24,440
$39,140
$87,770
$245,300
0%
-1.3%
-7.8%
+18.4%
+66.9%
+48.61%
+37.7%
+38.2%
+90.1%
+56.2%
+25.7%

A 15% allocation to Homestake between the years 1903 through 1930 reduced returns, especially during the roaring 1920's bull market in stocks. Such a portfolio would have grown from $1,000 to $4,730, or 17% less than the $5,130 value a DJI only portfolio would have earned. However, by the end of 1931, the tables began to turn with a vengeance, when the portfolio including Homestake was 18.4% higher than the Dow Jones only portfolio. The depression years, when deflation not inflation was a major problem, proved to be a great environment gold investments. By the end of 1940, a 15% allocation to Homestake would have allowed our hypothetical investor to build a portfolio value of $4,640 compared to the DJIA portfolio of $2,780. Incredible as it may seem, a 15% allocation to Homestake would have allowed an investor to essentially eliminate the devastating stock market losses of the Great Depression. The DJIA portfolio lost 45.8% from 1930 to 1940, but the DJIA + Homestake portfolio lost just 1.9% at a time when purchasing power was rising.

Portfolio performances for years 1903-1930

This graphic is available in the March 10, 1999 issue of J Taylor's Gold Resource & Environmental Stocks newsletter.

Portfolio performance for years 1903-1940

This graphic is available in the March 10, 1999 issue of J Taylor's Gold Resource & Environmental Stocks newsletter.

Post World War II prosperity and another stock market boom resulted in the DJIA + Homestake declining vis-à-vis gains made in the DJIA only portfolio until the 1970's when Homestake provided a marvelous insurance policy once again. As the 1968-1982 bear market in stocks was born, gold entered into a the greatest bull market in that money's history. So, by 1980, our hypothetical $1,000 invested in 1903 in the DJIA + Homestake grew to $39,140 compared to only $20,590 for the Dow only portfolio. This represented a 90.1% advantage for the portfolio containing a 15% allocation to Homestake.

The ebb and flow of this century's long term cycle again reversed in favor of the DJIA as the greatest bull market in stocks ever got under way in 1982. By the end of 1998, the advantage of our hypothetical DJIA + Homestake portfolio declined to just 25% as pictured in Chart VI.

Portfolio performance for years 1903-1980.

This graphic is available in the March 10, 1999 issue of J Taylor's Gold Resource & Environmental Stocks newsletter.

Why Homestake Helped

Annual Returns for Homestake and the DJIA

This graphic is available in the March 10, 1999 issue of J Taylor's Gold Resource & Environmental Stocks newsletter.

The chart above demonstrates why the inclusion of Homestake has been so beneficial over the longer run in enhancing wealth. The answer is to be found in gold, which generally provides returns that have a low or negative correlation with stocks. The fortunes of a major mining company like Homestake is tied very closely to the price of gold. And since gold prices tend to rise when cataclysmic events unfold with the market, the price of Homestake provided enormous safety for investors during the 1930's and 1970's. The negative low/negative correlation of returns between Homestake Mining Company's shares and the Dow Jones 30 Industrials can be seen from Chart IX below. Note the huge rise in Homestake when the DJIA fell during the 1930's and again in the 1970's.

The negative correlation of returns between Homestake and the DJIA can be seen from Chart IX that follows. Note the huge rise in Homestake when the DJIA fell in value, especially during the 1930's and 1970's.

Homestake is not currently among the senior gold shares recommended by this letter although we may initiate coverage in the near term. At the present time, we think there are other major gold producers like Anglo Gold and Newmont Mining that also offer the kind of protection Homestake offered investors during this past century. Another good way to insure your portfolio with gold shares is through the purchase of a gold share mutual fund. On our list at present is the Midas Fund, which we continue to like a great deal. The gold share mutual fund that has been around the longest is the International Investors Fund, which is part of the Van Eck family of funds. We plan to talk about this fund in next month's letter.

Next Month - Beating the Dow with Bonds & Gold

Last month I talked about a book I recently read called "Beating the Dow with Bonds." This well documented book written by Michael B. O'Higgins provides a time proven method for enhancing overall returns by answer the following questions at the start of each year:

  1. Should I invest in stocks or bonds?
     
  2. If the answer to Q-1 is "bonds", then do I want to be in long term or short term bonds?
     
  3. If the answer to Q-1 is "stocks", which stocks can I invest in that will maximize my returns each year? In combination with data from Mr. O'Higgins, I have imposed results from the International Investors Gold Fund to see if gold can improve on O'Higgins spectacular results. Be sure to keep your subscription current so you do not miss the results.
In every cubic mile of sea water there is 25 tons of gold