“Gold is money.”

The legendary financier’s retort could have made an excellent title for this chapter, as it has for many essays on gold. Alternative inspiration comes from Aristotle, who wrote over 2,300 years ago, “Money is a guarantee that we may have what we want in the future. Though we need nothing at the moment, it insures the possibility of satisfying a necessary desire when it arises.”

Aristotle clearly believed that the concept of money implied a guarantee of purchasing power, but paper money, as we know it, is anything but that. The US dollar, the most widely held currency in the world and the primary reserve currency, would have disappointed Aristotle deeply in its inability to guarantee purchasing power over time. Today’s dollar, adjusted according to the Consumer Price Index, is worth 69.1 cents in 1990 dollars, 44.5 cents in 1980 dollars, 20.5 cents in 1970 dollars and 15.4 cents in 1960 dollars.

What would Aristotle have thought of the concept of paper money and the pathetic loss of purchasing power over time? By the Greek philosopher’s time (384 BC-322 BC), gold had already been accepted as the major form of money. The first mentions of gold are found in Egyptian hieroglyphs dating to 2600 BC, and the first coinage of gold currency happened around in 650 BC in Lydia (now Northwest Turkey), a burgeoning kingdom in Asia Minor.

Gold Bullion Versus Gold Stocks

An important distinction between gold bullion and gold stocks must be made. They are not the same thing. It is true that when gold rallies, gold stocks tend to rally, and vice versa. This is quite similar to what happens to copper mine stocks when copper rallies, or what happens to oil company stocks when oil rallies.

Gold stocks are paper assets, while gold bullion is still considered one of the most reliable hard assets around. In other words, gold stocks are considered investments--companies try to mine the metal profitably and must constantly look to expand their business. Gold bullion is considered a hedge--in times of great uncertainty, the stocks and the metal can diverge significantly.

A good example is Black Monday, October 1987. Gold stocks sold off dramatically to the tune of 30 to 40 percent, while gold bullion rallied. The same thing happened in July 2002 during one of the most vicious stock market selloffs since the top in the major indexes in 2000. Gold bullion didn’t decline much, while gold stocks sold off 30 percent in just three weeks.

Many investors who caught a big part of the move in gold stocks off the 2000 lows were puzzled by their sharp decline in 2005. The early 2005 selloff was caused by a relief rally in the US dollar, borne by rising short-term interest rates and a tightening of monetary policy. Such conditions are dollar bullish, as they decrease temporarily the rate at which extra dollars are being dumped into the economy. Unless there is permanent change to long-term trade policy, or in the behavior of the US central bank, it is unlikely that the 2005 dollar rally will turn out to be anything more than a big upside correction in an ongoing multi-decade bear market for the US currency.

Since the US dollar (USD) was floated in 1971 after the end of the Bretton Woods agreement, it has declined against almost all major currencies over the long term. One can still extrapolate the exchange rate of the German mark (DM) though the exchange rate of the euro. By looking at the history of the USD/DM relationship, you can see what a 30-year-plus bear market looks like. Without getting too technical, this is the history of a broad decline in five major waves--in its wake are lower lows and lower highs. Since the dollar declined relentlessly in the 2002-04 period, there is room for a countertrend move, but ultimately, due to current macroeconomic policies, any upside correction is likely to fail.

Regarding US dollar/Japanese yen trading history (USD/JPY), the moves are even more extreme due to Japan’s perennial trade surplus with the US.

Some currencies, like the Australian and New Zealand dollars, have not performed as well over the long term against the greenback (save for the all-encompassing comeback in the 2002-04 period). But since 1971, the story of the US dollar is one of substantial decline.

Any correction in gold bullion in the rally off the 2001 lows is a good risk/reward entry point if you want to buy some bullion and if you plan to keep it for the next five or 10 years. Check www.kitco.com for gold and silver bullion quotes and pricing. Kitco can store the gold for a fee, but if you want to go though all the trouble of acquiring physical gold bullion you’re probably better off renting a safe-deposit box in a major bank.

A lot of investors disagree with the concept of storing gold in a safe-deposit box, since the monstrous rally in gold is a question of when, not if, and one must protect against confiscation risk. That confiscation risk is non-existent in the 21st century is a nice thought, but ownership of gold bullion by private individuals has been restricted in the US in the past. Therefore, while storing physical gold may be inconvenient and costly, some will certainly prefer that over having someone else store it. Several exchange-traded trusts, the shares of which can be purchased through a brokerage account, provide a more cost-effective way to hold gold bullion as a hedge without the difficulties of physical storage. These trusts, one in London and two in the US, are very similar in their structure. The biggest US exchange-traded trust is the streetTRACKS Gold Trust (NYSE: GLD), whose shares trade at one-tenth the price of gold and represent fractional ownership in the trust. The trust is sponsored by a subsidiary of the World Gold Council, the leading global authority in the gold mining industry. State Street Global Advisors, the largest institutional asset management firm in the world, handles marketing and advisory efforts for the trust.

The much-anticipated November 18, 2004, launch of the streetTRACKS Gold Trust reduced the significant barriers to ownership of gold bullion for many investors. Those once deterred by the large sums of money necessary to buy physical gold bullion, as well as the difficulty of storing and insuring those holdings, now had a simple, convenient investment vehicle. As of this writing, the trust had amassed roughly $2.5 billion in gold bullion stored securely in an HSBC Bank vault in London.

© 2006 Yiannis G. Mostrous
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